How to Stay Out of the Deficit Abyss

The economic situation feels unfamiliar but aspects of it are highly recognisable. One is the yawning budget deficits confronting America's states.

States have been here before. Back in the early 1990s they found themselves leaning into the deficit abyss. But as William Eggers of the Manhattan Institute points out in a report presented this week, there are things states can do to bridge the gulf, and even emerge winners after a downturn.* Conversely, it is possible to ensure that a state falters and flails, suffering worse than others the same size.

States that raise taxes and sharply expand their governments do not succeed. States that hold the line on rate increases, or cut rates in the face of trouble do well. So do those that cut back government or even merely curtail its expansion.

Consider the pressure on Doug Wilder, Virginia's governor, back in the early 1990s. Virginia had a $1.4bn deficit. And Governor Wilder was a Democrat, which is to say a leader in a party that, on the national level at least, tends to think expanding government is the answer to economic downturns.

Instead, Mr Wilder tried another tack. "I think", he said, that "the shortfall in revenues presents me with an opportunity to streamline government more closely to what government has a responsibility to do, without as much resistance as I would face if there were more funds to go around."

Mr Wilder proceeded to privatise some state concerns and held the line on the budget. The result of his work and that of his equally anti-tax successors was that Virginia remained relatively attractive - and drew investment and a taxpaying population.

Similarly, a $1bn deficit greeted William Weld when he became governor of Massachusetts. Mr Weld had won the election with a promise not to raise taxes, though few believed him (we're talking, after all, about "Taxachusetts"). Nonetheless, Mr Weld stood firm, cutting taxes five times and repealing a 1990 sales tax on services. He also reduced the state workforce by 7,000. He sold off the states' mental health properties. Altogether, Mr Weld managed more than $200m in privatisation. The leaner Massachusetts saw strong growth.

Then there is Michigan's John Engler, who abolished outright the state's department of commerce - great idea - and sold off the state's Accident Insurance Fund. Mr Engler recognised that the state had no business in the insurance field and won $255m for state coffers through this epiphany. Nor has the insurance provider turned the worse for it. A decade later, A.M. Best, a rating firm, graded the privatised company "excellent". Nevada later copied Michigan's move.

Other states also narrowed deficits through privatisation. Ohio sold its liquor stores and got about $20m; California dumped $200m in extra buildings and real estate.

Some governors went down the other path. James Florio of New Jersey raised taxes and defended his move as an act of courage. But as a result of the increases, New Jersey bled hundreds of thousands of jobs in a period when the country gained several million.

This history is important, since, in times of regret and self-flagellation such as the current one, we tend to assume tax increases are virtuous, or at least to allow ourselves to be talked into that position.

On the contrary, they often yield shortfalls, since they drive businesses and families to other, lower-tax states.

Even increases in sin taxes - what Mr Eggers calls those increases on "your Luckies, your liquor, and your lotto" - do not bring growth the way rate cuts do. The Atlanta Fed did a study in the 1990s that showed that raising tax rates correlated to lower growth for states. Other studies have documented population flight from high-tax venues (for more, see the Cato Institute's report on its website

The privatisation story matters, too, since states still have plenty left they can sell or cut. Mr Eggers makes other points: fiscal efficiency that can be realised through the "e-economy" is important. Among his recommendations is requiring agencies to procure most goods and services online. A Texas budget study showed that 5 per cent of procurement outlays went to processing purchases. Pennsylvania saved $13m in commodity costs by conducting online "reverse auctions", with contracts going to the lowest bidder.

There may be readers who find the experience of individual US states a little distant.

To these we commend that grand experiment in Eggers budgetry, the Thatcher revolution. While some of the privatisations in the UK have foundered, such as the railroads, it is still hard to deny that Britain, by cutting taxes and curtailing government's growth, emerged stronger from its "Winter of Discontent". Now America just has to get through its summer.

* Manhattan Institute State Budget Report (PDF format)

© Copyright 2002 Financial Times

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