Dec 17, 2019

“Fiscal Evasion” Tactics Make Matters Worse for State Budgets When Hard Times Hit

Budget rules should be simple and they should mandate transparency in accounting and budgeting
Eileen Norcross Senior Research Fellow

Balanced budgets seem eminently reasonable, which is why many states have rules and even constitutional requirements binding legislators to certain financial practices aimed at promoting good budgetary stewardship. However, a rule is only as good as its design, and not all budget rules are well-designed.

At times, state governments resort to a number of questionable tactics that only create the appearance of good fiscal health. While these practices may conform to the letter of the law and temporarily make a state’s financial health look rosier, lawmakers end up fooling themselves into an unworkable fiscal position. Eventually, unescapable economic reality hits, and the states that engage in these practices often end up suffering significant fiscal problems.

As uncertain economic times loom on the horizon, policymakers should act quickly to restore accountability and transparency to their budget processes.

What Is Fiscal Evasion?

There are many ways states engage in budgetary gimmicks. Sometimes, these gimmicks are “one-shot” moves: the intentional flouting of budgeting, accounting, or legal standards. Some of these tactics include delaying payments to vendors or pension funds, collecting taxes ahead of schedule, raiding or sweeping funds set aside for a specific use, and rosy projections of future revenue or savings.

More troubling than the bad practices that violate the rules are the bad practices built into the rules themselves, practices I define as “fiscal evasion.” Any legal means that a government uses to conceal the full cost of public spending are a kind of fiscal evasion. The end result is institutionalized deception, which both falsely convinces lawmakers of a policy’s sustainability while concealing the costs of policy choices to voters.

Consider balanced budget rules (BBRs), which are meant to ensure that yearly spending matches revenues. As with any rule, design and details matter. In some states, BBRs cover only the operating budget, which means other funds such as capital funds are not subject to the same limits.

Another questionable budget practice in some states is the proliferation of “special funds” that are created with general fund revenues or dedicated revenues that are outside of the general fund budget. This practice has a few problems: First, it encourages the creation of a “shadow budget” that avoids proper oversight and legislative discussion of how revenues are being used. Second, it leads to “fund sweeping,” in which money from special funds is moved back into the general fund to balance the budget. Games such as these end up potentially redirecting dedicated revenues away from their legislated purpose.

Another area that encourages evasiveness, but that is still within the letter of current accounting standards, involves the way states measure pension obligations. After the 2008 recession, many state and local governments found that they had to grapple with large and rising unfunded pension obligations. The shortfalls were in part driven by optimistic projections of pension fund investment returns.

In spite of independent assessments warning of growing public pension plan shortfalls, the practice of relying on optimistic returns projections continues. This is the case even though accounting standards have recently been tightened to encourage plans to modify the way they estimate unfunded liabilities; that modification includes a projection of when plans run out of assets.

But the application of the standard varies. For example, New Jersey used a conservative set of assumptions and projected higher unfunded liabilities resulting in the plans running out of assets within the next two decades. By contrast, Illinois projected a run-out date of 2066 for two of its major pension plans, leading to a much lower estimation and rosier picture of unfunded liabilities. As it stands, the method for measuring pension liabilities remains arbitrary. States should instead measure their pension liabilities based on low-risk bonds—pension liabilities’ nearest equivalent in terms of certainty and timing of payment.

Don’t Bank on Continued Growth

Meanwhile, as 2019 draws to a close, economic indicators are running mixed to positive. But while these indicators may mute immediate fears of recession, states should not rely on continued economic growth to make up for pension and other shortfalls.

For now, the economic news is largely good. According to the Bureau of Labor Statistics, 266,000 jobs were added in November as the unemployment rate hit a 50-year low of 3.5 percent. GDP growth, while slower than last year, remains a respectable 2.1 percent. Meanwhile, consumer confidence is up, and the Federal Reserve is unlikely to raise interest rates. And while the impact of tariffs or a global economic slowdown could still drag the American economy into a recession, most economists believe that it is unlikely that the United States will fall into recession in 2020.

So, in the coming year, the prospects for state and local government are largely positive. Tax revenues are strong in many states, with collections 13 percent higher than their prerecession peaks. Real tax revenues have rebounded in 41 states. Revenue surpluses owe in part to the 2017 federal tax reform. But state lawmakers should not assume these gains will continue. Indeed, it is not a question of whether a recession will hit, but rather when and how severely.

This points to the perennial challenge for states: don’t treat existing surpluses like windfalls; use them to guard against future shortfalls. The temptation to embark on new programs or expand spending should be checked against a commitment to bolster rainy-day funds and stabilize unfunded obligations.

Regardless of secular economic trends, maintaining good fiscal practices is always in season. To be recession-ready, governments should ensure that their fiscal practices and rules do not undermine fiscal prudence but rather reinforce it.

How to Reform Budget Rules

Three principles should guide lawmakers as they reform rules that allow for fiscal evasion: (1) rules should be simple, (2) they should mandate transparency in accounting, and likewise (3) they should require transparency in budgeting.

First, lawmakers should aim to simplify rules when possible. Complexity creates opportunity for gamesmanship, which could allow lawmakers to hide accounting tricks and mismanagement. The more caveats and complications that are built into the rules, the more opportunities there will be for hijinks. Combing through complex rules could be a profitable exercise in discovery. Lawmakers may find instances of fiscal evasion that had been hiding in their thicket of budgetary rules and pare them back accordingly.

Next, lawmakers should institute transparency in accounting. Long-term pension obligations are real and should be treated as such on the state books. Accounting reforms that have recently brought long-term pension obligations onto state balance sheets are a promising step in the right direction. Still, much work remains to be done in accurately calculating true state liabilities, as evidenced by the broad variation among states’ measurements of their obligations. Lawmakers should work to refine accounting practices to accurately and precisely reflect their states’ fiscal positions.

Finally, lawmakers should ensure transparency in budgeting. At a minimum, this means no more shadow budgets. States that have tended to rely on the creation of special funds—such as Illinois, Ohio, California, and Pennsylvania—should reform their budget procedures and bring special funds back into the general fund budget, where spending decisions are deliberated.

It is easy for politicians to decry extralegal “budget gimmicks,” particularly when being employed by a political opponent. It is harder, but arguably more important, to recognize that at times the rules themselves are structured in a way to facilitate deceptive budgeting. But this is what fiscal evasion is, and it is no less damaging to state fiscal health because it is technically within the rules. To set states on a path to a brighter financial future, legislators must reform these broken rules before it is too late.

Photo by Jeff Zelevansky/Getty Images

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