The Buckeye Institute for Public Policy Solutions i

Should Ohio Limit Government Spending and Taxes? A Joint Publication of The Buckeye Institute and the Independence Institute Russell S. Sobel, Ph.D. Department of Economics, West Virginia University Robert A. Lawson, Ph.D. School of Management, Capital University Barry W. Poulson, Ph.D. Senior Fellow, Independence Institute and Joshua C. Hall Senior Fellow, The Buckeye Institute for Public Policy Solutions

December 2004 www.buckeyeinstitute.org

Should Ohio Limit Government Spending and Taxes? ii

About The Buckeye Institute for Public Policy Solutions The Buckeye Institute for Public Policy Solutions is a public policy research and education institute, or think tank. As an independent, nonprofit, nonpartisan organization, its purpose is to provide Ohio’s leaders and citizens with market-oriented ways of thinking about problems facing our state and local communities. By widely distributing and publicizing its ideas and research, the Institute encourages more policymakers and opinion leaders to embrace new approaches to solving problems. To maintain the highest level of integrity, the Institute accepts no requests to conduct contract research or programs for businesses. All research projects and programs are determined by the staff and Board of Research Advisors. The Institute receives no government funding for its activities. All funding comes from the generous contributions of more than 300 private individuals, companies and foundations. The views expressed are those of the author(s) and do not necessarily represent the views of The Buckeye Institute, its trustees, or staff. Nothing written here should be construed as an attempt to aid or hinder the passage of any legislation. Additional information can be obtained from The Buckeye Institute for Public Policy Solutions, 88 E. Broad Street, Suite 1120, Columbus, Ohio, 43215, tel. 614.224.4422, www.buckeyeinstitute.org.

About the Independence Institute The Independence Institute is a nonprofit, nonpartisan Colorado think tank founded in 1985. It is governed by a statewide board of trustees and holds a 501(c)(3) tax exemption from the IRS. Its public policy research focuses on economic growth, education reform, local government effectiveness, and Constitutional rights. Additional information can be obtained from the Independence Institute, 3952 Denver West Pkwy, Suite 400, Golden, Colorado, 80401, tel. 303.279.6536, www.i2i.org.

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Should Ohio Limit Government Spending and Taxes?

The Buckeye Institute for Public Policy Solutions iii

A Joint Publication of The Buckeye Institute and the Independence Institute

Abstract The state and local tax burden on the average Ohioan has risen dramatically over the past twenty-five years. By most accounts, Ohio has evolved from a state with one of the nation’s lowest tax burdens to a state with one of the highest, with significant consequences: • Ohio’s tax burden has consistently exceeded the national average since 1994; • Ohio’s personal income growth has lagged the nation’s; and • Ohio University economist Richard Vedder estimates that a one percentage point increase in the state personal income tax rate results in economic growth falling by roughly 3.5 percent. Unfortunately, Ohio’s state legislators have been unable to restrain state spending growth: • State spending increased by 63.4 percent between Fiscal Year (FY) 1994 and FY 2002, almost three times the inflation rate; and • State revenues increased by 48 percent during the same period, more than twice the inflation rate. One possible solution to this problem is for Ohioans to adopt a Tax and Expenditure Limitation, or TEL. These limitations exist in 27 states and have been effective in restraining state and local government spending under the right conditions: • Colorado adopted the Taxpayer Bill of Rights, or TABOR, in 1992, saving Colorado taxpayers $3 billion between 1997 and 2001; • Michigan’s Headlee Amendment allowed the state to squirrel away a rainy day fund equivalent to 13.2 percent of the annual state budget, softening the effects of the business cycle; and • Washington’s Initiative 601 forced legislators to rein in spending for several years before legislators took advantage of its weak constitutional status to boost spending again after 2000. The experiences of these and other states suggest to Ohioans that there are three requirements for an effective TEL: 1. The TEL should be part of Ohio’s constitution and limits should not be amended without approval of voters; 2. State government spending and revenue growth should be limited to inflation plus population growth (not personal income growth); and 3. Surpluses should be automatically directed to a rainy day fund or, over certain minimum thresholds, refunded back to taxpayers.

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Should Ohio Limit Government Spending and Taxes? iv

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Should Ohio Limit Government Spending and Taxes?

The Buckeye Institute for Public Policy Solutions v

A Joint Publication of The Buckeye Institute and the Independence Institute

Contents Abstract ........................................................................................................................................... iii 1. Introduction ................................................................................................................................... 1 2. Ohio’s Fiscal Track Record ........................................................................................................... 1 3. Tax and Expenditure Limitations as a Tool For Fiscal Discipline .................................................. 5 4. The Next Generation TEL ........................................................................................................... 12 5. Using a TEL in Ohio ................................................................................................................... 14 6. Conclusion .................................................................................................................................. 17 Appendix A Case Studies: Colorado, Michigan, Washington, Florida, California, and Missouri .................... 18 Appendix B The Next Generation: A Model Tax and Expenditure Limitation Measure .................................. 25 Appendix C A Literature Review of the Empirical Research on TELs ............................................................ 35 About the Authors ........................................................................................................................... 40 Endnotes ........................................................................................................................................ 41

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Should Ohio Limit Government Spending and Taxes? vi

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The Buckeye Institute for Public Policy Solutions 1

Ohio has significant advantages, but its high tax burden makes the state less attractive for both lifestyle and investment reasons.

1. Introduction By almost every measure, Ohio’s tax burden has increased dramatically over the last two decades. Ohio has moved from a state with lower than average state and local taxes to one with higher than average taxes. This trend has significant implications for economic development. States such as California, Arizona, Florida, North Carolina, and even Texas can point to obvious lifestyle advantages such as a more temperate climate, more sunshine, and access to natural amenities such as beaches. Ohio has significant advantages, but its high tax burden makes the state less attractive for both lifestyle and investment reasons. Higher taxes relative to other states have hurt the state’s economy, reducing income for Ohio families and preventing the creation of tens of thousands of jobs. To restore its economic competitive advantage, Ohio must reconsider its approach to fiscal policy—the tax and spending decisions made by state and local governments. More importantly, it must manage government spending more effectively. To accomplish this, citizens and elected officials must draw on ideas that have been successful in other states. One of those ideas, a Tax and Expenditure Limitation, or TEL, has the potential to provide the fiscal discipline necessary to lower Ohio’s tax burden without compromising the flexibility needed to meet the state’s public obligations. By drawing on the positive and negative experiences of other states, Ohio can create a framework for fiscal discipline. In brief, the use of a Tax and Expenditure Limitation will improve Ohio’s economic competitiveness. This report explores why a change in the fiscal climate is necessary, and how to get there.

2. Ohio’s Fiscal Track Record To the uninitiated, it may come as a surprise to learn that Ohio is now a high tax state. But Ohio’s emergence as a high tax state is not surprising, given its recent fiscal history. Between Fiscal Year (FY) 1994 and FY 2002, state spending increased by 63.4 percent (Figure 1).1 This increase is almost three times the inflation rate over that time. State revenues, meanwhile, increased by 48 percent during the same period, more than twice the rate of inflation. So whether we look at spending or at revenue, state government grew at a rapid clip during these years.

Figure 1: Growth in Population, Inflation, State Government Revenues and State Government Spending FY 1994 to FY 2002 70%

63.4%

60% 48.0%

50% 40% 30%

21.4%

20% 10% 0%

2.3% Population Growth

Inflation

General State Government Revenues

General State Government Spending

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Should Ohio Limit Government Spending and Taxes? 2

Figure 2: State & Local General Revenue Spending from Own Sources, 1991-2002 $60

Billions of Dollars

$50 State and Local

$40 $30.6

$36.9

$33.9

$32.6

$42.9

$40.2

$38.8

$44.8

State

$30 $20

$16.5

$17.3

$18.8

$10

$14.1

$16.3

$15.1

$21.8

$20.7

$20.1

$18.4

$18.0

$16.8

$48.1

$49.9

$23.4

$23.9

$26.1

$26.8

$19.6

$20.9

$22.0

$23.1

$51.7

$27.6 $24.1

Local

2001-2002

2000-2001

1999-2000

1998-1999

1997-1998

1996-1997

1995-1996

1994-1995

1993-1994

1992-1993

1991-1992

0

Source: U.S. Census Bureau, State & Local Government Finances, various years.

If anything, the numbers above, from the Ohio Office of Budget and Management, understate the size of the total state budget. The General Revenue Fund—the primary source of funding for state programs—is only about half of state government spending. State government uses other funding sources as well, including the highway operating fund, lottery profits, and other special revenue programs and federal revenues allocated for specific purposes. Putting all these funds together, the state legislature approved total spending of $48.2 billion for FY 2004 and $49.8 billion for FY 2005.2 Since Ohio also spends federal money, it is important to break down the data. Ohio’s general funds from “own sources”—not including federal or other governmental funds—have increased dramatically since the mid-1990s (Figure 2).3 The U.S. Census Bureau reports that Ohio’s total general revenue from state and local governments increased from about $30.6 billion in 1992 to $51.7 billion in 2002. State government revenues alone increased from $16.5 billion to $27.6 billion. The rate of growth exceeded 5 percent annually.4 At this rate, Ohio’s government budget doubles every 14 years.

A. Ohio’s Tax Burden Given the soaring levels of government spending, it is not surprising that Ohio’s tax burden has also increased dramatically. The Ohio Department of Taxation, using comparative data from the U.S. Bureau of the Census, reports that in 1985, Ohio had the nation’s 31st lowest state and local tax burden. By 2000, however, Ohio had moved up to have the 20th highest tax burden. www.buckeyeinstitute.org

The Buckeye Institute for Public Policy Solutions 3

Even these Census Bureau numbers understate Ohio citizens’ tax burden. The U.S. Census Bureau’s analysis does not take into account recent tax law changes or the burden Ohio residents face by tax changes in other states. More and more states and cities, for example, are levying taxes on non-local residents such as tourists, consultants, and other professionals doing business beyond a state’s borders. In short, these states are trying to shift the burden for paying for local services to those outside the region, including Ohio residents. The Tax Foundation in Washington, D.C. makes adjustments to tax burden rankings to reflect this shift. When these adjustments are considered, Ohio’s state and local tax burden increases dramatically. Accordingly, its favorable ranking compared to other states deteriorates. According to the Foundation, Ohio’s state and local tax burden ranked as low as 47th in 1970.5 As late as 1980, Ohio still ranked among the bottom ten states in terms of state and local tax revenue as a percentage of personal income. Now, Ohio ranks third. Regardless of the measure used, whether the simplistic approach used by the U.S. Census Bureau (and adopted by the Ohio Department of Taxation and other groups) or the more sophisticated approach used by the Tax Foundation, Ohio’s state and local tax burden exceeded the national average in the mid-1990s. Since 1994, Ohio’s tax burden has consistently been above the U.S. average. In fact, the gap between Ohio and the national average has increased as Ohio’s tax burden has risen while the U.S. average has fallen.

B. Ohio’s Economic Performance While Ohio’s tax burden and government spending levels were rising, Ohio’s economy stagnated: • Inflation-adjusted personal income growth (a common measure of economic growth) grew at half the national rate between 1970 and 2001;6 • Ohio’s income growth lagged its neighboring states by 10 percent or more (Figure 3); • Ohio’s income growth lagged Indiana’s by more than one-third; and • Income growth lagged both our neighbors and the nation even after adjusting for Ohio’s anemic population growth (Figure 4).

Figure 3: Personal Income Growth in Selected States 1970-2001 140% 120%

125.4

100% 75.8

80%

86.0

63.0

73.3

71.2

MI

PA

60% 40% 20% 0%

U.S.

OH

IL

IN

Richard Vedder, Grinding to a Halt: Ohio’s Tax Policy and Its Impact on Economic Growth (Columbus, Ohio: The Buckeye Institute for Public Policy Solutions, 2002), Figure 3, page 6.

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Should Ohio Limit Government Spending and Taxes? 4

Figure 4: Real Per Capita Income Growth 1970-2001 70% 60%

64.5

62.0 52.9

56.7

58.3

IL

IN

54.3

50% 40% 30% 20% 10% 0%

U.S.

OH

MI

PA

Richard Vedder, Grinding to a Halt: Ohio’s Tax Policy and Its Impact on Economic Growth (Columbus, Ohio: The Buckeye Institute for Public Policy Solutions, 2002), Figure 3, page 6.

Regardless of the measure and the time period analyzed, Ohio has not done well economically over the past generation. Increasingly, research recognizes the role high state and local taxes play in reducing economic growth. It should be no surprise that Ohio, which has taken a turn towards a more expansive fiscal policy, has seen its economic standing compared to other states decline (see below).

State Taxes and Economic Growth: Research In Brief • Economist Zsolt Besci of the Federal Reserve Bank of Atlanta examined state economic performance and found that higher tax rates reduce state economic growth.7 • Cato Institute economic analysts Stephen Moore and Dean Stansel compared the ten states that reduced taxes the most between 1990 and 1996 with the ten that had raised taxes the most. The tax reducers enjoyed nearly 20 percent more economic growth than the tax increasers. Moore and Stansel also found that the states cutting taxes the most gained a significant number of new jobs. By contrast, the states increasing taxes the most had created no net new jobs.8 www.buckeyeinstitute.org

• Chris Edwards, Steve Moore, and Phil Kerpen found that the economic growth rate in the tax-increasing states was about half the rate of the tax-cutting states.9 • Ohio University economist Richard Vedder found that high-tax states have economic growth rates roughly onethird lower than low-tax states. In his study for the Joint Economic Committee of the U.S. Congress, Vedder found that this difference, applied over the 33-year time span of the study, amounted to $9,200 of additional income for a family of four in the low tax state. His estimates suggest that a one percentage point increase in the state personal income tax rate results in economic growth falling by roughly 3.5 percent.10

The Buckeye Institute for Public Policy Solutions 5

A properly defined TEL constrains lawmakers’ ability to increase taxes, spending, or both, while retaining their ability to set priorities and fund specific programs and agencies.

3. Tax and Expenditure Limitations as a Tool For Fiscal Discipline 11

Dissatisfied with rising tax burdens and stagnant economic performance, voters in many other states have imposed tax and expenditure limitation laws (TELs) as a means of obtaining fiscal discipline. TELs are a form of budgetary rules, which determine how much taxes, expenditures, or both can increase from one year to the next. Roughly speaking, these limitations create hard budgets for state policymakers to work with, much like private businesses and households are required to spend within certain limits to prevent excessive debt or financial insolvency. A properly defined TEL constrains lawmakers’ ability to increase taxes, spending, or both, while retaining their ability to set priorities and fund specific programs and agencies. A TEL can also provide for additional flexibility, but only if voters approve it. It can be structured to allow lawmakers to make a direct appeal to the public for spending on vital programs. In Colorado, where such appeals are often taken to the voters, the quality of the proposals for public spending has improved dramatically. Voters are willing to support tax and spending proposals that are well-defined and presented. TELs of various sorts are now in place in 27 states.12 They have varying degrees of effectiveness; Table 1 provides a detailed classification of these states based on our criteria. Empirical evidence indicates that well designed TELs are effective at imposing fiscal discipline on elected officials. Poorly designed ones are not.

Three Rules for Effective TELs Recent empirical studies are clear that fiscal rules such as a tax and expenditure limitation can significantly reduce state and local spending. But not all TELs are created equal. The details make all the difference, so designers must take care.

Rule 2. Effective TELs use a formula that limits the growth of government spending to the inflation rate plus population growth. Rule 3. Effective TELs provide for immediate refunds of surplus revenue above the specified limit.

Generalizing from the experience of the 27 states that have these limits, three rules appear to be necessary. These three rules provide the starting point for the model TEL legislation presented in Appendix B. Rule 1. Effective TELs are written into state constitutions.

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Should Ohio Limit Government Spending and Taxes? 6

Table 1 - Key Features of States with Tax and Expenditure Limitations State

Year

Type of Limit

Constitutional Limit?

Inflation plus Population?

Immediate Refund?

AK

1982

Spending

A cap on appropriations that grows yearly by the increase in population and inflation.

ü

ü

û

AZ

1978

Spending

Appropriations cannot be more than 7.41% of total state personal income.

ü

û

û

CA

1979

Spending

Annual appropriations growth linked to population growth and per capita personal income growth.

ü

û

û

1991

Spending

General fund appropriations limited to the lesser of: a) 5% of total state income, or b) 6% over the prior year’s appropriation.

û

û

û

1992

Revenue & Spending

Most revenues limited to population growth plus inflation. Changes to spending limits or increases must receive voter approval.

ü

ü

ü

Spending

Spending limited to average of growth in personal income for previous 5 years or prior year’s increase in inflation, whichever is greater.

û

û

û

1992

Spending

Voters approved a limit similar to the statutory one in 1991, but it has not received the three-fifths vote in the legislature needed to take effect.

ü

û

û

DE

1978

Appropriations to Revenue Limit

Appropriations limited to 98% of revenue estimate.

ü

û

û

FL

1994

Revenue

Revenue limited to the average growth rate in state personal income for previous 5 years.

ü

û

û

HI

1978

Spending

General fund spending must be less than the average growth in personal income in prior 3 years.

ü

û

û

ID

1980

Spending

General fund appropriations cannot exceed 5.33% of total state personal income.

û

û

û

IA

1992

Appropriations to Revenue Limit

Appropriations limited to 99% of the adjusted revenue estimate.

û

û

û

LA

1993

Spending

Expenditures limited to 1992 appropriations plus annual growth in state per capita personal income.

ü

û

û

û

û

û

ü

û

ü

Main Features of Limit

CO

1991 CT

MA

1986

Revenue

Revenue cannot exceed the three-year average growth in state wages and salaries. The limit was amended in 2002 adding definitions for a limit that would be tied to inflation in government purchasing plus 2 percent.

MI

1978

Revenue

Revenue limited to 1% over 9.49% of the prior year’s state personal income.

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The Buckeye Institute for Public Policy Solutions 7

Year

Type of Limit

Main Features of Limit

Constitutional Limit?

Inflation plus Population?

Immediate Refund?

1992

Appropriations to Revenue Limit

Appropriations limited to 98% of projected revenue. The statute was amended to allow for a 100% appropriation of the estimate for Fiscal Year 2004.

û

û

û

1980

Revenue

Revenue growth limited to 5.64% of prior year’s total state personal income.

ü

û

ü

1996

Revenue

Voter approval required for tax hikes over approximately $70 million or 1% of state revenues, whichever is less.

ü

û

ü

MT

1981

Spending

Spending is limited to a growth index based on state personal income.

û

û

û

NV

1979

Spending

Proposed expenditures are limited to the biennial percentage growth in state population and inflation.

û

û

û

NJ

1990

Spending

Expenditures are limited to the growth in state personal income.

û

û

û

NC

1991

Spending

Spending is limited to 7% or less of total state personal income.

û

û

û

1985

Spending

Expenditures are limited to 12% annual growth adjusted for inflation.

ü

û

û

1985

Appropriations to Revenue Limit

Appropriations are limited to 95% of certified revenue.

ü

û

û

2000

Revenue

Any general fund revenue in excess of 2% of the revenue estimate must be refunded to taxpayers.

ü

û

û

2001

Spending

Appropriations growth limited to 8% of projected personal income for biennium.

û

û

û

1992

Appropriations to Revenue Limit

Appropriations limited to 98% of projected revenue.

ü

û

û

Spending

Spending growth is limited by either the average growth in personal income or 9.5% of total state personal income for the previous year, whichever is greater. The number of state employees is limited to a ratio of state population.

ü

û

û

State

MS

MO

OK

OR

RI

1980 SC

and 1984

TN

1978

Spending

Appropriations limited to the growth in state personal income.

ü

û

û

TX

1978

Spending

Biennial appropriations limited to the growth in state personal income.

ü

û

û

UT

1989

Spending

Spending growth is limited by formula that includes growth in population, inflation and personal income.

û

û

û

WA

1993

Expenditures & Revenue

Spending limited to average of inflation for previous three years plus population growth.

û

ü

û

Source: National Conference of State Legislatures, “State Tax and Expenditure Limits,” and Michael New, Limiting Government through Direct Democracy: The Case of State Tax and Expenditure Limitations (Washington, DC: Cato Institute, 2001).

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Should Ohio Limit Government Spending and Taxes? 8

A. How Effective Are TELs? Early empirical studies of TELs found only mixed results. But more recent, more rigorous studies have found that properly designed limitations can significantly lower spending and improve the overall fiscal performance of states.

1. TEL Design Makes a Difference A criticism of most early TEL studies was that they treat all TELs alike, masking the fact that some could be very effective, while others might actually be counterproductive. Michael New has conducted the only study to date to take into account differences in TELs.13 New found that: • TELs passed through the initiative process significantly reduced state and local spending; • TELs enacted by state legislatures actually increased spending; • States in which TELs limit increases in revenue and spending to the sum of inflation and population growth saw slower government growth than states in which the limit was linked to growth in state personal income;14 and • States in which the TELs mandate immediate refunds of surplus revenue to taxpayers (i.e. Colorado, Michigan, Missouri, and Oregon) were also more successful in constraining government spending growth. Further, New found that the states with the “strongest” TELs, Colorado and Washington, had the strongest economic growth as well. For the years 1995 to 2002, their economic growth rates surpassed both the rate in Ohio and the national average.

Economic Performance of States with Effective TELs

Annual Increase in State Personal Income: Ohio Versus “Strong” TEL States, 1995-2002

Economic research indicates that states with lower overall taxes, other things being equal, have higher levels of economic output. The economic performance of Ohio versus “strong” TEL states can be seen to the right.

10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0

Although this comparison does not control for other factors, it indicates that states with TELs that constrain spending to population growth plus inflation seem to do better economically than other states. While personal income in Ohio rose by 5.0 percent annually and 6.7 percent nationally, it grew 7.5 percent in Washington and 9.3 percent in Colorado. www.buckeyeinstitute.org

9.3% 7.5%

6.7% 5.0%

U.S.

Ohio

Colorado

Washington

Richard Vedder, Grinding to a Halt: Ohio’s Tax Policy and Its Impact on Economic Growth (Columbus, Ohio: The Buckeye Institute for Public Policy Solutions, 2002), Figure 3, page 6.

The Buckeye Institute for Public Policy Solutions 9

TELs, as well as other budget rules, can significantly reduce state and local spending.

2. TELs Work Well With Other Tools A recent study by Dale Bails and Margie Tieslau was unique in using panel data to analyze the impact of a comprehensive set of budget institutions on state and local spending. They looked at a number of tools, including tax and spending limits, line item vetoes, balanced budget requirements, and term limits.15 As is common in panel data studies, the researchers also controlled for other economic and demographic variables. Bails and Tieslau found that the following budgetary institutions significantly reduced the rate of growth of state and local spending: • • • • •

Tax and spending limits; Balanced budget requirements in the presence of tax and spending limits; Supermajority vote requirements in the presence of balanced budget requirements; Term limits; and The initiative process.

Real (inflation-adjusted) per capita state and local spending in states with TELs is estimated to be $42 lower than in states without TELs. In states with both TELs and balanced budget requirements, spending is reduced by nearly $135. In states with the comprehensive budgetary institutions tested, real per capita expenditures are reduced nearly $473. In other words, Bails and Tieslau found that per capita state expenditures are significantly lower in states with all these measures than in states with none of these measures. Thus, recent empirical studies support the public choice view that budget institutions significantly affect fiscal policy. TELs, as well as other budget rules, can significantly reduce state and local spending.

B. TELs In Action: Colorado, Michigan, and Washington The success of TELs can be seen not only in formal studies, but in the experience of the states, particularly those that have used them for decades. California was one of the first states to adopt a statewide limitation— Proposition 13—in 1978. The states that have had the most success with spending and tax limitations, however, are Colorado, Michigan and Washington. • Colorado adopted the Taxpayer Bill of Rights, or TABOR, in 1992, after a statewide tax limitation measure adopted in 1978 was weakened by the legislature. Between 1997 and 2001, Colorado taxpayers received $3 billion in tax rebates or refunds because of TABOR and a booming state economy. TABOR has also been effective in restraining growth in local government spending and taxation even though voters have approved exceptions to the limit. • Michigan’s Headlee Amendment has limited state government spending to the rate of growth in personal income. By 2000, just before the recession, the state had squirreled away a rainy day fund equivalent to 13.2 percent of the annual state budget. Thanks to the amendment, the state www.buckeyeinstitute.org

Should Ohio Limit Government Spending and Taxes? 10

had a rainy day fund from which it could transfer close to $1 billion to help offset the revenue impact of the recession. • Washington State adopted Initiative 62, pegging state revenue growth to personal income growth, in 1979. Because the legislature continued to increase taxes, citizens voted for Initiative 601 in 1996, limiting spending and revenue growth to the rate of inflation plus population growth. The initiative forced legislators to rein in spending for several years. Unfortunately, because the initiative was statutory rather than constitutional, the legislature weakened its limits, and the initiative has not successfully constrained spending since 2000. These cases (and others detailed in Appendix A) have shown that TELs can be effective, but they require diligence on the part of state legislators and citizens. Otherwise, legislators will attempt to weaken and circumvent the limits.

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The Buckeye Institute for Public Policy Solutions 11

Can a TEL Stabilize a State Budget? When Governor Owens of Colorado recently encouraged Governor Schwarzenegger of California to adopt a TEL, he argued that this would help him stabilize the state budget.16 Owens maintained that the TABOR Amendment limited increases in government revenue and spending in the 1990s, making it easier for Colorado to cope with the revenue shortfalls during the most recent recession (2001-2002). The essay by Owens in The Wall Street Journal raises the question of whether states with effective TELs have been subject to less volatility in revenues and spending over the business cycle. Most state constitutions prevent state governments from running deficits. After a budget is passed, however, actual revenues and expenditures may deviate from projections, resulting in unexpected deficits.17 James Poterba conducted one of the few studies exploring how states adjust their budgets to unexpected shocks. Poterba’s approach was to measure how changes in spending and taxes were influenced by fiscal rules.18 He examined the impact of balanced budget rules, TELs, and general fund balances. To offset deficits, states may sometimes draw down their general fund balances or take money from their rainy day funds. Most states also allow short-term borrowing to offset the deficit. In some states the money must be repaid in the current fiscal year; others allow the state to wait until the following fiscal year. Regardless, state rules generally prevent the use of long-term debt to cover the deficit. In the short run, of course, states sometimes rely upon a variety of gimmicks to satisfy balanced budget rules: deferring expenditures to the following fiscal year, altering the fiscal year, raiding cash and trust funds, etc.

Poterba found that states with TELs experienced lower tax increases in periods of recession than states without TELs. In TEL states, a $1 increase in the budget deficit resulted in a $0.47 tax increase. This compares favorably with a $1.03 tax increase in states without TELs. On the other side of the ledger, Poterba found no evidence that spending cuts are any larger in states with TELs. He also explored how a state’s response to a deficit is affected by its general fund balance. In some states these reserves were allocated to a budget stabilization (rainy day) fund. The general fund balance, however, is a broader measure of the total reserves available to stabilize the budget. Not surprisingly, Poterba found that states with lower general fund balances must make larger spending cuts in response to budget deficits than states with higher general fund balances. States with general fund balances of more than 2 percent of spending reduced spending by $0.25 per dollar of deficit. States with lower general fund balances had to make cuts twice as great, or $0.55 per dollar of deficit. On the revenue side, the amount of tax increases as a fraction of the deficit also tended to be larger in states with low general fund balances. In short, the lower the fund balance going into a recession, the deeper the resulting spending cuts, or higher the tax increases. Though Poterba found that fiscal institutions affect the way that states respond to revenue shortfalls, he concludes that how fiscal institutions affect the level of government spending remains an open question.

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Should Ohio Limit Government Spending and Taxes? 12

The larger the share returned to taxpayers through tax cuts and tax rebates, the more effective the TEL will be in constraining the growth of government.

4. The Next Generation TEL

19

New TELs have been proposed in half a dozen states over the past year.20 This next generation of tax and expenditure limitations departs considerably from the TELs now in place. For one thing, they seek to address the trade-off between smoothing state finances and restraining government growth. A TEL can constrain the growth of government in the long run but destabilize the budget over the business cycle. That is in fact the nature of Colorado’s TABOR Amendment. On the other hand, a TEL designed to stabilize the budget over the business cycle may or may not constrain the growth of government in the long run. For example, Michigan’s TEL has been used to stabilize the budget over the business cycle, but it is not clear that it has constrained the growth of government. If all of the surplus revenue generated in periods of rapid growth is returned to the general fund to finance spending and to offset revenue shortfalls in periods of recession, then the TEL will do little to constrain government spending in the long run. Thus, we face a trade-off in the allocation of surplus revenue above the TEL limit. The larger the share returned to taxpayers through tax cuts and tax rebates, the more effective the TEL will be in constraining the growth of government. On the other hand, the larger the share of the surplus revenue set that is set aside in a budget stabilization fund, the more effective the TEL will be in offsetting revenue shortfalls, and less effective in constraining the growth of government in the long run. Understanding this trade-off is crucial in designing a TEL. The next generation of TELs is designed to achieve an optimum trade-off between these two goals. Three rules need to be adopted to both restrain state spending and smooth state revenue over the business cycle. They must do the following: • Introduce an effective brake, or limit, on the revenue the government can spend; • Determine the base of the TEL; and • Govern how the surplus revenue above the TEL limit is allocated or disbursed to the budget stabilization fund.

A. Tie the TEL Limit to Inflation + Population Growth The states have experimented with a variety of limits, with the most widely used one being the rate of income growth over some historical period. This type of limitation has significant flaws. First, it tends to be less stringent compared to other limits, resulting in a more rapid growth of government. Depending upon how the limit is applied, it may have little or even no impact on the growth of government. www.buckeyeinstitute.org

The Buckeye Institute for Public Policy Solutions 13

If interest groups are able to exempt portions of revenue or expenditures from the limit, it becomes less effective

It is also less effective in stabilizing the budget over the business cycle. A limit tied to a historic rate of income growth permits a very rapid rate of growth in revenue and spending when the economy is growing rapidly. That is, even when the limit is triggered it does so only with some lag. As a result, this type of limit is less effective than one that has no lagged impact. Indeed, it is possible for such a limit to be pro-cyclical. Recent studies have demonstrated that the most effective TELs define the limit as the sum of the inflation rate and population growth. While these limits also constrain the growth of government, they have proven less effective in stabilizing the budget over the business cycle. If such TELs ratchet down revenue and spending in periods of recession, they may also be pro-cyclical.

B. In Making the TEL Base, Broader is Better The states have also experimented with different revenue and expenditure bases against which the TEL is applied. In general, the broader the base, the more effective the TEL will be. If interest groups are able to exempt portions of revenue or expenditures from the limit, it becomes less effective both in constraining government and in stabilizing the government budget over the business cycle. A TEL with a narrower base also introduces economic distortions such as privilege seeking. On a related note, the use of actual historical measures of revenue and expenditures has proven more effective than the use of projected data. Historical data from the most recent budget cycle is easily obtained and does not rely upon projections of revenue or expenditures that are subject to error and bias.

C. Link the TEL to a Budget Stabilization Fund The basic principle of a rules-based budget stabilization fund is straightforward. A good analogy is a hybrid energy vehicle (HEV). An HEV has a braking system such that surplus energy created by the motor when the brakes are applied is stored in a battery, and then used to power the motor when the car is operating at a slower speed. Rules governing a budget stabilization fund operate much like an HEV. A brake is applied to limit the amount of revenue the state spends in periods of rapid economic growth. The surplus revenue is accumulated in a budget stabilization fund, and used to offset revenue shortfalls in a recession. At this point we assume that the budget stabilization fund is clearly distinguished from other funds that might be created. The money set aside in the fund is used for only one purpose, and that is to stabilize the budget. The TEL limit is held constant (it does not ratchet down) whenever there is a revenue shortfall, and becomes a binding constraint only when revenue recovers to that limit. www.buckeyeinstitute.org

Should Ohio Limit Government Spending and Taxes? 14

Voter surveys suggest that money should be transferred from the budget stabilization fund to offset some, but not all, of the revenue shortfall.

1. Develop Rules for Allocating Surplus Revenue into the Budget Stabilization Fund If we assume that an effective TEL is in place, then the opportunity cost of putting surplus revenue in the stabilization fund is the return of that money to taxpayers through tax rebates and tax cuts. The more of the surplus revenue that is returned to taxpayers, the lower the rate of growth of government is in the long run. Allocating some of that revenue to a budget stabilization fund provides the means of stabilizing the budget, but also reduces the constraint on the growth of government. Rules must establish how much of the surplus revenue to allocate to the budget stabilization fund, and what, if any, cap should be placed on its size. Wall Street and bond rating agencies often recommend something in the range of 6 to 7 percent of the state budget. But each state is unique in its preferences and requirements for a budget stabilization fund, and it is fair to say that there are no hard and fast rules.

2. Develop Rules for Allocating Money from the Budget Stabilization Fund to the General Fund If the primary emphasis is on budget stabilization, then money would be transferred from the stabilization fund to make up for the revenue shortfall, or until the budget stabilization fund is exhausted. But if the emphasis is on constraining the growth of government in the long run, then only a portion of the budget stabilization fund would be transferred. In this case a revenue shortfall would also require reductions in government spending as well. Voter surveys suggest that money should be transferred from the budget stabilization fund to offset some, but not all, of the revenue shortfall. One way to enact this preference is to require that only half of the revenue shortfall be offset by money transferred from the budget stabilization fund in any given fiscal year, with the other half offset by budget cuts. Such a rule might mean that the budget stabilization fund would not be exhausted in any given recession.

5. Using a TEL in Ohio It is worth considering what the impact of a TEL might have been had one been in effect in Ohio.

A. If a TEL Had Been in Place The Ohio Office of Budget and Management provides spending and revenue data in its Comprehensive Annual Financial Reports. Using FY 1993-94 as a benchmark, if a TEL pegged only to the inflation rate had been in place, state government spending would have been $9 billion lower than actual spending in FY 2002. If a limitation pegged to inflation plus Ohio’s population growth had been in place, state government spending in FY 2002 would have been $8.5 billion lower (Table 2). www.buckeyeinstitute.org

The Buckeye Institute for Public Policy Solutions 15

Table 2 - Actual vs. Estimated State Government Spending with a TEL, 1994-2001 (Billions of Dollars) Actual State

Inflation + Population Growth

Fiscal Year

State Government Spending

Est. State Govt. Spending

Difference

FY 1993-94

$22.4

$22.4

$0.0

FY 1994-95

$23.6

$23.0

$0.6

FY 1995-96

$24.1

$23.7

$0.4

FY 1996-97

$25.7

$24.5

$1.2

FY 1997-98

$26.9

$25.1

$1.8

FY 1998-99

$28.0

$25.5

$2.5

FY 1999-2000

$29.3

$26.2

$3.1

FY 2000-01

$31.4

$27.3

$4.1

FY 2001-02

$36.6

$28.1

$8.5

Source: Author’s calculations based on data from the Ohio Office of Budget and Management, Comprehensive Annual Financial Report for the Fiscal Year Ending June 30, 2003. Spending for FY 2001-02 partially reflects revised accounting standards that required state government to conform to Generally Accepted Accounting Practices. Readers should consult the notes to the report for more detailed explanations.

The cumulative effects of having the TEL in place would have saved between $22 and $24 billion over the nine year period (Table 2). These savings are likely underestimated because they do not include local government spending. These data were not available for comparable time periods from the Ohio Office of Budget and Management.

B. The Possible Future Savings from a TEL The effects of a TEL are more dramatic if we project its use into the future. If Ohio enacted a TEL for FY 2005, savings over the next ten years would be substantial. Assuming state spending, inflation, and population growth would increase at the same rate as in the period from 1994 to 2002, Ohioans would reap savings of $79 billion (see Table 3).

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Should Ohio Limit Government Spending and Taxes? 16

Table 3 - Ohio State Government Spending: Current Trends vs. TEL Alternative Fiscal Year

Total State Spending

Inflation + Population Growth

Difference

FY 2004-05

$50.3

$50.3

$0.0

FY 2005-06

$53.1

$51.7

$1.4

FY 2006-07

$56.1

$53.2

$2.9

FY 2007-08

$59.2

$54.7

$4.6

FY 2008-09

$62.6

$56.2

$6.3

FY 2009-10

$66.1

$57.8

$8.3

FY 2010-11

$69.8

$59.4

$10.3

FY 2011-12

$73.7

$61.1

$12.6

FY 2012-13

$77.8

$62.8

$15.0

FY 2013-14

$82.2

$64.6

$17.6

Source: Authors’ calculations based on total spending approved for FY 2005 according to Ohio Legislative Service Commission, LSC Fiscal Analysis: Selected Issues of the FY 2004-2005 State of Ohio Operating Budgets.

C. Scoring Recent TEL Proposals in Ohio Recently, several proposals have surfaced that would limit the rate of spending and taxation in Ohio. One of these proposals, HJR 14, was introduced in February of 2004 by State Rep. Jean Schmidt and seven co-sponsors. A second proposal is promoted by OhioTEL (www.OhioTEL.org), a grass roots advocacy group supporting a ballot initiative for 2005. A third proposal is supported by Ohio Secretary of State J. Kenneth Blackwell. It is currently under review by the Ohio attorney general’s office. In general, each of these proposals fit the primary criteria for “strong” legislation: they are constitutional limits, peg state spending and revenue growth to inflation plus the state population growth, provide for automatic tax rebates or refunds above certain thresholds, include state and local governments, and allow for voter overrides at the ballot box.

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Table 4: Comparison of Ohio TEL Proposals Proposal

Constitutional Restriction?

Inflation + Population Growth?

Automatic Rebate of Surplus?

State & Local Government

Voter Override?

HJR 14 (Schmidt)

NO

YES

YES

NO

YES

OhioTEL

YES

YES

YES

YES

YES

“Blackwell” Proposal

YES

YES

YES

YES

YES

HJR 14 is weaker because the legislature can unilaterally override the spending limits without voter approval. The experiences of Washington, Missouri, Florida, and other states have shown state legislatures tend to override and even ignore the limits rather than make difficult choices and trade-offs about spending (Appendix A). Moreover, HJR 14 restricts the limits to state government, not state and local spending.

6. Conclusion Over the past generation, Ohio has gone from being a low tax state to a high tax one. Policymakers from both parties have shown that they are unwilling or unable to stand up to special interest groups and take steps to control spending. Without a binding budget constraint at the constitutional level that will force policymakers to make tough choices, there is little hope that the recent trends will improve. Given the recent history of Ohio’s Medicaid program and the education spending legacy of the DeRolph case, it seems likely that the tax burden will continue to increase in Ohio unless something is done. In short, a well-constructed Tax and Expenditure Limitation might be the only thing that will force Ohio policymakers to hold the line on spending.

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Should Ohio Limit Government Spending and Taxes? 18

Appendix A Case Studies: Colorado, Michigan, Washington, Florida, California, and Missouri While empirical studies provide important insights into TELs, their effectiveness also depends upon the particular political and legal arrangements found in each state. Public-choice approaches to legislative decision making suggest that the way in which the legislators and the courts choose to interpret and implement a TEL is crucial. Surprisingly little research has been conducted into this interaction. We will review TEL implementation for several states to more fully understand the political and economic environment in which these measures operate. In each of the states studied here, political and legal institutions seem to have eroded the effectiveness of the fiscal limits. In some states, such as Florida, this influence was apparent in the original design of the limit. In other states, legislative actions and court decisions played a significant role after the limits were enacted. 21

A. Colorado

In 1978, Colorado became one of the first states to impose a statutory cap on government spending, limiting the growth of general fund expenditures to 7 percent annually. Thanks to that measure, taxpayers enjoyed a small rebate when the state government ran a surplus. When a recession hit in the early 1980s, Colorado, like other states, responded by increasing taxes to balance the budget. That increase ratcheted up government spending to rates in excess of the growth in state income in subsequent years. The Colorado TEL, like many other statutory limits, was simply ignored by the Legislature.

1. Making Colorado’s TEL Effective In the late 1980s citizens organized to enact a more stringent measure through a ballot proposal. After several failed attempts, the Taxpayer Bill of Rights, or TABOR Amendment to the Colorado Constitution, was enacted in 1992. TABOR remains the most stringent limit introduced in any state. It restricts the growth in state revenue and spending to inflation plus the percentage change in state population. TABOR also requires that surplus revenue above that limit to be rebated to taxpayers. As a further measure of restraint, the TABOR limit ratchets down the amount of revenue that the state can keep and spend as revenue falls. As an example, say the limit is at $10 billion. The limit is then adjusted up by the formula. But say the state actually receives only $9.8 billion because of a recession. The limit is then not the $10 billion but $9.8 billion (the money actually received). This is the “ratchet down” effect, the scourge of many special-interest groups. www.buckeyeinstitute.org

The Buckeye Institute for Public Policy Solutions 19

The TABOR Amendment also placed a procedural constraint on the power of government to raise taxes. Voter approval is required for any of the following: new taxes, tax rate increases, the extension of an expiring tax, or a tax policy change directly causing a net revenue gain to government. Voter approval is also required for state and local governments to retain and spend revenue in excess of the limit.

2. Colorado’s Political Response to the TEL In a failed attempt to pre-empt this stringent limit from being enacted through citizen initiative, the Legislature created a statutory TEL. In 1992, the Arveschoug-Bird Amendment placed a cap on general fund appropriations. The cap is equal to the lesser of two figures: 5 percent of Colorado personal income in the calendar year two years prior to the start of the fiscal year, or 6 percent over the previous year’s general fund appropriation. The amendment makes exceptions for federal mandates and court orders. Over time the Legislature has interpreted the 6 percent statutory cap as a floor on the growth in general fund expenditures, rather than a ceiling. The reason they did this is that the level of general fund spending in a given year is used to calculate the amount of general fund spending permitted in the next year. The desire to not leave any money “on the table” has affected the decision making within the Legislature in recent years. For the foreseeable future the Arveschoug-Bird amendment will have little if any impact on state fiscal policies. The 6 percent limit on the growth in general fund expenditures is significantly above the limit imposed by the TABOR Amendment.

3. Effects of TABOR Initially the TABOR Amendment was non-binding. Even with the growth in state revenues, state receipts were under the limit. But as the economy boomed in the second half of the 1990s, the limit started to have an effect. TABOR first became a binding constraint in 1997. Over the next five years, more than $3 billion in surplus revenue was returned to taxpayers, either by rebates or tax reductions. A referendum offered during this time to spend a portion of the surplus revenue was defeated by taxpayers. As with Arveschoug-Bird, the Legislature has also chosen to interpret the TABOR limit as a floor rather than a ceiling. Again, this introduces distortion and inefficiency in state finance, a problem that has become especially evident in the current fiscal crisis. Even if it might be prudent for the Legislature to hold revenue and spending growth below the amount permitted by TABOR, the Legislature has often failed to do so. The Legislature also chose to retain the surplus revenue generated in the current year in the general fund reserve, and to finance the required rebates from the surplus revenue generated in the following year. The Legislature has thus interpreted TABOR so as to erode its constraints, and to exacerbate the fiscal crises resulting from the current recession. www.buckeyeinstitute.org

Should Ohio Limit Government Spending and Taxes? 20

4. TABOR and Fiscal Discipline This legislative scheme worked fine when revenues kept rising in the boom years, but its flaw became apparent when the recent fiscal crisis hit. With the recession the TABOR surplus disappeared. Worse, the state had to finance a rebate for the previous year from reductions in current state spending. Naturally, this exacerbated the fiscal difficulty. As a way to alleviate the problem, the Legislature chose to increase the TABOR limit by adjusting for undercounting of population growth in the last decade. This permitted the state to retain and spend more revenue. A different set of problems resulted from the way in which the Legislature chose to offset surplus revenue. More than 20 bills have been passed to allocate the TABOR surplus. Most of it has in fact been generated by the income and sales taxes, and some of that surplus has been offset by rebates and reductions in those taxes. But the increased use of targeted tax cuts and tax rebates to benefit narrow interest groups means that less of the surplus is refunded to the people who actually paid the excess. A major problem in state finance emerged when another constitutional provision was approved by Colorado citizens in 2000. Amendment 23 requires constant growth in expenditures for K-12 education. This money comes from tax revenue, is earmarked for that purpose, and is exempt from the TABOR limit. This amendment, which requires a constant ratcheting up of education expenditures, combined with the TABOR Amendment, which ratchets government revenue down, placed the Legislature in an untenable position. It has discretion over less than one third of the state budget, since more than two thirds of it is allocated by mandates or other provisions to K-12 education, Medicaid, and prisons. When the recession created a revenue shortfall, the Legislature was required to make draconian cuts in higher education and social services to offset the difference. In the long run, the combination of TABOR and Amendment 23 will result in a structural deficit, which is prohibited by the balanced budget provision of the Colorado Constitution. The Colorado Legislature is now considering changes in each of these constitutional provisions in order to avoid future fiscal crises.22

5. The Effects of TABOR on Local Government TABOR has been more effective in constraining local government than state government. The amendment requires the state to compensate local governments whenever state legislation has a negative impact on local government revenues. When the state enacted a cut in the business personal property tax, it had to compensate local governments for revenue lost from this tax cut. Despite this provision, the financing and administration of some programs, such as K-12 education, has shifted from local government to the state government.

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The Buckeye Institute for Public Policy Solutions 21

6. Summary Colorado is currently experiencing its worst fiscal crisis in decades. While tax and spending limits have been effective in slowing the growth in state government in the long run, they have not been very effective in smoothing the growth of state revenue and spending over the business cycle. To make matters worse, the state does not have a true budget stabilization fund. Legislation has been introduced that would help smooth revenue and spending by linking the TABOR limit to both an emergency reserve fund and a budget stabilization fund. This legislation is similar to the model legislation in Appendix B. With some modifications, the Colorado TEL does serve as a role model for other states.

B. Michigan: Using a TEL to Stabilize the State Budget 23 The Michigan limit is unique in several respects. First, the Headlee Amendment, introduced in 1978, limits the growth of revenue to a fixed percentage of state personal income. That percentage is applied to either personal income in the prior year, or to average personal income in the prior three years, whichever is higher. When revenue exceeds the limit by 1 percent or more, the excess is refunded to taxpayers based on the Michigan income tax. Michigan’s formulaic allocation of surplus revenue to and from a budget stabilization fund (rainy day fund) is also unique. When annual personal income grows more than 2 percent (e.g., 3 percent) the percentage in excess of 2 percent (e.g., 1 percent) is multiplied by total state government revenue to determine the amount of money to be automatically transferred from the general fund to the rainy day fund. In addition, all general fund surpluses are also transferred into the rainy day fund. Withdrawals from the rainy day fund are automatic. When personal income growth is less than 0 percent (negative), the deficiency under 0 percent is multiplied by total general fund revenue to determine the amount to be transferred from the rainy day fund to the general fund. The Legislature can also appropriate money from the rainy day fund if unemployment rises above 8 percent. In an emergency the legislature can, by supermajority vote, approve emergency transfers from the fund. Just prior to the recession in 2000, the state had accumulated a rainy day fund of $1.2 billion, equal to 13.2 percent of state spending that year. As you would expect, given a pool of money that large, the fund became a target for special interest groups. There is, for example, an ongoing appropriation from the fund over the period 2000 to 2008 of $32 million for K-12 education, and $25 million for water pollution control. Legislators have been able to transfer money from the fund for a variety of purposes by simply declaring an emergency. Despite the dissipation of the rainy day fund in response to special interest group pressure, Michigan’s TEL has stabilized the budget over the business cycle. In the recent recession the state was able to transfer close to $1 billion from the rainy day fund to offset revenue shortfalls. www.buckeyeinstitute.org

Should Ohio Limit Government Spending and Taxes? 22

C. Washington: The Weakness of Statutory Requirements

24

The state of Washington joined the tax revolt in 1979, enacting a tax and spending limit known as Initiative 62. That amendment limited increases in state revenue to the rate of growth in personal income. As is often the case with TELs linked to personal income, the Washington measure was never an effective constraint on the growth of government. In the years after Initiative 62 was enacted, the state was able to pass a series of tax increases, and yet remain within the confines of the limit. In the early 1990s, citizens responded to the increased tax burden by using the initiative process to pass a more stringent statutory TEL. Initiative 601 imposed a limit on the growth in state spending equal to the rate of inflation plus population growth. When I-601 took effect in 1996, legislation was passed to ensure that spending was contained within the limit. Budget cuts of $120 million reduced expenditures for administration, social services, and prisons. Institutions of higher education were required to trim their benefits by $39 million. In subsequent years, when revenue growth exceeded the limit, tax cuts were enacted to return the surplus revenue. The flaw in the Washington TEL was that it was a statutory rather than a constitutional provision. Such limits are no safer than the next vote of the legislature. In 2000, when the Legislature wanted to pass a budget that exceeded the TEL limit, it simply obtained the supermajority vote required to suspend the limit. Since then the Washington tax and expenditure limit has ceased to be an effective constraint on government.

D. Florida: A Modern Day Fairy Tale

25

In 1994, Florida citizens gathered enough signatures to place an amendment on the ballot requiring voter approval for any new tax or tax increase. The Florida Supreme Court ruled that the initiative did not pass legal muster as a citizen initiative, and struck it from the ballot. The Florida Legislature responded by designing an amendment of its own, to pre-empt another citizen initiative. The Legislature imposed a revenue limit linked to the growth of state personal income. The growth rate of state revenue was capped at a five year moving average of state personal income growth. Two provisions of the Florida limit would render it completely ineffective as a constraint on the growth of state government. First, several components of revenue were excluded from the cap, including Medicaid matching funds, charges imposed by local and regional governments, and debt service. Second, the limit was allowed to grow year to year, regardless of whether it was reached in the previous year. (In some ways this is the opposite of TABOR’s “ratcheting down” effect.) The revenue cap increases each year with growth in personal income regardless of whether actual revenue rises or falls. As a result, the revenue cap has not and never will constrain the growth of state revenue and spending. www.buckeyeinstitute.org

The Buckeye Institute for Public Policy Solutions 23

Some have described the Florida TEL as a “Modern Day Fairy Tale.” Florida legislators appeared to be fiscally prudent, when in fact they designed a measure sanctioning higher levels of revenue and spending than had occurred previously. Clearly the actions of the Florida Legislature and courts have left the state with a meaningless spending and revenue restraint.

E. Missouri: How Legislative Discretion Erodes Effectiveness 26 One of the first TELs enacted was the Hancock Amendment, introduced in Missouri in 1980. It limited the growth in state revenue to a constant share of personal income, with surplus revenue rebated to taxpayers based on the state income tax system. The Hancock Amendment was never an effective constraint, however, and no tax rebates were ever made. Legislators, aided by the courts, were able to successfully evade and avoid the limit by exempting an increasing share of revenue from its authority. Initially, only 2 percent of revenue was exempt from the limit. A decade later, the amount was 18 percent. Over that period state revenue grew far in excess of personal income; in some years the growth in revenue was more than double the growth in personal income. Missouri demonstrates how the Legislature and the courts can erode the effectiveness of a tax and expenditure limit. Lawmakers failed to enact enabling legislation. As a result, there was never an agreement on what constituted total state revenue, nor what constituted revenue above the limit. Different state agencies came up with their own conflicting interpretations.

1. More Tax Increases Soon after the Hancock Amendment was passed, voters approved a 1 percent sales tax increase. Half of the new money was earmarked for property tax reduction, and half was earmarked for K-12 education. Both the Missouri Budget Office and the State Auditors Office ruled that this earmarked revenue was not subject to the Hancock limit. Amazingly, the Missouri Supreme Court agreed, ruling that this statutory tax increase pre-empted the constitution-based revenue limit. Other tax increases soon followed. The legislature enacted a statutory motor fuel tax increase. It, too, was exempt from the revenue limit. Other tax increases approved by voters were specifically excluded from the revenue limit as well. Over time special interests and politicians became more adept at circumventing the revenue limit. The courts sanctioned these acts, even when doing so violated the spirit if not the letter of the constitution. In 1993 the Legislature enacted another tax increase earmarked for K-12 education, this time without voter approval. Corporate taxes were also increased; corporations, small business, and higher income individuals were for the first time required to pay state income taxes on the federal income taxes they paid. www.buckeyeinstitute.org

Should Ohio Limit Government Spending and Taxes? 24

2. Citizen Response Missouri citizens responded by attempting to strengthen the constitutional constraints they had put in place. In 1994 they placed on the ballot an amendment requiring voter approval for new taxes. The opposition, including the governor and Legislature, was able to include in the ballot language the statement that the proposed amendment would cause state and local spending cuts ranging from $1 billion to $5 billion annually. Cuts would affect prisons, schools, colleges, programs for the elderly, job training, highways, public health, and other services.27 Not surprisingly, the proposed amendment was defeated by a two to one margin. In 1996, citizens successfully enacted an even more stringent amendment requiring voter approval for any tax increase that exceeds $50 million or 1 percent of state revenues, whichever is less. That amendment also requires refunds of excess tax revenues if the growth in state revenue exceeds the growth of personal income by 1 percent or more. This amendment was passed with the support of a new governor, the Legislature, and the business community. In contrast to the earlier proposed amendment, the enacted amendment contained the following language: This proposal would not affect current state or local funds, future effects would depend upon the actions of the General Assembly and Missouri voters.28 In contrast to the original Hancock Amendment, this new TEL has significantly reduced state revenue and spending. Since 1996 Missouri has offset $2.5 billion in surplus revenue with a combination of tax cuts and tax rebates.

F. California: The Ineffective Original

29

The origins of the national tax revolt can be traced to Ronald Reagan’s tenure as governor of California in the early 1970s, when his Prop 1 set the standard for all subsequent TELs. That measure set a limit on state spending equal to the current level of state expenditures as a share of state income. It also required that share to decrease by 0.1 percent each year until it reached 7 percent, at which time the legislature could halt the annual reduction by a two-thirds vote. To give some idea how stringent this approach was, total spending as a share of state income in California today is approaching 10 percent. While Prop 1 lost at the polls in 1973, it launched a tax revolt that resulted in initiatives to introduce limits at both the local and state level. After Prop 1 came Prop 13 in 1978, which limited local property taxes. It continues to be one of the most stringent limitations on local property taxation in the country. www.buckeyeinstitute.org

The Buckeye Institute for Public Policy Solutions 25

Prop 4, the Gann Amendment, was one of the first limitations adopted by any state. This measure limited increases in state and local appropriations from tax revenues to the sum of population growth and inflation. It was passed by nearly a 3 to 1 margin. Initially, it was effective in constraining government expenditures. In 1987, for example, revenue exceeded the budget limit, and California taxpayers received a $1.1 billion tax rebate. Over time, however, the Gann Amendment became a less effective constraint. Because the limit was imposed only on appropriations from tax revenues, legislators relied increasingly on fees and other non-tax revenues. In 1990, Prop 111 was enacted, dealing a death blow to Gann. This measure required increases in expenditures for K-12 education, and it also increased the Gann limit. Since then, the Gann Amendment has ceased to be an effective constraint on fiscal policy.

Appendix B The Next Generation: A Model Tax and Expenditure Limitation Measure One of the authors of this report has been consulting with a number of states on new or revised TELs. The following proposal for a new limit in Kansas embodies the principles of the next generation of TELs.30 WORKING DRAFT NO. 5 December 22, 2003 3rs1247 DRAFT CONCURRENT RESOLUTION NO. ____ By A PROPOSITION to amend the constitution of the state of Kansas by adding a new article thereto, prescribing certain limits upon taxes, revenues and expenditures by the state and local governments. Be it resolved by the Legislature of the State of Kansas, two-thirds of the members elected (or appointed) and qualified to the House of Representatives and two-thirds of the members elected (or appointed) and qualified to the Senate concurring therein: Section 1. The following proposition to amend the constitution of the state of Kansas shall be submitted to the qualified electors of the state for their approval or rejection: The constitution of the state of Kansas is amended by adding a new article thereto to read as follows: www.buckeyeinstitute.org

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Article 16 TAX, REVENUE AND EXPENDITURE LIMITATIONS ON STATE AND LOCAL GOVERNMENTS. § 1. Definitions. As used within this article: (a) ”State” means the state government including all branches, state offices, authorities, agencies, boards, commissions, institutions, instrumentalities and any division or unit of state government which are directly supported with tax funds, except that ”state” does not include any enterprise; (b) “local government” means any county, township, city, education district, other special district and any other taxing district or political subdivision of Kansas which is directly supported by tax funds, except that ”local government” does not include any enterprise; (c) “enterprise” means a state-owned or local government-owned business authorized to issue its own revenue bonds and receiving less than 10% of annual revenue in grants or other direct cash benefit from the state and local governments combined; (d) “bond” means any bond, note, debenture, interim certificate, grant and revenue anticipation note, lease-purchase agreement, lease certificate of participation or other evidence of indebtedness which, in any such case, is entered into or establishes a debt obligation for longer than one fiscal year, whether or not the interest on which is subject to federal income taxation; (e) “fiscal year” means the twelve-month fiscal period prescribed by law for the state or the local government; (f) “fiscal year spending” means all expenditures and reserve increases except, as to both, expenditures for refunds of any kind or expenditures of moneys received from the federal government, moneys received as grants, gifts or donations which are to be expended for purposes specified by the donor, moneys that are collections for another government, moneys received for pension contributions by employees and pension fund earnings, reserve transfers or expenditures; (g) “inflation” means the change expressed as a percentage in the consumer price index for the Kansas City metropolitan area, all goods, all urban consumers, as officially reported by the bureau of labor statistics of the United States department of labor, or its successor index; and (h) “population” means the more recent of either the periodic census conducted by the United States department of commerce or its successor agency or the annual update of such census as prescribed by the legislature by law, which shall be adjusted every decade to match the federal decennial census. www.buckeyeinstitute.org

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(i) “education district” means each school district, vocational or technical school, community college, technical college, municipal university, and any other public educational entity established as provided by law, except that “education district” does not include any state educational institution under the control and supervision of the state board of regents. lowing:

(j) “total state revenue” means all moneys received by the state from any source except any of the fol-

(1) Moneys received as grants, gifts or donations which are to be expended for purposes specified by the donor; (2) moneys received from the federal government; and (3) moneys which are income earned on moneys in permanent endowment funds, trust funds, deferred compensation funds or pension funds and which are credited to such funds; (k) “total local government revenue” means all moneys received by the local government from any source except any of the following: (1) Moneys received as grants, gifts or donations which are to be expended for purposes specified by the donor; (2) moneys received from the federal government; and (3) moneys which are income earned on moneys in permanent endowment funds, trust funds, deferred compensation funds or pension funds and which are credited to such funds. § 2. Prior Elector Approval for Tax Increases or Issuance of Certain Bonds. (a) For any fiscal year that commences on or after July 1, 2005, the state must have approval of the electors in advance (1) for any new state income, sales or other excise tax rate increase before the state tax rate increase can take effect, (2) for any state mill levy ad valorem property tax rate increase above the state mill levy ad valorem property tax rate for the prior year before the state mill levy ad valorem property tax rate increase can take effect, (3) for any extension of any expiring state income, sales or other excise tax or expiring state ad valorem property tax before the extension can take effect, or (4) for any state tax policy change enacted into law by the state which would directly cause a net tax revenue gain to the state or local government, before such tax policy change can take effect. (b) For any fiscal year that commences on or after July 1, 2005, each local government must have approval of the electors in advance (1) for any new local government income, sales or other excise tax rate increase, which is authorized by law, before the local government tax rate increase can take effect, (2) for any local government mill levy ad valorem property tax rate increase, which is authorized by law, before the local www.buckeyeinstitute.org

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government mill levy ad valorem property tax rate increase can take effect, (3) for any extension of any expiring local government income, sales or other excise tax or local government ad valorem property tax, which is authorized by law, before the extension can take effect, or (4) for any local government tax policy change authorized by law and adopted in a resolution or ordinance by a local government which would directly cause a net tax revenue gain to the local government, before such tax policy change can take effect. (c) For any fiscal year that commences on or after July 1, 2005, the state and each local government must have approval of the electors before authorizing any bonds, except for refinancing existing bonded debt at a lower interest rate. (d) The legislature shall provide by law for the manner of submitting matters subject to approval under this section to the electors. § 3. Spending and Revenue Limits. (a) For any state fiscal year that commences on or after July 1, 2005, fiscal year spending by the state shall not increase above the fiscal year spending for the preceding state fiscal year by more than the maximum percentage increase determined pursuant to this section. The maximum percentage increase in fiscal year spending for a state fiscal year shall be equal to the result obtained by adding the rate of inflation for the calendar year ending during the preceding state fiscal year, plus the percentage change in state population during the calendar year ending during the preceding state fiscal year if a positive number, adjusted for revenue changes approved by electors under section 2 of this article. (b) If the amount of the total state revenue for the preceding state fiscal year exceeds the amount of total state revenue for the second preceding state fiscal year, the total state revenue limitation for a state fiscal year shall be the result obtained by adding (1) the lesser of (A) the amount of total state revenue for the preceding state fiscal year or (B) the amount of the total state revenue limitation for the preceding state fiscal year, and (2) the product of (A) the amount determined under clause (1) of this subsection, and (B) the sum of (i) the rate of inflation for the calendar year ending during the preceding state fiscal year, plus (ii) the percentage change in state population during the calendar year ending during the preceding state fiscal year if a positive number. (c) If the amount of the total state revenue for the preceding state fiscal year is less than the amount of total state revenue for the second preceding state fiscal year, the amount of the total state revenue limitation for a state fiscal year shall be the lesser of (1) the amount of total state revenue for such state fiscal year, or (2) the amount of the total state revenue limitation for the most recent state fiscal year for which the amount of total state revenue exceeded the amount of total state revenue for the preceding state fiscal year. (d) For any local government, other than an education district, for any local government fiscal year that commences on or after July 1, 2005, fiscal year spending by the local government, other than an education district, shall not increase above the fiscal year spending for the preceding local government fiscal year by more than the maximum percentage increase determined pursuant to this section. For any fiscal year that commences on or after July 1, 2005, the maximum percentage increase in fiscal www.buckeyeinstitute.org

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year spending by a local government, other than an education district, equals the sum of inflation during the preceding calendar year plus the percentage change in the local government population during the preceding calendar year if a positive number, adjusted for revenue changes approved by the electors under section 2 of this article. (e) For any education district fiscal year that commences on or after July 1, 2005, fiscal year spending by the education district shall not increase above the fiscal year spending for the preceding education district fiscal year by more than the maximum percentage increase determined pursuant to this section. For any fiscal year that commences on or after July 1, 2005, the maximum percentage increase in fiscal year spending by an education district equals inflation during the preceding calendar year, plus the percentage change in its pupil or student enrollment for the school year commencing during the preceding calendar year as compared to the school year preceding that school year if a positive number, adjusted for revenue changes approved by the electors under section 2 of this article. (f) If the amount of the total local government revenue for the preceding local government fiscal year exceeds the amount of total local government revenue for the second preceding local government fiscal year, the total local government revenue limitation for a local government fiscal year shall be the result obtained by adding (1) the lesser of (A) the amount of total local government revenue for the preceding local government fiscal year or (B) the amount of the total local government revenue limitation for the preceding local government fiscal year, and (2) the product of (A) the amount determined under clause (1) of this subsection, and (B) the sum of (i) the rate of inflation for the calendar year ending during the preceding local government fiscal year, plus (ii) in the case of a local government other than an education district, the percentage change in local government population during the calendar year ending during the preceding local government fiscal year if a positive number, or (iii) in the case of an education district, the percentage change in its pupil or student enrollment for the school year commencing during the preceding calendar year as compared to the school year preceding that school year if a positive number. (g) If the amount of the total local government revenue for the preceding local government fiscal year is less than the amount of total local government revenue for the second preceding local government fiscal year, the amount of the total local government revenue limitation for a local government fiscal year shall be the lesser of (1) the amount of total local government revenue for such local government fiscal year, or (2) the amount of the total local government revenue limitation for the most recent local government fiscal year for which the amount of total local government revenue exceeded the amount of total local government revenue for the preceding local government fiscal year. (h) The legislature, by law, shall provide a mechanism to adjust the amount of a limitation under this section to reflect any subsequent transfer of all or any part of the cost of providing a governmental function. The mechanism shall adjust the amount of a limitation so that total costs are not increased as a result of the transfer. The adjustment mechanism provided for in this subsection shall be used in determining a limitation under this section beginning with the fiscal year immediately following the transfer. www.buckeyeinstitute.org

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(i) The legislature, by law, shall provide a mechanism to adjust the amount of a limitation under this section to reflect the cost of providing a governmental function on account of any subsequent annexation, creation of a new governmental unit, or any consolidation or change in the boundaries of a governmental unit. The mechanism shall adjust the amount of limitation so that total costs are not increased as a result of the annexation, creation, consolidation or change in boundaries. The adjustment mechanism provided in accordance with this subsection shall be used in determining a limitation under this section beginning with the fiscal year immediately following the annexation, creation of a new governmental unit, or consolidation or change in the boundaries of a governmental unit. (j) In the case of the state or any local government having a fiscal year ending on June 30, 2005, for the purposes of determining total revenue limitations under this section for the state or any such local government, the total authorized fiscal year expenditures for the fiscal year ending on June 30, 2004, shall be construed to be the total revenue limitation for that preceding fiscal year and the total authorized fiscal year expenditures for the fiscal year ending on June 30, 2005, shall be construed to be the total revenue limitation for that preceding fiscal year. In the case of any local government having a fiscal year ending on December 31, 2005, for the purposes of determining total local government revenue limitations under this section for any such local government, the total authorized fiscal year expenditures for the fiscal year ending on December 31, 2004, shall be construed to be the total revenue limitation for that preceding fiscal year and the total authorized fiscal year expenditures for the fiscal year ending December 31, 2005, shall be construed to be the total revenue limitation for that preceding fiscal year. § 4. Emergency Reserve Funds. (a) For any state fiscal year that commences on or after July 1, 2005, if revenue from sources not excluded from total state revenue exceeds the total state revenue limitation for that state fiscal year and subject to the other provisions of this section, a portion of total state revenue in excess of the total state revenue limitation, determined in accordance with section 3 of this article, shall be transferred in the amount and in the manner prescribed by the legislature by law to the emergency reserve fund, which fund is hereby created in the state treasury, to the extent necessary to ensure that a balance of the emergency reserve fund at the end of the state fiscal year is an amount equal to not more than 3% of the total state revenue limitation for the ensuing state fiscal year. Any amount required to be maintained in the ending balance of the state general fund as provided by law shall be excluded from the amount available for transfer to the emergency reserve fund of the state by this section. Each transfer to the emergency reserve fund of the state prescribed by this section shall be made before making any transfer to the budget stabilization reserve fund as provided in section 5 of this article or any refunds as required by section 6 of this article. The state shall not be required to transfer any moneys other than any amount of total state revenue in excess of the total state revenue limitation to the emergency reserve fund. The moneys in the emergency reserve fund shall be in addition to, and shall not be used to meet, any other reserve requirement under this constitution or any law. In no case shall additional moneys be transferred to the emergency reserve fund if the balance in the emergency reserve fund is more than 3% of the total state revenue limitation for the ensuing state fiscal year. www.buckeyeinstitute.org

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(b) Moneys in the emergency reserve fund of the state may be expended only for emergencies declared by law. Two-thirds (2/3) of the members then elected (or appointed) and qualified in each house, voting in the affirmative, shall be necessary to declare an emergency within the state of Kansas as a whole and to pass any bill making an appropriation of money from the emergency reserve fund. Income earned on the emergency reserve fund of the state shall accrue to the fund. (c) For each local government fiscal year that commences on or after July 1, 2005, each local government shall reserve and maintain in an emergency reserve fund an amount equal to not more than 3% of its total local government revenue limitation for the ensuing local government fiscal year in accordance with this section. For any local government fiscal year that commences on or after July 1, 2005, if total local government revenue from sources not excluded from total local government revenue exceeds the total local government revenue limitation for that local government fiscal year and subject to the other provisions of this section, a portion of total local government revenue in excess of the total local government revenue limitation, determined in accordance with section 3 of this article, shall be transferred in the amount and in the manner prescribed by the legislature by law to the emergency reserve fund of the local government. Any amount required to be maintained in the ending balance of the general fund of the local government as provided by law shall be excluded from the amount available for transfer to the emergency reserve fund of the local government by this section. (d) Moneys in the emergency reserve fund of a local government may be expended only for emergencies within a local government declared by the local government in the manner prescribed by law. Income earned on the emergency reserve fund of the local government shall accrue to the fund. (e) As used in this section “emergency” means an extraordinary event or occurrence that could not have been reasonably foreseen or prevented and that requires immediate expenditures to preserve the health, safety and general welfare of the people within a local government or the state and ”emergency” does not mean a revenue shortfall or budget shortfall. § 5. Budget Stabilization Reserve Funds. (a) For any state fiscal year that commences on or after July 1, 2005, if total state revenue exceeds the total state revenue limitation for that state fiscal year, then the remaining excess amount, after making any transfer to the emergency reserve fund as required by section 4 of this article, shall be reserved as prescribed by this section or refunded as prescribed by section 6 of this article, subject to the other provisions of this section. Any amount required to be maintained in the ending balance of the state general fund as provided by law shall be excluded from the amount available for transfer to the budget stabilization reserve fund of the state by this section. (b) After any amount required to be transferred to the emergency reserve fund of the state pursuant to section 4 of this article has been transferred, an amount of any remaining excess amount of total state revenue shall be transferred in the amount and in the manner prescribed by the legislature by law to the budget stabilization reserve fund, which fund is hereby created in the state treasury. The amount transferred to the budget stabilization reserve fund in accordance with this subsection shall be equal to the lesser of (1) the amount necessary to ensure that the www.buckeyeinstitute.org

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balance in the budget stabilization reserve fund at the end of the state fiscal year is an amount equal to 10% of the total state revenue limitation for the ensuing state fiscal year, or (2) the amount equal to 50% of any such remaining excess amount of total state revenue. Income earned on the budget stabilization reserve fund shall accrue to the fund. In no case shall additional moneys be transferred into the budget stabilization reserve fund if the balance in the fund is equal to or more than 10% of the total state revenue limitation for the ensuing state fiscal year. (c) For any state fiscal year that commences on or after July 1, 2005, if the amount of the total state revenue is less than the amount of total state revenue for the prior state fiscal year, the legislature shall provide by law for the transfer of moneys from the budget stabilization fund to the state general fund in an amount equal to not more than the difference between the amount of total state revenue for the prior state fiscal year and the amount of total state revenue for the state fiscal year. Under no other circumstances shall moneys be transferred or expended from the budget stabilization fund of the state. (d) For each local government fiscal year that commences on or after July 1, 2005, each local government shall reserve and maintain in a budget stabilization reserve fund an amount equal to not more than 10% of its fiscal year estimated spending in accordance with this section. For any local government fiscal year that commences on or after July 1, 2005, if total local government revenue from sources not excluded from total local government revenue exceeds the total local government revenue limitation for that local government fiscal year and subject to the other provisions of this section, a portion of total local government revenue in excess of the total local government revenue limitation, determined in accordance with section 3 of this article, shall be transferred in the amount and in the manner prescribed by the legislature by law to the budget stabilization reserve fund of the local government. Any amount required to be maintained in the ending balance of the general fund of the local government as provided by law shall be excluded from the amount available for transfer to the budget stabilization reserve fund of the local government by this section. No amount shall be transferred to the budget stabilization reserve fund of a local government until after any amount required to be transferred to the emergency reserve fund of the local government pursuant to section 4 of this article has been transferred. (e) For any current local government fiscal year that commences on or after July 1, 2005, if the amount of the total local government revenue is less than the amount of total revenue for the prior fiscal year, the local government shall provide for the transfer of moneys from the budget stabilization fund to the general revenue fund of the local government in an amount equal to not more than the difference between the amount of total local government revenue for the prior local government fiscal year and the amount of total revenue for the current local government fiscal year. Under no other circumstances shall moneys be transferred or expended from the budget stabilization fund of the local government. § 6. Disposition of Excess Revenues. (a) Any excess amount of total state revenues for a state fiscal year that remains after the transfers to the emergency reserve fund and budget stabilization reserve fund pursuant to section 4 or section 5 of this article, if any, shall be reserved in the current state fiscal year and shall be refunded as provided by law during the next ensuing state fiscal year to the taxpayers who paid the state ad valorem property taxes or state income, sales or other excise taxes for or during the preceding state fiscal year, in a manner www.buckeyeinstitute.org

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that is proportional, on a pro rata basis, to the manner in which such taxes were collected from such taxpayers. Any amount required to be maintained in the ending balance of the state general fund as provided by law shall be excluded from the amount available to be reserved and refunded by the state as prescribed by this section. (b) Any excess amount of local government revenues for a local government fiscal year that remains after transfers to the emergency reserve fund and budget stabilization reserve fund of the local government pursuant to section 4 or section 5 of this article, if any, shall be reserved in the current local government fiscal year and shall be refunded during the next ensuing local government fiscal year to the taxpayers who paid the ad valorem property taxes or income, sales or other excise taxes of the local government for or during the preceding local government fiscal year, in a manner that is proportional, on a pro rata basis, to the manner in which such taxes were collected from such taxpayers. Any amount required to be maintained in the ending balance of the general fund of the local government as provided by law shall be excluded from the amount available to be reserved and refunded to taxpayers by the local government as prescribed by this section. (c) In a case of any amount that is received pursuant to any tax and required to be reserved and refunded to taxpayers by the state or a local government pursuant to this section and that is determined by the state or local government in the manner prescribed by law to be insufficient for refunds to be made during the ensuing state or local government fiscal year, as the case may be, such amount shall be reserved for refunds to be made thereafter when the amount reserved is sufficient therefor. § 7. State Temporary Borrowing. On or after July 1, 2005, during any state fiscal year, transfers which are temporary and are to be repaid, or any other temporary borrowing, through certificates of indebtedness or any other device or manner, of any moneys in the state treasury to be credited to the state general fund, are prohibited unless the moneys so transferred or otherwise borrowed are restored or repaid to the original funds or accounts of the state treasury from the state general fund within the same state fiscal year. The provisions of this section do not apply to transfers from the emergency reserve fund or the budget stabilization reserve fund to the state general fund in accordance with this article. § 8. General Revenue Supplanting. (a) On or after July 1, 2005, any appropriation of moneys in the state treasury that either supplants any appropriation from the state general fund, or that, if not made, would require an appropriation from the state general fund is prohibited. For purposes of this subsection, any appropriation of moneys in the state treasury that is funded by user charges or fees imposed on goods or services that do not exceed the cost of the goods or services provided shall not be deemed to be an appropriation that supplants any appropriation from the state general fund. (b) For any local government fiscal year that commences on or after July 1, 2005, no local government shall impose or shall increase user charges or fees imposed for goods or services provided by the local government to supplant general revenues of the local government. For the purposes of this subsection, any imposition or increase of user charges or fees imposed on goods or services that do not exceed the cost of the goods or services provided shall not be deemed to be supplanting general revenues of the local government. www.buckeyeinstitute.org

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§ 9. State Mandates on Local Governments. A local government may not be required to fulfill any mandate imposed by the state unless and until, and may be required to fulfill that mandate only to the extent that, funds are provided to the local government by the state for that purpose. The legislature is not required to appropriate funds for mandates if more than two years have passed since the effective date of the mandate and no claim for funding has been made by local government during that period. § 10. Construction and Enforcement. (a) The provisions of this article shall be liberally construed for the purpose of effectuating the purposes thereof, except that nothing in this article shall be construed to authorize any new or increased tax of any kind other than as provided or authorized by law enacted by the legislature in accordance with and subject to the other provisions of this constitution. (b) In any case of a conflict between any provision of this article and any other provision contained in the constitution, the provisions of this article shall control. (c) All laws in force at the time of the adoption of this amendment and consistent therewith shall remain in full force and effect until amended or repealed by the legislature. The legislature shall repeal or amend all laws inconsistent with the provisions of this article to conform with the provisions of this article. (d) Any individual or class of individuals shall have standing to bring a suit to enforce this article. A court of record shall award a successful plaintiff costs and reasonable attorney fees in the suit, but may not allow the state or a local government to recover costs and reasonable attorney fees unless a suit against it is ruled frivolous.” Sec. . The following statement shall be printed on the ballot with the amendment as a whole: Explanatory statement. This amendment would establish requirements for prior voter approval of tax increases and certain bond issuances by the state and local governments, would place limitations on increases in state and local government spending and provide for the disposition of excess state revenues by establishing certain reserve funds and prescribing certain tax refunds by the state. ”A vote for this proposition would . . . “A vote against this proposition would . . .” Sec. . This resolution, if approved by two-thirds of the members elected (or appointed) and qualified to the House of Representatives, and two-thirds of the members elected (or appointed) and qualified to the Senate shall be entered on the journals, together with the yeas and nays. The Secretary of State shall cause this resolution to be published as provided by law and shall cause the proposed amendment to be submitted to the electors of the state at the general election to be held on November 2, 2004, unless a special election is called at a sooner date by concurrent resolution of the legislature, in which case it shall be submitted to the electors of the state at the special election. www.buckeyeinstitute.org

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Appendix C A Literature Review of the Empirical Research on TELs Most empirical studies have focused on whether and how TELs constrain government revenues and expenditures. This is consistent with the view that they are designed and implemented to impose fiscal discipline on governments. But it is not always clear what is meant by fiscal discipline. Some people might argue that fiscal discipline means decreasing the absolute size of government. Indeed a recent failed limitation measure in Colorado called for decreasing the absolute size of local government by a fixed dollar amount each year. Others might argue that TELs are designed to constrain the growth of government. Few would disagree that an effective limit should hold government growth below the double-digit rates of the 1970s. It was that inflationary expansion that triggered the tax revolt, and TELs themselves. If fiscal discipline is interpreted to mean constraining the growth of government relative to the private sector, then tax and spending limits may be linked to some measure of aggregate economic activity, such as state income. But business cycles make these limits problematic. These sorts of TELS permit a rapid growth in government, in periods of prosperity, that cannot be sustained when revenues fall during a recession. As noted earlier, they may also result in a ratcheting up of government spending over time if governments respond to falling revenues by increasing taxes. A more stringently designed TEL is linked to inflation and population growth. In the long run this has the potential to keep the growth of government below the growth of the private sector. One often-criticized implication of this version is a ratchet down effect that happens as revenues fall in a recession. When linked to a budget stabilization fund, however, this type of TEL can limit the ratchet down effect in the long run as well as provide greater budget stability over the business cycle. In combination, a TEL and a budget stabilization fund permits citizens to achieve an optimum trade-off between stabilizing the budget over the business cycle and constraining the growth of government in the long run. Whether or not we perceive TELs to have been successful in constraining the growth of government, then, depends on what we mean by fiscal discipline. With this caveat in mind we turn to the empirical literature that has attempted to measure the success of TELs.

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A. Do TELs Actually Constrain Government Revenue and Spending? Do TELs actually limit government revenue and spending? A number of empirical studies have tried to answer this question. The wide divergence in their results reflects the use of different methodologies and data sets. Early studies focused on a variety of political units, and analyzed the impact of TELs over different time periods. Cross sectional studies tended to find TELs ineffective in constraining government spending. Dale Bails conducted one of the earliest such studies, and found that in the majority of states TELs had an insignificant impact.31 An extension of this work essentially confirmed this finding.32 Cross sectional research by Burton Abrams and William Dougan, as well as work by James Cox and David Lowery, also found TELs ineffective in constraining state spending.33 Time series studies, meanwhile, have found mixed results. Daphne Kenyon and Karen Benker compared the growth of state spending relative to personal income in TEL states with that of non-TEL states. They found no significant difference.34 In another study, William Dougan examined time series data from 1960 to 1984 for 16 states. He found that in 7 of these states the TEL had a significant negative impact on government spending.35 Barry Poulson and Jay Kaplan used time series analysis to examine the impact of Colorado’s first statutory TEL, and found that it significantly reduced state spending in the short run, though not in the long run.36 Philip Joyce and Daniel Mullins came to a similar conclusion, finding that TELs significantly reduce state revenues in the short run, but not in the long run.37 All these empirical studies, however, do not account for the interdependent nature of TELs and state spending patterns. If states that experience rapid increases in spending are more likely to adopt TELs, then the analysis will be biased. A few empirical studies have addressed this interdependence problem. One approach is to control for some measure of voter preference, such as the political party of elected officials. This can reduce the possibility that the observed correlation between budget rules and fiscal outcomes simply reflects not the effects of rules but voter preferences. But if this approach does not fully capture the impact of voter preferences, it may still lead to spurious results. Another approach is to solve for interdependence using variables that affect budget rules and not fiscal policy. Kim Reubens uses this technique.38 In some states, laws provide for the initiative process that allows citizens to directly propose and vote on TELs. The existence of the initiative process should be positively correlated with the passage of TELs, but unrelated to current expenditure levels. Substituting this variable for the TEL variable in the model, Reubens can separate the effects of the TEL itself from the effects of changes in voter preferences for limits. When this model is run with the TEL variable, the results show a positive relationship between TELs and government spending. When the model is run using the initiative variable, the effect of the TELs is to reduce state spending 1.8 percent. www.buckeyeinstitute.org

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In an attempt to account for other variables that could effect state spending, more recent empirical studies use panel data and cross sectional time series data. For example, empirical evidence suggests that government expenditure, in both levels and growth rates, is closely related to income, population, and other economic variables. One of the first studies to use panel data, controlling for the effects of population and income on the public sector, was done by Harold Elder.39 Elder found that when he controlled for the effects of these economic variables, TELs have a significant role in reducing the growth of government. Ronald Shadbegian also uses panel data to test the impact of TELs on the size and growth of state government.40 He includes population, income, and federal intergovernmental grants as control variables. Shadbegian finds that in states with low income growth, TELs reduce the size of government, and lower the growth in government spending. He also finds, however, that TELs increase government spending growth in states with high income growth. In these states, tax and expenditure limits provide cover for politicians who appear to be fiscally prudent, but who in fact increase spending more than their counterparts in states without the limits. One criticism of all the studies mentioned above is that they treat all TELs alike. The only study so far to take into account differences in TELs is that of Michael New. He uses panel data to analyze the impact of TELs for both state and local spending. As is typical of panel data studies, New’s analysis controls for other economic and demographic variables that could impact state and local spending. New includes variables indicating whether the TEL was passed by initiative, by the legislature, by constitutional convention, or by referendum. He finds that TELs passed through the initiative process significantly reduce state and local spending, but that TELs enacted by state legislatures actually increase spending. Further, he finds that measures limiting increases in revenue and spending to the sum of inflation and population growth (as is the case in Colorado and Washington) reduce government spending more than those linked to state personal income. Finally, he finds that TELs that mandate immediate refunds of surplus revenue to taxpayers, i.e. Colorado, Michigan, Missouri, and Oregon, are more successful in reducing government spending. Finally, a study by Dale Bails and Margie Tieslau is unique in using panel data to analyze the impact of a comprehensive set of budget institutions on state and local spending.41 The institutions include tax and spending limits, the line item veto, balanced budget requirements, and term limits. Bails and Tieslau control also for other economic and demographic variables. They find that the following budgetary institutions significantly reduce the rate of growth of state and local spending: tax and spending limits, balanced budget requirements in the presence of tax and spending limits, supermajority vote requirements in the presence of balanced budget requirements, term limits, and the initiative process. Real per capita state and local spending in states with TELs is estimated to be $42 lower than in states without TELs. In states with both TELs and balanced budget requirements, spending is reduce by nearly $135. In states with the comprehensive budgetary institutions tested, real per capita expenditures are reduced nearly $473. Recent empirical studies, then, support the view from public choice theory: budget institutions significantly affect fiscal policy. TELs, as well as other budget rules, can significantly reduce state and local spending. www.buckeyeinstitute.org

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Decision makers must pay attention to the design of limits, though, if they want to constrain government spending. The most effective TELs are constitutional measures that limit the growth of government spending to inflation and population growth, and that provide for immediate refunds of surplus revenue above the TEL limit. They are the most effective when they linked to other budget rules, most importantly, balanced budget requirements.

B. How do TELs Affect the Distribution of Income? A fuller understanding of TELs would extend the analysis to their impact on income distribution. When revenue is generated above the specified limit, some states simply return the surplus to the general fund to finance expenditures. In some states the surplus is held in a general fund balance. When that general fund balance is then used to finance a budget stabilization fund, it is spent during revenue shortfalls. In some cases the general fund balances are used for targeted expenditures such as education or capital projects. As we would expect from the rent-seeking model of government finance, general fund balances may become a prize for special interest groups. The allocation of surplus revenue to finance government spending will redistribute income from those who paid the excess taxes to those benefiting from the new government spending. Special interest groups are often successful making that targeted expenditure exempt from the TEL limit, ensuring that the surplus spending benefits themselves. As a way around the problem of targeted spending of surpluses, some TELs mandate tax cuts and tax rebates when revenue exceeds the specified limit. One approach would return the surplus revenue to those who paid the excess taxes. Rarely is this achieved. As a result, the tax cuts and tax rebates have the effect of redistributing income from those who paid the excess taxes to others who may have paid little or no taxes. One of the few studies to explore how tax cuts and tax rebates affect the distribution of income is by Barry Poulson.42 He finds that in Colorado surplus revenue above the TABOR limit was not returned to those who paid the excess taxes. Most of the surplus revenue was generated by the income tax, and some of the surplus was in fact offset by broad based cuts in the income and sales tax. But much of the surplus was offset by targeted tax cuts and tax rebates benefiting special interest groups. The impact of this redistribution was egalitarian, shifting surplus revenue from upper income families who paid most of the excess income taxes, to lower income families who paid little or no taxes.

C. What Structural Changes Should be Considered Before Implementing TELs? A final set of issues involves the impact of TELs on governance. One question is the extent to which TELs erode fiscal federalism. TELs may be imposed at the local level but not the state level, as was the case with California’s Prop 13. A number of states have introduced TELs at the state level but not the local level. Still others, such as Colorado, introduced TELs designed to constrain fiscal policy at both levels. www.buckeyeinstitute.org

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From the outset a major concern was that limits imposed at one level of government would simply shift the financing of programs to another level of government, with no net impact. The obvious example is K-12 education, which is often financed through both state and local government. Some TELs address this issue by limiting the power of the state to mandate expenditures at the local level without providing the financing for them. Finally, satisfying the conditions imposed by TELs usually requires new administrative procedures. When TELs require voter approval for increase in taxes and debt, for example, new accounting, reporting, and election procedures are also required. Litigation surrounding these limits may require additional legal resources. These and other administrative procedures relating to TELs may be costly, particularly for local governments with limited resources. The costs and other burdens of TELs must be weighed against the benefits to citizens of exercising control over fiscal powers of government directly, rather than leaving fiscal decisions to the discretion of their elected representatives. Surveys often reveal widespread popular support for TELs. Nonetheless, assessing the costs and benefits to citizens of this control through TELs remains elusive.

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Should Ohio Limit Government Spending and Taxes? 40

About the Authors Russell S. Sobel, Ph.D., is associate professor of economics at West Virginia University and director of the university’s Entrepreneurship Center. Dr. Sobel specializes in state and local public finance, particularly taxation. Dr. Sobel’s research has been published in many leading academic journals, including the Journal of Political Economy, Economic Inquiry, Journal of Economic Perspectives, Southern Economic Journal, Public Choice, National Tax Journal, Public Budgeting and Finance, and Journal of Public Finance and Public Choice. He is coauthor of Growth and Variability in State Tax Revenue: An Anatomy of State Fiscal Crises (Greenwood, 1997) and a widely used principles of economics textbook, Economics: Private and Public Choice (Thompson/South Western, 10th ed.). He earned his Ph.D. in economics from Florida State University and B.B.A. from Francis Marion College (South Carolina). Robert A. Lawson, Ph.D., holds the George H. Moor Chair of Business and Economics at Capital University in Columbus, Ohio. He is also a member of The Buckeye Institute’s Board of Academic Advisors. He has published articles in several journals, including Public Choice, the Journal of Labor Research, the Asian Economic Review, Cato Journal, the Journal of Institutional and Theoretical Economics, and the Journal of Public Finance and Public Choice. He is a co-author of the widely cited annual report, Economic Freedom of the World. A Cincinnati native, he earned his B.S. in economics from the Honors Tutorial College at Ohio University in 1988 and his M.S. (1991) and Ph.D. (1992) in economics from Florida State University. He is Senior Fellow in Economic Growth at The Buckeye Institute for Public Policy Solutions, an adjunct scholar with the Mackinac Center for Public Policy, and Faculty Affiliate for the DeVoe Moore Policy Sciences Center at Florida State University. Barry W. Poulson, Ph.D., is a senior fellow at the Independence Institute and a professor of economics at the University of Colorado, specializing in public finance, development economics and economic history. His recent research focuses on convergence of economic growth in frontier economies. He is also completing a project on the impact of constitutional constraints on fiscal policy. He is a past president of the North American Economics and Finance Association. He is currently an adjunct scholar of The Heritage Foundation. He also serves on the Colorado Commission on Taxation. He earned his Ph.D. in economics from The Ohio State University. Joshua C. Hall is a senior fellow at The Buckeye Institute. He was a staff economist with the Joint Economic Committee of Congress before serving as the director of the Center for Education Excellence and then director of research for The Buckeye Institute. In addition to studies written for the JEC and The Buckeye Institute, his work has appeared in several academic journals, including the Journal of Labor Research, the Journal of Economics and Politics, and the Independence Review. He earned his B.A. and M.A. in economics from Ohio University and is currently pursuing his doctorate in economics at West Virginia University.

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Endnotes 1

Ohio Office of Budget and Management Comprehensive Annual Financial Report for the Fiscal Year Ended June 30, 2003, Table 2, p. 232.

2

Legislative Services Commission, LSC Fiscal Analysis, Selected Issues of the FY 2004-2005 State of Ohio Operating Budgets.

3

General revenue from “own sources” includes all state and local tax revenue and revenue from various charges and fees, but excludes federal government transfers, income from state operated enterprises such as liquor stores and utilities, and revenue going to certain trust funds like worker’s compensation.

4

Federal State and Local Governments: State and Local Government Finance (Washington, DC: U.S. Census Bureau, 19 August 2004). [Online] available from http://www.census.gov/govs/www/estimate.html.; accessed 15 September 2004.

5

Comparing the 50 States’ Combined State/Local Tax Burdens in 1970 (Washington, DC: The Tax Foundation, 2004). [Online] available from http://www.taxfoundation.org/statelocal70.html.; accessed 15 September 2004.

6

Ibid.

7

Zsolt Becsi, “Do State and Local Taxes Affect Relative State Growth?” Federal Reserve Bank of Atlanta Economic Review, vol. 81, no. 2 (March/April 1996): 18-36.

8

Stephen Moore and Dean Stansel, Tax Cuts and Balanced Budgets: Lessons from the States (Washington, DC: Cato Institute, 17 September 1996).

9

Chris Edwards, Stephen Moore and Phil Kerpen, States Face Fiscal Crunch after 1990s Spending Surge (Washington, DC: Cato Institute, 2003).

10

Richard Vedder, State and Local Taxation and Economic Growth (Washington, D.C.: Joint Economic Committee of Congress).

11

This section, as well as Appendixes A and B, draw heavily from Barry Poulson, Tax and Spending Limits: Theory, Analysis and Evidence (Golden, CO: The Independence Institute, January 2004). The authors and The Buckeye Institute gratefully acknowledge the permission of the Independence Institute to reprint this material here and to Dr. Poulson for helping to incorporate it into our analysis of the Ohio situation. www.buckeyeinstitute.org

Should Ohio Limit Government Spending and Taxes? 42

12

National Conference of State Legislatures, State Tax and Expenditure Limits (Denver, CO: National Conference of State Legislatures, January 2004). [Online] available from http://www.ncsl.org/programs/fiscal/ tels2004.htm.; accessed 15 September 2004.

13

Michael New, Limiting Government through Direct Democracy: The Case of State Tax and Expenditure Limitations (Washington, DC: Cato Institute, 2001). New used panel data to analyze the impact of TELs on the level of state and local spending. As is commonly done in panel data studies, he controlled for other economic and demographic variables that could impact state and local spending. He also included variables indicating whether the TEL was passed by initiative, by the legislature, by constitutional convention, or by referendum.

14

Ibid.

15

Dale Bails and Margie Tieslau “The Impact of Fiscal Constitutions on State and Local Expenditures,” Cato Journal, vol. 20, no. 2 (Fall 2000):255-277.

16

Bill Owens, “Hasta La Vista, Deficit,” Wall Street Journal, 16 October 2003.

17

States differ in the stringency of balanced budget rules that require elimination of the deficit. Some states require elimination of the deficit in the current fiscal year, while others allow the deficit to be carried forward into the next fiscal year. A few states do not require the deficit to be eliminated in the following fiscal year.

18

James Poterba, “Do Budget Rules Work?” NBER Working Paper No. 5550 (Cambridge, MA: National Bureau of Economic Research, 1994).

19

Much of this discussion is drawn from Poulson, “Putting State Fiscal Policies on Cruise Control” The State Factor (Washington, D.C.: American Legislative Exchange Council, 2003).

20

One of the current authors, Dr. Barry Poulson, has been consulting with these states as a member of the American Legislative Exchange Council (ALEC) Task Force on Tax and Fiscal Policy.

21

The discussion of this case study draws on the following works of Barry Poulson, Learning to Live With Colorado’s Tax and Spending Limits (Golden, CO: Independence Institute, 2001); “Surplus Expenditures: A Case Study of Colorado,” Public Budgeting and Finance, vol. 21, no. 4 (Winter 2001): 18-43.; “Fiscal Crises in Colorado” (Golden, CO: Independence Institute, 2003).; “A Constitutional Impasse: Gallagher, Bird-Arveschoug, TABOR and Amendment 23” (Golden, CO: Independence Institute, 2003).; and “Creating a Rainy Day Fund for Colorado,” Treasurer’s Advisory Group on Constitutional Amendments, Mimeo, 2003.

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22

For insight into this controversy see Colorado Treasurer’s Office, “Treasurer’s Advisory Group on Constitutional Amendments” (Denver, CO: Colorado Treasurer’s Office, undated). [Online] available from http: //www.treasurer.state.co.us/AdvisoryBoard/Reports.html.; accessed 15 September 2004.

23

The discussion of this case study draws on The Constitution of the State of Michigan Article IX (Mount Pleasant, IA: Public Interest Institute, 2002). [Online] available from http://www.limitedgovernment.org/state_ constitutions/state_map.htm.; accessed 15 September 2004.

24

The discussion of this case study draws on the following works of Michael New: Limiting Government Through Direct Democracy and Proposition 13 and State Budget Limitations: Past Successes and Future Options (Washington, DC: Cato Institute, 2003).

25

The discussion of this case study draws on Randall Holcombe, Tax and Expenditure Limitations: Issues for Florida (Tallahassee, FL: The James Madison Institute, 2001).

26

The discussion of this case study draws from Dean Stansel, Missouri’s Hancock II Amendment: the Case for Real Reform (Washington, DC: Cato Institute, 1994); Public Interest Institute, “The Constitution of the State of Missouri Article X”; and Ray McCarty, 2003 Fiscal Review of Missouri State Government (Jefferson City, MO: Missouri Chamber of Commerce and Industry, 2003).

27

McCarty, 2003 Fiscal Review of Missouri State Government, p. 20.

28

Ibid.

29

The discussion in this case study is from Lewis Uhler and Barry Poulson, Tax and Expenditure Limits: From Roots to Current Realities (Roseville, CA: The National Tax Limitation Foundation, 2003); and New, Limiting Government Through Direct Democracy.

30

This Amendment has been introduced in the Kansas Legislature by Sate Rep. Brenda Landwehr.

31

Dale Bails, “A Critique on the Effectiveness of Tax-Expenditure Limitations,” Public Choice, vol. 38, no.2 (1982): 129-38.

32

Dale Bails, “The Effectiveness of Tax-Expenditure Limitations: A Reevaluation,” American Journal of Economics and Sociology, vol. 49 (1990): 223-38.

33

Burton Abrams and William Dougan, “The Effects of Constitutional Restraints on Government Spending” Public Choice, vol. 49 (1981): 223-38; and James Cox and David Lowery, “The Impact of the Tax Revolt Era State Fiscal Caps.” Social Science Quarterly, vol. 71, no. 3 (September 1990): 492-507.Abrams and Dougan, Cox and Lowery. www.buckeyeinstitute.org

Should Ohio Limit Government Spending and Taxes? 44

34

Daphne Kenyon and Karen Benker, “Fiscal Discipline: Lessons from the State Experience” National Tax Journal, vol. 37 (1984): 437-46.

35

Dougan, “The Effects of Tax or Expenditure Limits on State Government.”

36

Barry Poulson and Jay Kaplan, “A Rent-Seeking Model of TELs,” Public Choice, vol. 79, no. 1-2 (April 1994): 117-34.

37

Daniel Mullins and Philip Joyce, “Tax and Expenditure Limitations and State and Local Fiscal Structure: An Empirical Assessment” Public Budgeting and Finance, vol. 16, no. 1 (Spring 1996): 75-101.

38

Kim Reubens, “Tax Limitations and Government Growth: The Effect of Tax and Expenditures Limits on State and Local Government,” MIT Department of Economics, 1995. Mimeo.

39

Harold Elder, “Exploring the Tax Revolt: An Analysis of the Effectiveness of State Tax and Expenditure Limitation Laws,” Public Finance Quarterly, vol. 20, no. 1 (January 1992): 47-63.

40

Ronald Shadbegian, “Do Tax and Expenditure Limitations Affect the Size and Growth of State Government?” Contemporary Economic Policy, vol. 14, no. 1 (January 1996): 22-35.

41

Bails and Tieslau “The Impact of Fiscal Constitutions on State and Local Expenditures.”

42

Poulson, “Surplus Expenditures in Colorado” and “Surplus Expenditures: A Case Study of Colorado.”

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The Buckeye Institute for Public Policy Solutions 45

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Should Ohio Limit Government Spending and Taxes? 46

Should Ohio Limit Government Spending and Taxes? A Joint Publication of The Buckeye Institute and the Independence Institute Russell S. Sobel, Ph.D. Department of Economics, West Virginia University Robert A. Lawson, Ph.D. School of Management, Capital University Barry W. Poulson, Ph.D. Senior Fellow, Independence Institute and Joshua C. Hall Senior Fellow, The Buckeye Institute for Public Policy Solutions

December 2004

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