INTRODUCTION INTRODUCTION Back-to-Basics Budgeting Nationwide, states collectively are facing the worst budget crises since World War II. Much of what states are up against was spawned by events very much beyond their control. The irrational exuberance of the stock market in the mid to late 1990s and the bursting of the IT and telecom bubbles continue to have negative implications on all areas of state revenue growth. It was hard to imagine the rapidity and overwhelming negative trajectory that the market correction took. To make matters worse, the corporate fraud and abuse that gripped the headlines and read like a sordid novel continue to cause investor worry and muddle the equity markets. The fallout of the events of 9/11 drove the nation deeper into its slumber and consequently we still teeter on the edge of a double-dip recession. Further, the anticipation of war with Iraq is battering consumer and business confidence and is forestalling the economic recovery that the principal economic measures seem to point to. In the early 1990s, the advent of managed care made great strides in reducing waste and inefficiency in the health care system. But even with continuing vigilance against excesses, spiraling health care inflation has returned with a vengeance. Coupled with burgeoning public assistance enrollment in these times of need, health care costs are leading to double-digit increases in states’ anticipated budgets -- at a time when revenues are actually dropping or, at best, are seeing meager growth. But policy-makers and elected officials, too, bear some blame for the plight that states find themselves in. The roaring ‘90s allowed states the latitude to add significant new programs that today are draining coffers. Still enthralled with the frenzied atmosphere of tax cutting and program expansion, a blind eye was turned to the impending downturn. To deal with the softening of the economy and market corrections over the past few years, a myriad of quick fixes and one-time revenues were invented to paper the way back to budget balance and prosperity. It didn’t work. If the last paragraph sounds like a mea culpa – it is. While external events played a role, Connecticut, like most other states, failed to make the fundamental changes needed in 2001 and 2002 to right its budget mess. This document is all about recognizing that structural and permanent changes are needed in the state budget if we are to salvage the state’s bond rating and balance the books over the long term. Much is said about Connecticut’s relative position as compared with a number of other states. We do not have the worst fiscal crisis, in large measure because the state’s spending cap did act as a firewall against the uncontrolled spending increases that we saw in the late 1980s. (This fiscal year’s deficit is just 5 percent of general fund expenditures. Next fiscal year’s current services gap is about 15 percent of planned expenditures.) The restructuring of the state’s economy over the last decade has meant a more diversified economy and with it a recession that is relatively mild compared with the one ten years ago. We retain some strategic advantages, including our highly skilled work force and budding clusters of the future, over other states. But these relative strengths should not and cannot be used as an excuse to do what we have done over the past several years. Indeed, if we put our financial house in order, our relative strengths will be our competitive edge moving into the future. Thus, this budget – however reluctantly – raises taxes by hundreds of millions of dollars to help balance the budget. The tax increase plan attempts to ensure that the pain of balancing the budget is shared by all – income-earners at all levels, consumers, and businesses. Fundamental to the tax plan is that our economic competitiveness is not compromised. This budget abides by the spending cap – which will become as much of the budget battle over the next few months as the revenue gap. Hundreds of millions of dollars in anticipated spending is reduced over the next two fiscal years. The reductions are aimed at protecting fundamental and 1 INTRODUCTION basic services. It also recognizes that the years of unfettered entitlements – which called for gold- plated benefits for as many people as possible -- are gone and can no longer be sustained. This document gets us back to the basics: This budget is all about balance – balancing tax increases and spending cuts in an ultimate attempt to balance the budget. The use of one-time revenues and other gimmicks is minimal. People may disagree with its spending priorities – but it attempts to recognize that to stay competitive on the tax front, spending must be limited to absolute necessities. From boom to bust Like many other states, Connecticut saw its budgetary balances go from boom to bust almost in the blink of an General Fund Surplus/Deficit eye. On a gross basis, Connecticut enjoyed Prior To Disposition (In Millions of Dollars) unprecedented surpluses in the mid and late 1990s. In $800 $702 the four years prior to Connecticut registering a deficit, $610 $613 surpluses were between $500 million and $700 million $600 $512 $381 annually. The following year, the state registered a $400 whopping $800 plus million gross deficit. In actuality, if $250 $200 not for a special session that moved prior year surplus to $81 cover a portion of the deficit and some mid-year spending $0 cuts, the gross deficit would have been in excess of $1.2 -$200 billion. -$400 To solve its fiscal woes, the state was forced to draw -$600 down on its entire approximate $600 million Rainy Day -$628 -$800 Fund at the end of FY 2001-02 – something that was -$817 never anticipated. Even then, it had to bond the -$1,000 remaining deficit of just over $220 million for five years. '95 '96 '97 '98 '99 '00 '01 '02 '03 The first Fiscal Year Est. General Fund Unappropriated of the full Surplus/Deficit payments of about $50 million is due in the coming fiscal year. In retrospect, despite abiding by the (In Millions of Dollars) $400 spending cap for ongoing program growth, the state $313 $300 should have placed additional dollars in a Budget $300 $250 $263 Reserve Fund as opposed to concentrating its one- time surplus dollars on debt avoidance and debt $200 retirement. Learning from that mistake, the Governor $81 proposed legislation and the statute was changed to $100 $72 $31 $29 provide that at least 7.5 percent of general fund $0 expenditures are built, over time, into the Rainy Day Fund in the future. -$100 Today, with no Budget Reserve Fund left, the state -$200 faces a gross deficit of $628 million in the current -$222 fiscal year because of the continuing dreary fiscal -$300 climate. (As will be outlined later, the Governor is -$400 proposing a new deficit mitigation plan that will totally '95 '96 '97 '98 '99 '00 '01 '02 '03 close the deficit and mean a $29 million deposit in a new Budget Reserve Fund.) Fiscal Year Est. How could state finances change so quickly and see a swing of as much as $1.8 billion? The answer lies in the huge stock roll up in the mid to late 1990s and the collapse of the equity markets in 2000 and 2001. Capital gains realizations drove much of the surpluses we saw in the 1990s and into the beginning of the current century. As can be seen from the federal data capital gains realizations chart, Connecticut residents’ capital gains realizations increased by booming double-digit growth for 2 INTRODUCTION six years in a row. One has to go back to the beginning of the 1980s to witness a similar experience. Over the past six years, Capital Gains Realizations capital gains realizations grew by more than 500 percent Reported By CT Residents (In Millions) From a state budget standpoint, fiscal analysts continued to predict and budget for a downturn in the market, but the stock Income Capital Percent boom kept chugging along. As can be seen from the revenue Year Gains Change variance chart, in the years of the greatest surpluses anywhere 1994 $2,547 -16% between a third and 70 percent of each fiscal year’s surplus was tied to the stock market gains – that is even though just between 1995 $3,832 50% 12.5 percent and 15 percent of income tax revenue comes from 1996 $4,732 23% such income. The estimates and finals category of the state 1997 $7,787 65% income tax, about half of which is capital gains in good stock 1998 $9,867 27% market years, rose between 14 percent and 32 percent annually in 1999 $11,800 20% those six years. 2000 $15,435 31% And as is the case in most wealthy Revenue Variance Due Primarily To Income Tax Collections states, rising stock markets tend to mean healthy increases in other tax $799.8 $800 $704.2 revenues as well, especially the $624.4 5.8% $567.6 . $532.4 74.7% 57.7% withholding portion of the income tax 67.4% $400 68.9% $526 26.3% $461 29.8% 46.4% and the sales tax. Withholding tax 49.2% $421 $262 $264 grew between 7.5 percent and 15.1 21.5% 12.1% 27.7% 31.4% 37.6% 34.3% 8.6% percent annually in the boom years, $0 -18.7% -53.7% -$421 with sales taxes going up 3.6 -$576 percent to 8.6 percent annually.