The Massachusetts state budget has reached a point of reckoning, as the nation’s looming recession threatens to shatter Beacon Hill’s ability to juggle the budget’s structural imbalance and skyrocketing health care costs, according to Point of Reckoning: Two Decades of State Budget Trends, a new policy brief released today by MassINC, a nonpartisan think tank in Boston.

This brief, which analyzes two decades of state fiscal policy, reveals the volatile capital gains tax as the largest source of revenue growth in recent years. Pegged to the whims of Wall Street, capital gains tax revenues plummet during recessions, endangering the state’s ability to cope with the impact of a struggling economy on revenue collections and the demand for state services.

“Given these multi-year trends on both the revenue side and the spending side, the Commonwealth now finds itself in an extremely precarious position,” said Greg Torres, MassINC president. “We have gradually introduced an unsustainable level of risk and volatility to both sides of the ledger. As the current economic slowdown turns into a recession, we are moving into uncharted financial waters,” he continued.

According to the policy brief, state revenues are expected to increase by $750 million to $1 billion based on the long-term performance of the economy, far short of the $1.3 billion to $1.6 billion needed to match likely spending growth. Between 2002 and 2006, capital gains tax generated most of the revenue growth that helped make up the gap between overall revenues and spending, hitting a high of $1.7 billion in 2006. However, those receipts could easily evaporate: During the last two recessions, capital gains taxes dropped by two-thirds (post-September 11th) and 75 percent (1987-1991).

“Relying on capital gains for budget growth introduces enormous risk into the policymaking process,” explained Cameron Huff, author of the policy brief. “The state is already struggling with health care and other costs that exceed its ongoing revenue capacity. A major, sustained decline in capital gains receipts clearly would plunge the state’s finances into crisis,” he continued.

Health care spending dominates the state’s on-going programs, according to the policy brief, almost doubling from 16 percent of the state’s budget in 1987 to 30 percent in 2006. Practically all of this spending (90 percent) is dedicated to Medicaid, an entitlement that provides health care to the poor. The program’s requirements – those who meet the income threshold are served – mean that its annual cost increases are not only large, but also unpredictable and outside the control of state administrators. The state’s new universal health care law adds additional fiscal uncertainty.

While Massachusetts is similar to other states in facing these pressures, successfully dealing with them is made more challenging by the Bay State’s demographic trends.

“New workers and new businesses provide revenue that insulates the effects of a budget out of balance,” noted Torres. “Massachusetts will have a tougher time growing out of this problem because our cost of living and anemic job growth continue to cause out-migration from the state.”

The policy brief also details a history of budget winners and losers over the past 20 years. In addition to health care programs, K-12 education has seen dramatic increases in spending in response to the state’s reform movement. On the other hand, state support for higher education and local aid has been significantly cut back.

The brief outlines six points of possible reform, including considering a broadening of the state’s tax structure to move away from its dependency on capital gains; developing specific criteria for withdrawals from the state’s rainy-day reserve fund; and creating greater transparency of all government spending in the face of increased off-budget spending.

• The Massachusetts budget faces a structural imbalance, with on-going spending exceeding revenues. This is an unsustainable situation that endangers the state’s ability to meet basic commitments and key budgetary priorities, including the new universal health care law. At its core, there is a mismatch between expectations of reasonable revenue growth and the growth in spending required to maintain current programs and honor existing financial commitments. Based on historical performance, the growth in revenues in 2009 would be between $750 million and $1 billion, and the estimated growth in spending needed to sustain existing programs between $1.3 and $1.6 billion – before any new programs or initiatives are included. This imbalance reflects long-term trends and is not particular to the current year. In order to balance the state’s budget, state leaders have come to rely on nontraditional revenue sources and the rainy-day reserve fund.
• The state has become increasingly dependent on volatile funding sources for revenue growth – most notably, the capital gains tax. Between 2002 and 2006, capital gains tax revenues accounted for 54 percent of the state’s growth in tax revenues. At the same time, this source of revenue has very large swings tied to fluctuations in the stock market, including steep drops in revenue during bear markets. In 2002, capital gains tax revenues declined by almost $800 million in a single year. In 2006, capital revenue tax revenues were at a record high of $1.7 billion.
• In recent years the state has also become highly reliant on business taxes as a source of new revenue. Business tax receipts accounted for 41 percent of the state’s new revenues between 2002 and 2006. Tax receipts from businesses are also volatile. Between 2000 and 2002, they dropped $700 million.
• On the spending side, health care has become the state’s predominant spending priority, growing from 16 percent of the state’s budget in 1987 to 30 percent in 2006. Medicaid accounts for nearly 90 percent of the state’s health care spending. As an entitlement, the state is required to fund the state share in any given year or change the laws. The Massachusetts program offers more benefits than is federally mandated and also covers a broader population. Approximately half of the cost of Medicaid is paid by the federal government. Because many components of the program are not directly under the control of the state administrators (e.g. who and how many enroll and the health status of enrollees), spending can fluctuate unpredictably. Medicaid accounted for almost two-thirds of all spending growth since 1987. The state’s new universal health care law adds further to the fiscal uncertainty.
• Over the last 20 years, there have been winners and losers as choices have been made about where to spend public dollars. At the same time that the state added almost $1.3 billion of new spending for education reform, non-school aid to cities and towns declined by almost $800 million. State support for public higher education fell by more than $300 million, with large swings in spending that led to major tuition increases. Public safety spending more than doubled from $600 million to $1.4 billion over the last two decades, while the overall human services budget remained essentially flat.
• Since 1987, the share of total state spending that occurs outside the annual budget has increased from 20 percent to almost 33 percent, creating confusion and a lack of transparency. In FY 2006, the state’s budget was $25.6 billion, but total state spending was $37.5 billion. There is not consistency regarding what spending is on-budget and what is off-budget. In recent years, some spending for health care, employee pensions, public transit, and school construction has been removed from the state’s annual budget.

About MassINC: The Massachusetts Institute for a New Commonwealth (MassINC) MassINC (The Massachusetts Institute for a New Commonwealth) is a nonpartisan, evidence-based organization. Its mission is to develop a public agenda for Massachusetts that promotes the growth and vitality of the middle class. Its governing philosophy is rooted in the ideals embodied in the American Dream: equality of opportunity, personal responsibility, and a strong commonwealth.