TAX REDUCTIONS, THE ECONOMY
AND THE DEFICIT IN THE ARIZONA
STATE GOVERNMENT GENERAL FUND
A Report from the Office of the University Economist
November 2008
Dennis Hoffman, Ph. D.
Professor of Economics, University Economist,
and Director, L. William Seidman Research Institute
Tom R. Rex, MBA
Associate Director, Center for Competitiveness and Prosperity Research
Center for Competitiveness and Prosperity Research
L. Wiliam Seidman Research Institute
W. P. Carey School of Business
Arizona State University
Box 874011
Tempe, Arizona 85287- 4011
( 480) 965- 5362
FAX: ( 480) 965- 5458
EMAIL: Dennis. Hoffman~ asu. edu
ww. wpcarey. asu. edu/ seid
SUMMARY
The state governent general fund shortfall in the current fiscal year is projected to be near $ 1
billion - even after transfers of monies from the rainy- day fund and other funds. This is in
addition to a shortfall of more than $ 1 bilion in the last fiscal year. At current trends, the budget
may ultimately grow beyond a bilion dollars in the current year and an even larger deficit is
proj ected for the next fiscal year.
While the current economic recession is significantly worsening the size of the budget deficit,
the real problem is a structural deficit caused by substantial tax cuts not offset by equivalent
spending decreases, and by not putting enough money into the rainy- day fund. The state faces
the prospect of budget deficits every time economic growth slows.
Numerous and substantial tax reductions passed by the Legislature over the last 15 years have
not stimulated the Arizona economy or caused a surge in governent revenues. Relative to the
size of the Arizona economy, state governent general fund revenue has fallen significantly
since 1995, likely reaching a historical low in the near term. Expenditures also have declined
relative to the size of the economy. Spending increases beyond the needs of a growing state are
not a cause of the current deficit or the long- term structural deficit.
State and local governent revenues and expenditures in Arzona also are historically low
compared to the rest of the nation. For example, the Tax Foundation ranks the Arizona tax
burden, defined as per capita taxes as a share of per capita income, as 41st in the nation in 2008,
the lowest on record.
Much of the structural deficit results from the tax cuts of the last 15 years. These revenue cuts
were not matched by spending cuts of a commensurate size because of the increasing population-driven
demands for public services and infrastructure, such as education and public safety. The
structural deficit also results from an outdated tax code that creates large cyclical swings in
revenue and causes revenue to grow more slowly than the pace of the overall economy. Many of
the changes to the tax code during the last 15 years exacerbated these problems.
Other actions also have contributed to the near- term dilemma. For example, the Legislature
weakened the provisions of the original legislation setting up the budget stabilization fund. The
result is less monies available for transfer from the rainy- day fund to the general fund, and a
greater need for spending reductions or revenue enhancements to balance the budget, during a
recession.
A deficit of$ l billion represents 10 percent of the state's general fund appropriations. However,
since 45 percent of the general fund is protected from budget cuts, the remainder of the general
fund is facing a deficit equal to 18 percent of its budget.
The current state government general fund deficit wil need to be closed through spending cuts
and/ or revenue enhancements. All of the " easy" budget fixes were used to balance last year's
budget. Further, only limited monies remain in the rainy- day fund. The mix of expenditure
reductions and revenue enhancements used to balance the budget should be carefully considered
for several reasons.
1
First, unlike much of the private sector, demand does not decline for most public- sector services
during a recession. In some governent programs, demand rises. Thus, imposed decreases in
public spending during recessions come at the same time that demand for public services is
stable or rising, resulting in a reduction in the quantity and/ or quality of governent services.
For the most disadvantaged of those consuming public services, real hardship can ensue.
Second, spending reductions by governents during recessions worsen economic conditions.
Less spending for goods and services by governents wil result in reduced demand for private-sector
goods and services. If spending reductions are accomplished by employee layoffs, then
private- sector businesses are affected further as laid- off workers either leave the state or cut back
substantially on their purchases. It is not realistic to expect that many laid- off governent
employees will find jobs in Arizona until the recession has ended.
The result of state spending cuts of $ 1 billion would be to very significantly worsen and lengthen
the economic recession. A total of approximately 20,000 workers ( 8,000 state governent and
university workers and 12,000 others) might lose their jobs.
Third, cutting the public- sector workforce causes public- sector revenues to decline as the laid- off
workers spend less and experience losses in income. Further, the savings to state governent of
not paying the former workers' salaries and benefits are partially offset by rising payments to the
ex- workers for unemployment insurance and other public health and welfare programs.
Fourth, the negative economic effect of a tax increase would be no larger than that of a
governent spending decrease. In fact, it should be less. Some ofthe tax payments would come
from personal savings. A portion of a tax increase would be exported to nonresidents and to the
federal governent ( since state taxes are federally deductible).
The negative effect of a tax increase would be spread across the state, with individual households
and businesses suffering only slightly. In contrast, a spending reduction would have substantial
negative effects on a relatively small number of businesses - those selling directly to state
governent and to laid- off governent workers. A relatively small number of individuals also
would bear the brunt of a governent spending reduction: laid- off governent employees and
workers at hard- hit businesses.
Fifth, the size of a tax increase would be relatively small. Even in the extreme example of a tax
increase of $ 1 billion that affected individuals only and was not exported, the increase would
equate to only about $ 150 per Arzona resident, or $ 400 per household. A tax increase of this
magnitude would offset only about a third of the state tax cuts implemented between 1993 and
2008 and would be considerably less than the federal tax rebates distributed in May. Arizona stil
would rank as a low- tax state at 37th, just lower than Mississippi, according to Tax Foundation
data ( assuming no other states increased taxes).
Sixth, without enhancing revenues, the state will be unable to adequately support a growing
population. In particular, Arizona faces substantial infrastructure needs over the next quarter
century.
2
TAX LAW CHANGES
Changes to Arizona's tax laws have been numerous since 19891, following a period oflimited
changes during the mid- 1980s. Initially ( from 1989 through 1992), the changes resulted in
substantial increases in tax collections. Since then, the changes have resulted in reductions in tax
collections in all but two years, as Arzona policymakers have taken many opportunities to
reduce tax burdens, primarily for individuals. Substantial reductions were implemented in each
year from 1995 through 2001, and again in 2007 and 2008.
As estimated by the Joint Legislative Budget Committee, the nominal dollar effects of the tax
law changes are shown in Table 1. The cumulative effect of these annual changes sums to a
revenue loss of about $ 1.18 billion. Adjusting for inflation, the cumulative loss is somewhat
greater at $ 1 .29 billion. Adjusting for population growth as well as inflation places the loss at
$ 1.38 billion. The limited effects from the adjustments for inflation and population growth result
from tax increases, not decreases, in the earliest years of the time series. Tax law changes since
1993 cumulate to a decline in general fund revenues of about $ 1.63 billion on a nominal basis
and $ 2.58 billion after adjusting for inflation and population growth.
Expressed as a percentage of general fund expenditures, the effects of the tax law changes were
large from 1989 through 1991, raising revenues at least 3.6 percent in each of the three years.
Between 1995 and 2001, the decreases in revenues ranged from 1.8 to 6.5 percent of the size of
the general fund. In 2007 and 2008, the tax cuts amounted to about 2 percent of the size of the
general fund. The tax increases of 1989 through 1992 were reversed by 1996 on a nominal basis,
by 1997 on a real basis, and by 1998 on a real per capita basis. Tax decreases since then have
lowered general fund revenues to considerably below the historical norm, after adjustments for
economic and population growth.
Tax Changes and the Economy
The relationship between tax law changes and economic performance was examined using
quarterly earnings data from the U. S. Bureau of Economic Aralysis. The quarterly data allow the
economic figures to be aligned with the fiscal year general fund data. While gross domestic
product by state is the broadest measure of the economy, inflation- adjusted data go back only to
1990 and the data are only available annually. Thus, the next- broadest economic measure -
earnings - is used. The data were adjusted for inflation using the quarterly GDP implicit price
deflator.
Changes in general fund revenues resulting from tax law changes in Arzona have been inversely
related to real earnings growth. The highest correlation of -. 64 occurs when the percent change in
economic growth leads by one year the tax change as a share of general fund expenditures. The
second highest correlation of -. 58 occurs when economic growth and the magnitude of the tax
change in the same year are compared. Thus, the change in economic performance precedes the
change in taxes. When the economy is strong, surpluses in the general fund are realized, allowing
taxes to be cut while still balancing the budget as required by the Arizona Constitution. When the
economy is weak, budget deficits occur, precluding tax cuts and sometimes resulting in tax
increases.
i All years in this paper refer to the July 1 to June 30 fiscal year used by the State of Arizona. Measures of economic
growth and inflation were converted to a fiscal year basis.
3
The effects of the tax law changes expressed as a percentage of general fund expenditures are
shown in Chart i compared to inflation- adjusted earnings growth. As seen in the chart, the
Arzona economy is highly cyclical, with the growth rate of inflation- adjusted earnings ranging
from about 0 to i 0 percent over the last 25 years. While real growth in this measure has not been
more than marginally negative during recessions, this is due to the state's rapid population
growth. Real per capita earnings fell from 1989 through 1992, from 2002 through 2003, and
from 2007 through 2008.
TABLE 1
ARIZONA GENERAL FUND TAX CHANGES
GDP
Nominal Implicit Real
Fiscal Incremental Price Arizona Incremental
Year Tax Change* Deflator Population Tax Change*
1989 $ 121,700,000 0.6377 3,535,183 $ 190,828,369
1990 109,300,000 0.6609 3,622,184 165,368,553
1991 208,376,000 0.6867 3,684,097 303,435,939
1992 9,707,500 0.7062 3,788,576 13,746,880
1993 - 19,343,100 0.7219 3,915,740 - 26,794,189
1994 - 25,452,500 0.7377 4,065,440 - 34,503,339
1995 - 120,693,000 0.7537 4,245,089 - 160,144,456
1996 - 284,668,400 0.7684 4,432,499 - 370,4 71,655
1997 - 174,537,300 0.7821 4,586,940 - 223,155,116
1998 - 172,380,000 0.7926 4,736,990 - 217,492,295
1999 - 141,790,900 0.8025 4,883,342 - 176,679,543
2000 - 104,614,100 0.8169 5,023,823 - 128,057,559
2001 - 157,803,100 0.8358 5,167,260 - 188,799,044
2002 - 33,171,300 0.8538 5,301,097 - 38,849,963
2003 12,381,000 0.8696 5,444,881 14,237,087
2004 57,418,100 0.8906 5,579,307 64,474,142
2005 - 4,942,000 0.9183 5,744,367 - 5,381,779
2006 - 18,050,000 0.9498 5,952,083 - 19,003,599
2007 - 193,758,600 0.9777 6,165,689 - 198,177,015
2008 - 217,510,000 1.0000 6,338,755 - 217,510,000
2009 - 34,550,000 1.0250 6,475,000 - 33,707,317
Cumulative - 1,184,381,700 - 1,286,635,898
Cumulative Real Per Capita Multiplied by 2009 Population ;,;,;,;,;,;,;,;,
Real Per Capita
Incremental
Tax Change
$ 53.98
45.65
82.36
3.63
- 6.84
- 8.49
- 37.72
- 83.58
- 48.65
- 45.91
- 36. 1 8
- 25.49
- 36.54
- 7.33
2.61
11.56
- 0.94
- 3.19
- 32.14
- 34.31
- 5.21
- 212.73
- 1,377,424,565
* Each yearly amount represents the incremental dollar value of tax law changes relative to the
prior year.
Sources: The nominal incremental tax change is from the Arizona Joint Legislative Budget
Committee, published in the State of Arizona 2008 Tax Handbook. The GDP Deflator is from the
U. S. Department of Commerce, Bureau of Economic Analysis; it is the fiscal year average, with
the base being FY 2008. The Arizona population estimate is from the U. S. Department of
Commerce, Census Bureau; it is the figure at the beginning of the fiscal year. The GDP deflator
and population for FY 2009 were projected.
4
CHART 1
INCREMENTAL TAX CHANGE AS A SHARE OF GENERAL FUND EXPENDITURES
AND PERCENT CHANGE IN INFLATION- ADJUSTED EARNINGS
12
10
8
6
4
2
0
- 2
- 4
- 6
- 8
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Fiscal Year
1- Tax Change - Earnings I
Sources: Arizona Joint Legislative Budget Committee and U. S. Department of Commerce,
Bureau of Economic Analysis.
A close examination of Chart I reveals that economic performance leads the changes in tax
policy. Economic growth during the 1980s peaked at around 10 percent in 1984 and 1985 and
was down to 4.7 percent in 1988, the year preceding the first year of tax increases. Economic
gains continued to slow, bottoming at no change in 1990. After the recession that ended in 1991,
economic growth in Arizona began to accelerate despite the state's relatively high tax burden.
Real economic growth reached 5 percent in 1993 and rose further to 6 percent in 1994 and 7
percent in 1995. The first tax cut did not occur until 1993 and was minimal; it was not until 1995
that the first sizable tax decrease occurred, considerably after economic growth had strengthened.
Economic gains remained at 7 to 8 percent through 2000, even though the state's tax burden fell
from above to considerably below the historic norm during this period.
Despite historically low tax burdens, the state's economic growth rate fell sharply during 2001
and 2002, ending the long period of tax cuts. Following the 2001 calendar year recession,
economic growth again rose. Despite a historically low tax burden, economic growth rates
during the expansion were less than those of either of the two prior expansions. Using general
fund surpluses that largely can be traced to the real estate boom, another round of substantial tax
cuts were implemented in 2007 and 2008, with smaller reductions in 2006 and 2009. Despite
these tax reductions, economic growth fell sharply from 2006 to 2008, with no gain registered in
2008.
5
Thus, the level of state tax collections in Arzona has had no impact on the state's economic
growth over the last 25 years. However, the possibility that economic growth in Arizona relative
to the national average has been affected by tax levels needs to be examined.
Based on the Tax Foundation's measure of state and local governent tax burden - defined as
per capita taxes as a share of per capita income - Arzona's tax burden from 1977 ( the first year
available) through 1980 was about equal to the national average, with the state's rank a little
above the median state ( between 17th and 21st). Since 1981, Arzona's tax burden according to
the Tax Foundation has always been lower than the U. S. average, though it approached the
national average in 1991 when Arzona ranked 25th among the states. Since 1991, Arzona's tax
burden has declined from 9.7 percent of per capita income to 8.5 percent in 2008. The national
average tax burden barely dropped during this period and was 9.7 percent in 2008. Arzona's tax
burden ranked 41st in the nation, the lowest on record, in 2008.
The Census Bureau's governent finance data go back to 1964, but the figures for 2006 are the
most recent. Relative to personal income, the state and local governent tax burden in Arzona
historically was usually higher than the national average, typically by several percent and in
some years by more than 10 percent. Only in the early 1980s was it lower. Since 1997, however,
it has been lower than the national average in each year. In 2006, the Arizona figure matched the
lowest on record at 6 percent less than the national average. On a per capita basis, state and local
governent taxes in Arzona were 19 percent less than the national average in 2006, also the
lowest figure on record.
Despite the significant decline in Arzona's tax burden relative to other states since the mid-
1990s, economic growth in Arizona relative to the nation in recent years has been no different
than the historical relationship. Real per capita earnings growth in Arzona has fluctuated
throughout the last 25 years from higher than the national average to lower, with the differential
small in most years ( see Chart 2). Ar extended period of substantially inferior growth in Arizona
from 1987 through 1990 began long before the substantial tax increases of 1989 through 1991.
Despite the state's low tax burden in recent years, which included sizable tax cuts in 2007 and
2008, Arzona's economic growth during 2007 and 2008 dropped considerably, to substantially
below the national average. Arzona's decline in real per capita earnings and the negative
differential between the state and national growth rate in 2008 each was the largest in the last
quarter century.
That the changes in taxes in Arizona - both increases and decreases - have not had a
noticeable empirical impact on the state's economic growth should not come as a surprise. A
conceptual basis for such an effect is lacking, as discussed in the " Taxes and Economic Growth"
section.
Tax Changes and the Deficit
In contrast, the state's general fund has been substantially affected by these tax cuts. The general
fund was significantly in deficit during the last recession and is experiencing a more severe
shortfall in the current recession. While the economic recession contributes to the budget deficit,
the severity of the current deficit results from many years of significant tax cuts not accompanied
by an equivalent amount of spending cuts. These revenue reductions were not matched by
6
CHART 2
ANNUAL PERCENT CHANGE IN INFLATION- ADJUSTED PER CAPITA EARNINGS
8
6
4
2
o
- 2
- 4
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Fiscal Year
i - United States - Arizona I
Source: U. S. Department of Commerce, Bureau of Economic Analysis.
spending cuts of a commensurate size because of the increasing population- driven demands for
public services and infrastructure, such as education and public safety.
The tax reductions of the last 15 years have been the main cause of the structural deficit, which
also is the result of an outdated tax code that creates large cyclical swings in revenue and that
causes revenue to grow more slowly than the pace of the overall economy. Many of the changes
to the tax code during the last 15 years exacerbated these problems.
While reductions in expenditures have not matched the cuts in revenues, expenditures by state
and local governents in Arzona also have fallen significantly relative to the national average.
Using the Census Bureau data, per capita expenditures in 2006 were 18 percent less than the
national average. As recently as 1990, the per capita figure exceeded the US. average. Similarly,
expenditures relative to personal income were 5 percent less in Arizona than the national average
in 2006. They were above average as recently as 1994 and as much as 21 percent above average
in 1990.
Looking specifically at state governent general fund expenditures as reported by the JLBC,
expenditures have remained between 4 and 5 percent since 1979, considerably below the 7
percent expenditure limit specified in the Arzona Constitution. As seen in Chart 3, after dipping
below 4 percent in 2003 and 2004, actual expenditures as a share of personal income rose,
reaching 4.8 percent in 2007 - still less than the shares in the early 1990s. Using projections of
personal income for 2008 and 2009, the expenditure ratio begins to fall. The baseline shown in
7
the chart for 2009 uses appropriated expenditures, but spending cuts to narrow or close the
current deficit almost certainly will lower the actual expenditures considerably. Instead of the
4.56 percent for 2009 in the baseline, the share likely will be closer to 4.1 percent - one of the
lowest in the 30- year history.
Thus, the existing state general fund budget deficit as well as the underlying structural deficit
cannot be blamed on excessive spending. Instead, very aggressive tax cuts are the primary cause,
with other shortcomings in the revenue system - increasingly cyclical revenues and revenue
growth not keeping pace with economic growth - also contributing to the deficit.
Other actions also have contributed to the near- term dilemma. For example, the Legislature
weakened the provisions of the original legislation setting up the budget stabilization fund.
During the 1990s, the original 15 percent cap was reduced to 5 percent, though it was
subsequently raised to 7 percent. Withdrawals from the rainy- day fund also were restricted to
years of economic growth of less than 2 percent. Further, the formula- recommended transfers
have not been adopted consistently by the Legislature, and the rainy- day fund has been used to
fund expenditures unrelated to cyclical fluctuations in revenues. The result is less monies
available for transfer from the rainy- day fund to the general fund, and a greater need for
spending reductions or revenue enhancements to balance the budget, during a recession.
CHART 3
STATE GOVERNMENT GENERAL FUND EXPENDITURES
AS A PERCENTAGE OF PERSONAL INCOME
7.0
6.5
6.0
5.5
:: -
3.5
3.0
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
- Baseline __ Assuming Expenditure Reductions
Note: The constitutional expenditure limitation is 7 percent.
Sources: Arizona Joint Legislative Budget Committee and U. S. Department of Commerce,
Bureau of Economic Analysis.
8
TAXES AND ECONOMIC GROWTH
Nearly any position on the relationship between taxes and economic performance is supported in
the published literature. However, the bulk of the modern literature indicates that taxes have only
a small effect on economic growth. For example, one study suggests that a 10 percent reduction
in all state and local taxes would increase employment growth over the course of 20 years by 2.5
percentage points over and above the growth that would have occurred without the tax reduction.
In a fast- growing state like Arzona, where the 20- year increase in employment from 1987 to
2007 was 98 percent, such an increase is inconsequentiaL.
Generally, tax burdens must be far out of line with competitor regions before much of an effect
on the economy can be measured. For a state, a tax cut will have little effect on the economy
unless the tax burden is comparatively quite high ( especially versus competing states) and the tax
reduction is very large. In general, tax policy is an ineffcient way to stimulate the economy.
Investment in infrastructure and education has been shown to have a greater effect on economic
growth.
Taxes as a Business Expense
Despite the attention given to taxes, state and local tax payments are a small expense for most
businesses, averaging less than 2 percent of operating income. Therefore, the difference in state
and local tax rates between states would have to be very large to have a noticeable effect on a
company's profits. The compensation of company offcers is a larger expense than state and
local taxes.
Taxes receive attention because many state and local governents grant tax incentives, tax
credits and tax exemptions to businesses. A rational profit- seeking business will avail itself of
such opportunities. In site location decisions, such tax breaks can be a deciding factor only if two
or more locations are viewed equally on all other factors.
The Laffer Curve and Supply- Side Economics
Supply- side economics is based on the concept that tax reductions stimulate economic growth,
with the stimulus so great that governent revenues rise despite the lower tax rates. The " Laffer
Curve" popularized this theory.
The economist Arhur Laffer brought the relationship between taxes and economic performance
into the popular literature in the 1970s. However, the analytical foundations of his Laffer Curve
were established centuries ago. Moreover, the curve is a mathematical relationship ( Rolle's
Theorem).
The concept is simple. A single tax rate produces the greatest governent revenue: the revenue-maximizing
rate ( RMR). Setting rates below the RMR leaves governents with less than
maximum revenue but setting rates higher than the RMR stifles the economy - resulting in
lower tax collections despite the higher rate. The relationship between tax rates and revenues
follows a curve. The exact shape of the curve can vary by specific circumstances, but the end
points always are the same: No tax results in no public revenue while a i 00 percent tax rate
would cause all legal economic activity to cease. The diffculties in real- world application of this
9
relationship are to identify the tax rate that constitutes the RMR, and to describe the exact shape
of the curve.
The simple concept of the Laffer curve has been lost in some applications. Proponents of limited
governent erroneously argue that tax rates are always above the RMR and reduced taxation is
always better.
Laffer originally discussed the relationship between tax rates and tax revenues in the context of
national tax rates, particularly the federal income tax, which was quite high in the 1970s. The
concept also is valid at a regional level such as a state. However, state tax rates are low relative
to the federal income tax rate. Thus, a decrease in a state tax rate is less likely to have a supply-side
effect and any effect likely is smalL.
On the other hand, a state tax by definition is narrower than a national tax and thus is more likely
to have a RMR that is being exceeded in reality. This is because states compete for economic
activity, most of which is mobile ( not tied to a particular place as in the case of a mine). Capital
and labor can move easily throughout the country.
While tax rates may influence capital and labor mobility across the states and give rise to Laffer-type
effects, capital and labor move for a host of reasons. The amount and quality of public
infrastructure ( such as airports, roads, and schools) available in a region - amenities supported
by state and local government tax revenues - is among the factors influencing economic
growth. So the RMR in a state or region will be the rate that allows suffcient investment in
public amenities that foster economic growth without imposing tax burdens that stifle growth.
For a tax cut to result in a positive effect on economic growth and governent revenue, the
existing tax rate must be higher than the RMR. For much of a positive effect to result, the tax
rate must be very high and be lowered to near the RMR. Such a situation is most likely in the
case of a narrow tax. In addition, a greater economic impact is likely from a reduction in a
business tax with a rate above the RMR than in a personal tax with a high tax rate since one
business decision ( for example, in site selection) can affect many workers.
The Situation in Arizona
Most of the taxes cut in Arzona since the early 1990s have been broad- based taxes applied to
individuals. In particular, decreases in the individual income tax have accounted for five- eighths
of the cumulative $ 1. 1 8 billion nominal overall decrease since 1989. Even in the early 1990s, the
individual income tax rate was less than the average of the states. Thus, the lack of evidence that
actual tax cuts ( or increases) in Arizona had an effect on economic performance fits this Laffer
Curve analysis.
For a net positive effect to accrue on governent finance from a state tax cut, the state must have
underutilized resources. For example, if a state with higher- than- optimal tax rates also has high
unemployment and high commercial and industrial vacancy rates, then a reduction in taxes to
near the optimal point might stimulate economic growth, putting more residents to work and
more highly utilizing existing facilities. Since labor to support the faster economic growth would
not have to be imported to the state, population growth would not accelerate. Thus, the increase
10
in governent revenues would not be offset by the need to increase public spending to support
new residents.
Except during recessions, Arizona has had neither high unemployment rates nor high
commercial/ industrial vacancy rates. The majority of jobs created in Arizona are filled by labor
imported into the state from other states and other countries. ( Arzona would not have strong net
migration and population growth if this were not the case.) Thus, even assuming that tax cuts in
Arzona did have an effect on economic growth, the requirement of excess capacity is not met. If
lowered taxes stimulated the Arizona economy further, then even more labor would have to be
imported into the state, both for the construction of the facilities needed to house these economic
activities and for the permanent employment created. Thus, while public revenues would
increase, the need for public spending also would rise. Unless the incomes of the imported
workers were above the existing average ( considerably so if the worker had or would have
school- age children), taxes paid by new residents would not cover the costs of providing them
with public services.
One example exists in Arzona of a tax reduction that might have a net positive effect on
economic growth and public- sector finance. The business property tax, a narrow tax, is
demonstrably high relative to other places. ( Some reduction in the business property tax
currently is being phased in.) It is a tax that disproportionately affects some businesses,
particularly manufacturers who use considerable equipment in their operation. High- tech
manufacturers, such as semiconductor plants, are among those with considerable equipment.
These companies pay high wages. Lower business property taxes might encourage companies to
expand facilities in Arizona. Although most of the labor force needed for an expansion would be
imported, the high wages of these new workers could result in a net positive effect even on
public- sector finance.
Value of Public Services
Over time, some supply- side enthusiasts have moved to a position that any tax cut is good for the
economy and enhances public revenues - which violates the Laffer Curve. The idea that lower
taxes always are better ignores the purpose of taxation.
Taxes merely are the price paid for a service that is publicly provided. Particularly at the state
and local level, many governent services directly impact the lives of all: education of children,
water provision and sewer services, collection of trash, building and maintaining roads, police
and fire protection, the judicial system, the correctional system, etc. Many public services, such
as education ( kindergarten through graduate school) and provision and maintenance of physical
infrastructure, are of key importance to businesses, particularly high- tech and other " new-economy"
companies. For these types of companies, the quality of public goods is more
important than the level of taxes. Thus, business climate benefits from investment in various
public programs.
Empirical evidence exists that public infrastructure plays a role in increasing business
investment, job creation and economic growth. Similarly, tax reductions financed by cutting
education, infrastructure spending, and other services valued by businesses likely wil have a
negative effect on economic performance.
II
The idea that taxes remove money from the economy is false. Tax revenues are spent in much
the same way as private- sector revenues: paying employees, purchasing materials from the
private sector, etc. On average, a higher portion of public- sector spending is for wages and
salaries while private- sector firms spend a higher portion of their revenues on raw materials and
manufactured goods.
At most, it might be argued that the in- state multiplier effect of governent spending is less than
that of private- sector expenditures. However, this is unlikely. A public- sector worker is no
different than a private- sector employee in how they spend money. To the extent that private-sector
businesses spend a higher proportion of their revenues on goods than the public sector and
to the extent that most of these goods are manufactured out of state ( manufacturing in Arizona is
limited except in a few high- tech subsectors), the multiplier likely is higher for public- sector
spending than for private- sector spending.
12
RESOL VING THE CURRNT DEFICIT
Arzona's economy currently is in recession, in large part due to the real- estate bust. The
economic downturn in the state likely will be prolonged and worsened by what appears to be
increasing evidence of a deepening national and even global downturn.
During a recession, the demand for goods and services provided by many private- sector
companies declines, as consumers experience job losses, wage reductions, investment losses, or
simply become more cautious in their spending. As a result, companies need fewer employees
and employment in the private sector falls.
Unlike much of the private sector, the demand for most public- sector services does not decline
during a recession. For example, children continue to attend school, workers continue to use
roads and highways, households continue to produce trash and wastewater, and needs for fire
protection do not abate. In some governent functions, the demand for public services is
countercyclical, rising during an economic recession. The demand for public safety rises since
crime tends to increase during hard economic times. The demand for unemployment benefits,
food stamps, and other public assistance is higher during recessions due to increases in the
number of unemployed and to reductions in income among those still working.
To appreciate the severity of the current economic downturn, following a significant budget
deficit in the prior fiscal year, projections of the state governent's general fund budget deficit
in the current fiscal year exceed $ 1 bilion. Some of this deficit will be made up by monies
currently in other funds. In addition to the $ 120 million balance in the rainy- day fund, the
Governor's budget management plan released on October 1,2008 assumes that $ 50 million is
available to transfer from other funds, and at least $ 75 million is available from revenue
enhancements. Considering these funds, the general fund shortfall is projected to be near $ 1
billion. This is in addition to a shortfall of more than $ 1 billion in the last fiscal year. At current
trends, a larger deficit is projected for the next fiscal year.
A deficit of$ l bilion represents 10 percent of the state's general fund appropriations for the
current fiscal year. The general fund budget for fiscal year 2009 is just short of $ 1 0 billion.
However, since 45 percent of the general fund is protected from budget cuts, the remainder of the
general fund is facing a deficit equal to 18 percent of its budget.
The shortfall will need to be eliminated through spending cuts and/ or revenue enhancements. All
of the " easy" budget fixes were used to balance last year's budget. The Legislature has
demonstrated a preference for spending cuts. However, imposed decreases in public spending
during recessions come at the same time that demand for public services is stable or rising,
resulting in a reduction in the quantity and/ or quality of governent services. For the most
disadvantaged of those consuming public services, real hardship can ensue.
Spending reductions by governents during recessions not only negatively affect those being
served, but also worsen economic conditions. The spending cuts take the form of reductions in
governent employment and in governent purchases of goods and services from the private
sector. The latter obviously has a detrimental effect on those private- sector companies selling
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directly to the public sector. Governor Napolitano's directive of October 8, 2008 to freeze
contracts in excess of $ 50,000 is the first step in this process.
Governent workers laid off during a recession have little hope of finding another job in
Arizona in the near term. If unemployed workers leave Arzona to seek employment
opportunities in a state less hard hit by the recession, then all of the expenditures that the former
workers made at private- sector companies will be lost to the Arzona economy, as wil the sales
taxes and other public- sector taxes and fees paid by the former workers.
If unemployed governent workers remain in Arzona, their spending will decline, negatively
affecting the companies at which the former workers shop, and also adversely affecting the
collection of sales taxes, on which Arizona's governents are disproportionately dependent.
Thus, in addition to reducing demand for private- sector goods and services, cutting the public-sector
workforce will cause public- sector revenues to decline.
Further, laid- off government employees wil be eligible for unemployment insurance payments
and may qualify for other public welfare, such as food stamps. Thus, the savings to state
governent of not paying the former workers' salaries and benefits will be parially offset by
rising payments to the ex- workers for unemployment insurance and other public welfare
programs.
The result of state spending cuts of $ 1 billion would be to very significantly worsen and lengthen
the economic recession. A total of approximately 20,000 workers ( 8,000 state governent and
university workers and 12,000 others) might lose their jobs.
The reduction of government spending during a recession has the effect of trying to balance the
public budget on the backs of a relatively small share of the state's residents and businesses -
primarily the laid- off workers, and secondarily the private- sector companies ( and their
employees) at which the laid- off workers shop.
Spending Reductions Compared to Revenue Increases
Spending reductions are not the only way to balance the budget. The Governor's Budget
Management Plan released on October 1, 2008 includes nontax revenue enhancements, though
no details are presented in the plan. In any case, nontax revenue enhancements will not be
adequate to close most of the likely shortfall ( after fund transfers) in the state governent
general fund.
Additional funding also would be available by increasing tax rates. Ar increase in taxes was one
of the methods used to balance the budget during the lengthy economic decline of the late 1980s
and early 1990s, another economic downturn disproportionately caused by the boom- bust cycle
in real estate.
The overall tax burden in Arizona currently is well below the national average. The relative tax
burden on individuals is even lower, given that some taxes on businesses are high relative to
other states. Assuming that litte of any tax increase would be levied on businesses, the negative
economic effect of a tax increase would be no larger than that of a governent spending
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decrease. In fact, it should be less. Some ofthe tax payments would come from personal savings.
A portion of a tax increase would be exported to nonresidents and to the federal governent
( since state taxes are federally deductible).
In order to reduce the effect on lower- income individuals, any tax increase could be made to be
highly progressive. The primary negative effect of a tax increase that largely spares lower-income
households would be that middle- and upper- income households would have less money
to spend in the private sector. But the effect would be spread throughout the state. Individual
households and businesses would suffer slightly, in contrast to the substantial negative effects on
a relatively small number of individuals and businesses that would result from a governent
spending reduction. Further, individuals - whether state governent employees or the
disadvantaged who are highly dependent on public assistance - would not be devastated in the
tax increase option.
For perspective, a tax increase of $ 1 billion that affected individuals only and was not exported
( for example, to tourists) still would equate to only about $ 150 per Arizona resident, or $ 400 per
household. A tax increase of this magnitude would offset only approximately one- third of the
state tax cuts implemented between 1993 and 2008. Such a tax increase would be considerably
less than the rebate in federal taxes that most Arzonans received in May. Further, any increase in
Arzona taxes would be deductible from the federal income tax, lowering the after- tax impact on
disposable incomes. According to the Tax Foundation rankings for 2008, even with an increase
of this magnitude Arizona still would retain its low- tax status. Assuming no changes in the tax
burdens of other states, Arizona's rank would be 37th, one spot lower than Mississippi.
Without enhancing revenues, state governent will be unable to adequately support a growing
population. In particular, Arizona faces substantial infrastructure needs over the next quarter
century.
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