Number A-39 in Series, "New Federalism: Issues and Options for States"

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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About the Series

This series is a product of Assessing the New Federalism, a multiyear project to monitor and assess the devolution of social programs from the federal to the state and local levels. Alan Weil is the project director. The project analyzes changes in income support, social services, and health programs. In collaboration with Child Trends, the project studies child and family well-being.

The project has received funding from The Annie E. Casey Foundation, the W.K. Kellogg Foundation, The Robert Wood Johnson Foundation, The Henry J. Kaiser Family Foundation, The Ford Foundation, The John D. and Catherine T. MacArthur Foundation, the Charles Stewart Mott Foundation, The David and Lucile Packard Foundation, The McKnight Foundation, The Commonwealth Fund, the Stuart Foundation, the Weingart Foundation, The Fund for New Jersey, The Lynde and Harry Bradley Foundation, the Joyce Foundation, and The Rockefeller Foundation.

This series is dedicated to the memory of Steven D. Gold, who was codirector of Assessing the New Federalism until his death in August 1996.

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nterest in state government budgets is growing. With the devolution of historically federal responsibilities for welfare and other programs to states, their ability and willingness to fund and implement these programs amid changing economic circumstances becomes increasingly important. State fiscal health has been particularly strong in recent years. How states use this strength—expanding programs, saving for less prosperous times, or reducing tax rates—will significantly affect states' future ability to meet the needs of their citizens.

Between 1988 and 1997 (the most recent year for which data are available) state governments' real per capita spending increased by almost 30 percent, with an almost equal increase in revenues. While it is not surprising that state budgets increase during good economic times, state spending during this period increased faster than both personal income and economic output did. On the expenditure side, public welfare, especially medical expenditures, and education have been leading factors. On the revenue side, increases in intergovernmental transfers and rapid changes in income and sales tax revenues account for most of the growth.

Changes in State Government Expenditures

How has state spending changed in recent years? Table 1 shows real per capita national totals of state government spending in each fiscal year for the 10-year period from 1988 through 1997. According to Census data, total real general expenditure increased from about $2,000 to about $2,600 per capita. This increase of almost 30 percent occurred during a period when real per capita income increased about 9 percent and the gross domestic product increased about 16 percent (not shown).

So why did state spending increase so rapidly? Almost half of the increase in state spending ($280 per capita) was due to increased spending for public welfare. There was also significant growth in spending for education at the elementary, secondary, and college levels, accounting for about one-quarter of the total increase in state spending. Corrections spending grew rapidly (54 percent), but accounted for only a small share of the total. Health and hospitals expenditures also grew substantially, by $46 per capita. On the other hand, other categories of expenditure (highways, interest, and other general expenditures) grew more slowly than the economy. Interest payments by states declined because the cost of borrowing fell due to the low inflation rate in the latter half of the decade. In addition to these broad trends, the period from 1988 through 1997 can be analyzed by looking at two subperiods. From 1988 through 1995, total expenditures rose $45 or more per capita each year, and public welfare spending accounted for 52 percent of the increase. In 1996 and 1997, expenditure growth slowed and public welfare spending declined.

TABLE 1: Real Per Capita Expenditures by State Governments, FY 1988 through FY 1997 (1992 Dollars)

Year	Total Expenditures	Elementary and Secondary Education	Higher Education	Public Welfare	Corrections	Health and Hospitals	Highways	Interest	Other General Expenditures
1988	$2,034	$430	$271	$396	$63	$164	$191	$91	$427
1989	2,116	452	278	418	68	174	193	92	442
1990	2,164	448	285	447	74	182	188	92	449
1991	2,267	457	293	508	79	187	192	96	455
1992	2,419	477	305	618	80	190	193	97	459
1993	2,468	484	307	642	79	203	196	92	464
1994	2,533	484	309	683	85	209	199	88	476
1995	2,601	506	317	691	92	213	203	87	491
1996	2,595	520	319	673	94	213	200	87	488
1997	2,624	534	323	676	97	210	200	88	496
Percentage Change, 1988-1997	29%	24%	19%	71%	54%	28%	5%	-4%	16%
Sources: Expenditure data from U.S. Bureau of the Census, State Government Finances. Population data from U.S. Bureau of the Census, Population Estimates Program, Population Division. Data deflated using state and local government implicit price deflators from national income and product accounts. Note: Rows may not add due to rounding.

Changes in real per capita state spending for education can happen three ways. These changes may occur because of (1) changes in the number of students per capita, (2) changes in the state share of educational expenses, and (3) changes in real expenditures per student. During the period from 1988 through 1997, the number of students in public elementary and secondary schools increased only slightly faster than the population. Thus, there was little change in the number of students per capita. The state share of expenditures for elementary and secondary education remained nearly constant between 1988 and 1996, at about 48 percent.¹ Thus, almost all of the increase in real per capita elementary and secondary education expenditures, shown in table 1, was reflected in an increase in real expenditures per student.

Public welfare spending grew by more than two-thirds; no other category of spending grew so fast or accounted for such a large share of the increase in state spending. Table 2 gives more detail about the growth of public welfare spending. Throughout the entire 10-year period, payments to vendors for medical services—much of it under the Medicaid program—accounted for more than half of welfare spending. From 1988 through 1997, this category alone grew by a whopping 111 percent and accounted for 80 percent of the growth in welfare spending. Welfare spending declined between 1995 and 1997 once Medicaid spending growth had stabilized.²

TABLE 2: Real Per Capita State Government Expenditures for Public Welfare, FY 1988 through FY 1997 (1992 Dollars)

		Components of the State Public Welfare Experience
Year	All Public Welfare Expenditures	Medical Vendor Payments	Categorical Cash Assistance	Categorical Assistance—Intergovernmental to Counties	Other Public Welfare
1988	$396	$202	$46	$38	$110
1989	418	217	45	41	116
1990	447	239	45	42	120
1991	508	287	49	46	126
1992	618	370	53	62	132
1993	642	388	55	61	138
1994	683	416	54	65	149
1995	691	427	50	64	151
1996	673	418	44	61	149
1997	676	426	39	59	152
Percentage Change, 1988-1997	71%	111%	-14%	54%	38%
Sources: See table 1.

Some Medicaid expenditures, particularly those by public hospitals, fall under the health and hospitals category (table 1). Expanded Medicaid programs probably explain most of the increase in health and hospitals expenditures as well as the bulk of the increase in public welfare spending.

Direct state spending for cash assistance declined by $7 per capita, or 14 percent. State payments to counties to finance local government spending on welfare and Medicaid clients increased by $21 per capita, or 54 percent. Other categories of public welfare spending also accounted for only a small share of the total growth.

Figure 1 illustrates the growth in state spending over the 10-year period. Roughly half the change occurred in categories other than public welfare, primarily education spending. The remainder of spending growth, however, can be attributed to increased public welfare spending. The vast majority of the change was due to increased medical vendor payments, with much smaller changes in expenditures for other categorical assistance and other public welfare.

Changes in State Government Revenues

How did state governments pay for the increase in spending between 1988 and 1997? State governments get general revenue from four sources: (1) federal intergovernmental revenues; (2) taxes; (3) current charges, including tuition revenues of state colleges and universities and other revenues from the sale of state services; and (4) other general revenues, such as net lottery receipts and interest earned on state bank accounts.

Table 3 shows real per capita state government revenues broken down by source for the years 1988 through 1997 and tax revenues by source for 1998 and 1999.³ Fiscal year 1998 marked an important event in the history of state government finance: Total state personal income tax revenues exceeded general sales tax revenues for the first time since the widespread adoption of state general sales taxes in the late 1930s.⁴ This watershed was the result of a surge in state personal income tax revenues. In fiscal years 1998 and 1999, personal income tax revenue increased more than $70 per capita—about as much as it had increased in the previous five years. In 1998 and 1999, general sales tax revenue increased at a slightly more rapid pace than in the previous decade. By 1999, revenues from selective sales, corporate income, and other taxes all had declined slightly. The reasons behind the surge in income tax revenues are discussed below.

TABLE 3: Real Per Capita State Government Revenues, FY 1988 through FY 1997, and Tax Revenues, FY 1988 through FY 1999 (1992 Dollars)

Year	Total Per Capita General Revenue	General Sales Tax	Selective Sales Tax	Individual Income Tax	Corporate Income Tax	Other Taxes	Current Charges	Federal Intergovernmental Revenues	Other General Revenue
1988	$2,095	$410	$203	$377	$102	$151	$162	$473	$217
1989	2,176	421	202	401	108	150	174	488	232
1990	2,203	424	202	409	93	152	182	504	238
1991	2,254	421	206	406	83	153	193	551	241
1992	2,393	425	216	413	85	156	209	629	259
1993	2,496	438	229	428	92	164	219	677	248
1994	2,558	455	231	434	94	165	225	708	245
1995	2,620	469	229	445	103	169	230	718	257
1996	2,648	479	228	463	101	169	231	715	263
1997	2,712	490	229	482	102	174	241	719	277
1998	NA	507	232	524	101	180	NA	NA	NA
1999	NA	514	228	550	101	171	NA	NA	NA
Percentage Change, 1988-1997	29%	20%	13%	28%	0%	15%	49%	52%	28%
Percentage Change, 1988-1999	NA	26%	12%	46%	-1%	13%	NA	NA	NA
Sources: 1988 to 1997: see table 1. 1998 and 1999: tax data from U.S. Bureau of the Census, Quarterly Summary of State and Local Tax Revenue. Note: NA indicates the data are not available. Rows may not add due to rounding.

Between 1988 and 1997, total per capita revenues were slightly greater than expenditures in each year, except fiscal years 1991 and 1992, when the nation was at the low point in the business cycle. Over the entire period, real per capita revenues grew the same 29 percent as expenditures. The largest and fastest-growing component of revenue was federal grants to states, which grew 52 percent and accounted for more than one-quarter of state government revenues in 1997. Current charges also grew quite rapidly (49 percent), but accounted for less than 10 percent of revenues in 1997. Every other component of revenue grew more slowly than the total. Once again, the period can be divided into two subperiods; note that federal intergovernmental revenue had almost no net growth between 1995 and 1997.

So why did federal intergovernmental revenue grow so fast between 1988 and 1995? Table 4 shows this revenue's components. The largest share of federal intergovernmental revenues, 57 percent by 1997, came from federal intergovernmental revenues for public welfare, which grew by 82 percent during the period. While federal intergovernmental revenue for health and hospitals grew even faster (99 percent), it accounted for only a small share of states' intergovernmental revenues. Intergovernmental grants to states for highways remained virtually flat.

TABLE 4: Real Per Capita State Federal Intergovernmental Revenues, FY 1988 through FY 1997 (1992 Dollars)

		Components of Federal Grants to States by Purpose of Grant
Year	Total Federal Intergovernmental Grants to States	Education	Health and Hospitals	Highways	Public Welfare	Other
1988	$473	$85	$20	$63	$226	$80
1989	488	88	22	65	234	79
1990	504	91	23	59	253	78
1991	551	95	25	58	294	79
1992	629	102	27	57	360	83
1993	677	107	31	63	388	88
1994	708	111	33	66	408	90
1995	718	113	37	69	408	92
1996	715	117	38	65	406	89
1997	719	112	39	64	410	93
Percentage Change, 1988-1997	52%	32%	99%	2%	82%	16%
Sources: See table 1. Note: Rows may not add due to rounding.

Table 5 illustrates the public welfare components of federal intergovernmental revenue for 1997 and 1988. Real per capita Medicaid revenues rose from $141 to $315 (123 percent), while real per capita revenues from non-Medicaid federal intergovernmental grants grew from $84 to $96 (14 percent). Thus, nearly all of the growth in federal intergovernmental revenue to states was due to growth in federal Medicaid revenues.

TABLE 5: Real Per Capita Federal Intergovernmental Grants to State Governments for Public Welfare

	FY 1997	FY 1988
Total	$410.00	$226.00
Medicaid	315.00	141.00
Non-Medicaid Total	96.00	84.00
Detail on Non-Medicaid Total
AFDC	32.00	50.00
Food Stamp Administration	8.00	5.00
Low-Income Energy Assistance	4.00	7.00
Social Services Block Grant	9.00	12.00
Community Services Block	0.08	1.79
Work Incentive Program	0.0	0.57
Other Non-Medicaid	43.00	7.00
Sources: Federal grant data by program is from the U.S. Bureau of the Census. Federal Expenditures by State by Fiscal Year 1997 and 1998. Population data from U.S. Bureau of the Census. Note: Numbers may not add due to rounding. Data deflated using state and local government implicit price deflators from national income and product accounts.

Figure 2 presents a visual summary of the growth in state revenues over the period. This revenue growth can be divided into three major categories. The combined impact of the individual income and general sales tax accounts for about one-third of the growth. A roughly equal share of growth is due to the combined growth in all other taxes, current charges, and other general revenues. The final slice, accounting for approximately 40 percent of the increase, is due to growth in intergovernmental revenue. About three-quarters of the growth in intergovernmental revenue is due to increased revenue for public welfare, which is primarily due to growth in federal Medicaid expenditures.

Why Did Sales and Personal Income Tax Revenues Increase?

Revenues from the personal income and sales taxes—the two most important sources of state own-source revenue—both grew considerably faster than personal income. The growth of sales tax revenue is particularly surprising because the sales tax base had been steadily eroding for years as households have switched their consumption toward traditionally untaxed services.⁵ In recent years, interstate sales—particularly sales via the Internet—have been threatening to speed the erosion of the sales tax base.⁶

Changes in sales and income tax revenues were the result of a combination of three factors. First, in some cases, legislated changes in state tax policies increased revenues. Second, increases in economic activity generally increased both the income and sales tax bases and caused revenue growth. Third, changes in the composition of both the income and sales tax bases had significant impacts on revenue growth.

Figure 3 illustrates the results of information provided by the National Association of State Budget Officers (NASBO) on legislated changes to each state's personal income and sales taxes during each year from 1988 through 1997. These changes generally reflected the business cycle, and the largest increases took effect during fiscal years 1991 and 1992 as the country struggled to emerge from a recession. As the nation's economy improved, legislated tax increases diminished; after 1995, there were significant legislated income tax cuts. Legislated sales tax increases in 1991 and 1992 were smaller than legislated income tax increases. However, after 1994 legislated cuts in income taxes far outpaced the very modest legislated declines in the sales tax.

The net impact of legislated changes in state income taxes over the decade was quite small. Actual 1997 income tax revenues were about 4 percent greater than they would have been had there been no income tax policy changes after 1987.⁷ Thus, only about one-seventh of the 28 percent increase in real per capita income tax revenue was due to legislated policy changes. Changes in the size and composition of the income tax base had a far more important influence on revenues than legislated policy changes.

State income tax bases grew substantially between 1988 and 1997. Income tax bases vary somewhat from state to state but generally include most labor and capital income. Federal adjusted gross income (AGI) is the best widely available measure of states' income tax bases. Over the period from 1988 through 1997, real per capita federal AGI grew about 14 percent (Internal Revenue Service).

Taken together, the 14 percent increase in the income tax base and the 4 percent legislated tax increase account for about 18 percent of the 28 percent increase in real per capita state income tax revenue between 1988 and 1997. What accounts for the remaining 10 percent?

States with progressive income tax systems will find that state income tax revenues rise more than proportionally with income.⁸ Since most states do not index their tax brackets for inflation, even when real incomes are stagnant, inflation leads to bracket creep that increases real revenues. In recent years, disproportionate income gains by those at the upper end of the income distribution have been even more important than inflationary bracket creep. Dye and McGuire (1998) find that during the period from 1976 to 1995, 37 states had an income tax revenue elasticity greater than one—that is, revenues increased more rapidly than the tax base in a policy-neutral environment. A similar pattern exists for the period from 1988 through 1997. After taking changes in income tax policy into account, income tax revenues increased more rapidly than the income tax base.

The sales tax story is somewhat different. The net impact of legislated changes in the sales tax was more substantial than the income tax. Actual 1997 sales tax revenue was about 10 percent higher than it would have been had there been no sales tax policy change after 1987. So about one-half of the 20 percent increase in real per capita sales tax revenue was due to legislated policy changes. Changes in the size and composition of the sales tax base explain the remainder.

Sales tax bases vary more across states than do income tax bases. Some states exempt food for home consumption; others impose sales tax on an array of personal services, such as beauty salons and dry cleaning. Despite these differences, the vast majority of all states' sales tax revenues come from retail sales. Between 1988 and 1997, real per capita retail sales increased nearly 17 percent (Survey of Buying Power 1989-1999).

Taken together, the 17 percent increase in the sales tax base and the 10 percent legislated increase should have resulted in about a 27 percent increase in sales tax revenues. In reality, sales tax revenues increased only about 20 percent over this period. What restrained sales tax revenues?

The most reasonable explanation for lower-than-expected sales tax revenue growth is that a higher percentage of sales escaped taxation in 1997 than in 1988. Despite policy changes broadening the sales tax base, sales tax revenues eroded as consumers increasingly made purchases through catalogs and the Internet, often escaping taxation. Part of this continuing trend, and perhaps even more important than consumer purchases, are business purchases that today escape sales taxation. Recent evidence (Ring 1999) indicates that a significant share of sales taxes are paid by businesses on intermediate transactions. Businesses may evade these cascading sales taxes by bringing some activities "in house." For example, many large businesses have established in-house photocopy divisions rather than purchasing taxable photocopy services from independent vendors.

Summary and Conclusion

The 1990s brought major changes in the states' fiscal environments. A generally positive national economy brightened states' fiscal pictures. Changes in federal policies had important impacts on both spending and revenues. Federal spending on intergovernmental grants burgeoned early in the decade but slowed after 1996. Even while welfare and other historically federal responsibilities became state responsibilities, long-term structural changes in the economy altered the productivity of states' two most important sources of tax revenue. Key fiscal changes included:

• A 71 percent increase in real per capita state spending on public welfare (now the largest single item in state budgets).
• A pronounced shift in state public welfare spending toward payments that compensate vendors for medical aid to the indigent.
• Substantial increases in total and per student spending for elementary and secondary education.
• Very large increases in federal Medicaid payments prior to 1996, which financed states' increased medical vendor payments.
• Large real per capita increases in state income tax revenues due to strong overall economic growth and disproportionate income growth among upper-income taxpayers.
• Surprisingly large increases in sales tax revenue despite continued evidence of sales tax base erosion. Sales tax revenue gains were the result of strong overall economic growth and legislated rate increases and base broadening.

At the end of the 1990s, states had significantly more spending responsibilities and revenues than at the start. The composition of state spending changed significantly, with increased emphasis on health care and education. The general makeup of revenues also substantially changed as federal intergovernmental revenues and individual income taxes grew more important.

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Notes

1. Data on the state share of elementary and secondary education spending in 1997 are not yet available. Data on population, number of students, and educational expenditures in 1996 can all be found in the U.S. Statistical Abstract 1999. Data on educational expenditures in 1988 can be found in the U.S. Statistical Abstract 1995. Public higher education enrollments also grew at about the same rate as the general population.

2. See Holahan, Bruen, and Liska (1998) for a discussion of the reasons for the slowdown in Medicaid spending, and see Holahan and Liska (1997) for an analysis of the prospects for future Medicaid growth.

3. The most recent tax data available as of this writing were current as of December 14, 1999. Some of the tax revenue data is preliminary. See the Census Web site, http://www.census.gov/govs/www/qtax.html, for details.

4. States that do not have a significant income tax are Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. States with no general sales tax are Alaska, Delaware, Montana, and Oregon.

5. See Merriman and Skidmore (1998) for further discussion and analysis of the decline and prospects for future recovery.

6. For more information about the potential impact of Internet sales on sales tax revenue, see Goolsbee (1999) and NTA (1999).

7. This calculation measures the cumulative impact of all policy-induced changes in tax revenues reported in the National Association of State Budget Officers' Fiscal Survey of the States. The calculation assumes that a permanent policy change that reduces (or increases) revenues by X% in one year will also reduce them by X% in each succeeding year unless it is repealed.

8. Even a state that has a flat income tax rate (like Illinois) has a progressive income tax system since the first few thousand dollars of income are not subject to taxation.

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References

Dye, Richard F., and Therese J. McGuire. 1998. "Block Grants and the Sensitivity of State Revenues to Recession." 1997 Proceedings of the National Tax Association (NTA) (15-23). Washington, D.C.: NTA.

Goolsbee, Austan. 1999. "Internet Commerce, Tax Sensitivity, and the Generation Gap." In Conference Report: Tax Policy and the Economy, edited by James M. Poterba. Cambridge, Mass.: National Bureau of Economic Research.

Holahan, John, Brian Bruen, and David Liska. 1998. "The Decline in Medicaid Spending Growth in 1996: Why Did It Happen?" Kaiser Commission on Medicaid and the Uninsured Issue Paper. Washington, D.C.: The Henry J. Kaiser Family Foundation.

Holahan, John, and David Liska. 1997. "The Slowdown in Medicaid Spending Growth: Will It Continue?" Health Affairs 16 (2): 157-63.

Internal Revenue Service. Various years. Statistics of Income Bulletin. Washington, D.C.: GPO.

Merriman, David, and Mark Skidmore. 1998. "How Have Changes in Demographic and Industrial Structure Influenced Sales Tax Revenues?" Proceedings of the Ninetieth (1997) Annual Conference on Taxation (45-54). Washington, D.C.: NTA.

National Association of State Budget Officers (NASBO). Various years. Fiscal Survey of the States. Washington, D.C.: Author.

NTA. "Communications and Electronic Commerce 1999 Tax Project. Final Report." Accessed at http://www.ntanet.org/.

Ring, Raymond J., Jr. 1999. "Consumers' Share and Producers' Share of the General Sales Tax." National Tax Journal 44 (1): 41-53.

Survey of Buying Power. 1989-1999. Sales and Marketing Management (September). Annual Supplement. New York.

U.S. Bureau of the Census. Various years. Statistical Abstract of the United States. Washington, D.C.: GPO.

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About the Author

During the 1999-2000 academic year, David Merriman is a senior research associate in the Urban Institute's Assessing the New Federalism project while on leave from the Department of Economics at Loyola University Chicago, where he is an associate professor. His research interests include state and local public finance and urban and regional economics.

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