The Patrick administration has been working to enhance its long-term financial planning based on best practices prescribed by the Government Finance Officers Association (GFOA). Best practices include the use of a sound conceptual approach, ensuring that near-term decisions measure long-term impacts, and developing a solution framework that is aligned with policy goals. The Commonwealth has implemented a conceptual approach of “structural balance“ that is designed to delineate among different causes of fiscal imbalance. The application of this approach identifies three critical challenges facing the Commonwealth: a remaining structural deficit due to the significant reduction in tax revenue since the recession, cost inflation on safety net and health care programs, and the need to improve policy measures to address economic volatility. Each of these challenges is a central feature of our FY12 budget proposal as further described in the conclusion to this section.
Structural Balance Approach and Analysis
The goal of structural balance is to base spending on policy priorities and a predictable level of sustainable revenue. Our supporting analysis includes a five-year forecast for revenue and spending based on historical trends as well as the outlook for the state economy. The forecast includes a projection of tax revenue, based on input from local economists, that also provides the basis to develop an estimated long-term trend-line for tax revenue. The forecast indicates that the state economy will be below trend during a four year recovery period beginning in fiscal year 2012 before reaching a “steady-state” level of long-term tax revenue growth of approximately 5% in 2016. The imputed trend-line was developed using the tax revenue figures from 2016 and discounting revenue back by the estimated 5% annually. A similar approach was taken to develop a pre-recession revenue trend-line and select results of this analysis are highlighted in the exhibit below. (note: the time horizon in the exhibit has been truncated in order to emphasize the key findings discussed below).
The results of this analysis provide three useful insights into our near-term fiscal challenges. First, tax revenue in FY07 (i.e. pre-recession) was approximately $2 billion greater than the then current trend-line. Second, the impact of the recession on this trend-line after FY09 was a significant downward shift of an additional $2 billion. Finally, the outlook for the economy suggests that recovery in tax revenue will be only modest: approximately $500 million based on the difference between the trend and forecast for tax revenue in FY12. The combined impact of these effects is that the FY12 budget will have approximately $5 billion less in available resource than we had in FY07 on an inflation adjusted basis, with an expectation that only 10% of this amount will be re-couped during the recovery.
The estimates of tax revenue were done in tandem with trend based projections for spending that are largely influenced by health care cost inflation. Health care costs in the state have been growing at 8-9% which has had the effect of increasing the share of health care costs from 31% to 38% over the four year period ending with FY10 (Exhibit 2). The impact of this increase combined with the reduction in revenue sources described above, is that the Commonwealth will have approximately 25% less in resource available for non-health care spending in FY12 than was available in FY07.
The growth rate of health care costs also suggests that there could be a further squeeze on other spending and a risk of increasing structural deficits if health care cost inflation cannot be addressed. If current trends continue, for example, the growth in total state spending by FY15 would be approximately 6% (driven by an 8-9% spending rate for health care and a 3% rate for most other programs) as compared to an estimated revenue growth rate of 5%. The 1% differential would result in additional structural deficits of nearly $400 million annually, providing a clear indication that the current levels of health care cost inflation are not sustainable.
The Application of Long-Term Planning to Inform Near-Term Decisions
The structural balance analysis has informed our understanding of the state’s fiscal imbalances and our recommendations to address these challenges in the FY12 budget. The revenue forecast and trend-line allows us to employ the $500million cyclical shortfall as a guideline on the maximum use of one time resources that are sustainable over time. Any spending in excess of this amount would continue to sustain a structural deficit or require budgetary spending that is not sustainable. The FY12 budget includes use of $385 million in one time resources, well within the sustainable level based on our cyclical shortfall. This is based in part on the assumption that the state would also restrain spending during a strong economy when tax revenue is above the then current trend-line (see Managing Economic Volatility in the solutions section below).
A Solution Framework Aligned with Policy Goals
The Governor’s House 1 proposal for fiscal year 2012 addresses the state’s key fiscal challenges through a series of reforms and initiatives that have been informed by our analysis of the state’s long-term fiscal outlook. They include: