How to Govern in a Recession

The American economy is gripped by recession. State governments are currently and will continue to be in a fiscal squeeze over the short- and medium-term future.

* About 46 states struggled to close a combined budget gap of $37 billion in the fiscal year ending June 30, 2002.

* Efforts to balance the books included tapping reserves, redirecting tobacco settlement monies, slashing public jobs, foregoing maintenance, raising fees, increasing taxes, and implementing targeted and across-the-board budget cuts.

* This year’s shortfall is even bigger than last year’s—a combined deficit of $58 billion—so state policymakers will be forced to make even more tough choices.

* This is the biggest budget crisis that states have faced since 1983, yet it is likely to be worse because, among other factors: state budgets play a larger role in supporting education and social services, due to federal devolution; internet shopping is shrinking state tax revenue; incentives for business attraction and a concerted push by multi-state corporations have reduced corporate tax in many states; and retrenchment of public payrolls may have a large macroeconomic effect—as growth in government jobs had partially offset the fall in private sector employment. (This will not be true in the coming year.)

During recession, state policymakers face a situation that is converse to the business community. Like the private sector, revenue shrinks, deficits balloon and budgets are slashed. But unlike the private sector, business booms. More and more of the government’s “customers” clamor for income support, food stamps, retraining, health and housing assistance, and other needed (and costly) services.

So how can state policymakers succeed where business need not tread? What can be cut? Where should money be spent? What tools are needed make tough decisions?

It may be best to use the same tool employed by innovative members of the private sector—a strategic audit. And the first step in such an audit may be to review a specific state’s performance on the Development Report Card for the States (DRC).

Auditing the States in a Recession

In the public sector, governors, mayors, and development professionals are evaluated by the public equivalent of private-market sales figures—numbers of jobs created or lost; companies recruited, expanded or closed; etc. There is no doubt that these are important indicators of a state’s economic health. But, like quarterly reports prepared for private firms, there are two problems with focusing exclusively on these “sales figures.”

First, how much a firm sells is less important than how much it makes. Using only employment benchmarks to characterize the health of the economy neglects other equally important figures, like wage levels, distribution of job opportunities, or quality of life.

Second, the number of jobs created reveals very little about the underlying competitive strengths and weaknesses that determine, for example, how well a state’s economy can weather recession. This might be termed the “return on investment” of taxpayer dollars. For example, no short-term job gains can overcome basic weaknesses in the state’s economic fundamentals.

One could view the DRC’s Performance Index, http://drc.cfed.org/grades/indexes/performance.html therefore, as a thorough review of a state’s “profits and losses.” This measure looks at the extent to which the economy is providing jobs for those who seek them, how well people are compensated for the work that they do, the degree to which the opportunity to attain a higher standard of living is widely shared, and the level of the overall quality of life.

The Business Vitality Index http://drc.cfed.org/grades/indexes/business_vitality.html is the state’s version of a “product line.” In a firm, some products move faster than others. Some are more profitable. Some are being phased out. Others are on the drawing board. It’s roughly the same with a state’s economy: it is composed of existing firms of all sectors, sizes, and levels of competitiveness and—if the business climate is right—a steady stream of new firms are struggling to start up, gain market share, and grow.

The Development Capacity Index http://drc.cfed.org/grades/indexes/development_capacity.html reviews a state’s “fundamentals.” Like a top business consultant, this index considers and evaluates the underlying building blocks of a state economy—its human resources, its technological assets, its financial base, and its infrastructure and amenities.
Avoiding the Quick Fix: Looking Toward the Long-Term

When government resources are scarce and competition for them is intense, practically every policy or programmatic decision involves a painful tradeoff. Most of the resulting funding choices are currently driven by the short-term considerations of achieving balanced budgets. Short-sighted decisions tend to treat the most obvious symptoms of economic trouble but displace efforts toward more solidly grounded, long-term gains.

The constraints brought on by tough financial times are particularly hard on development practitioners, anti-poverty advocates, and elected officials who would seek a better balance between solutions that promise quick short-lived benefits and initiatives that take longer to implement but can fundamentally improve the economic and social fortunes of a state or locality and expand opportunities for all. The choices are particularly hard when the demands for immediate relief are loud and insistent and the taboo on tax increases is hard to overcome. But even in the face of such pressures, officials cannot afford to discard their larger development goals.

Thirty years ago opportunities lost during a recession merely meant a halt in forward progress. Today, intense international competition turns economic stalls into lost market positions. Poor policy choices are no longer benign; they are costly and have serious long-term implications.

Admittedly, hard times are never welcome, but they create opportunities for positive and fundamental change in state development efforts. Pressures will increase, for example, to provide more tax incentives to attract or retain business in order to achieve short-term employment goals. But now more than ever, normally reticent officials must tackle controversial issues, reevaluate development strategies, refocus spending priorities, and restructure management so operations run more efficiently.

Though the temptation is to create patchwork solutions, the challenge is to find creative ways of preserving and improving those elements that are essential to good economic health. Quite simply, the higher quality of a state’s human, financial, technological, infrastructural, natural, and social capital, the better its overall economic performance. No state can be completely protected from the troughs that are part of our cyclical capitalist economy. But a jurisdiction with solid development resources can avert disaster and ride through the rough weather.

Making Smart Choices

The following guidelines are designed to help state policymakers visualize a better approach to coping with economic downturns. The fiscal crisis of the current recession can be used make changes that should have been made before.

1. Set spending priorities based on what’s critical for your area’s long-term success.

Don’t cut programs across the board or, conversely, try to spend a little on everything. Although this seems fair, it is probably not the prudent, long-term course to take. Use the data provided here to evaluate your state’s fundamentals – where are its strengths, where are its weaknesses? Follow the lead of the states that focus on funding results not activities. Develop a series of strategic goals like Oregon Benchmarks http://www.econ.state.or.us/opb/sitemap.htm and use these to devise a priority plan to improve a state’s ability to compete in good times and in bad. And work with agency line staff on deciding where savings can be generated and programs can be improved.

2. Consider investments in education, health care, and child development as part of an overall economic development strategy that needs to be maintained in both good and bad times.

Most traditional economic developers think of human services and other such social investments as nonessential budget items just because they can be considered “social” rather than “economic” investments. But budgets for preventive health care, education, and childhood development are important investments for the long haul. They can improve the future workforce, lower dropout rates and teenage arrests, and cut the costs of prisons and law enforcement.

3. Use tax incentives judiciously and strategically, and only in concert with accountability and performance checks.

State officials often try to jump-start stalled economies by using tax incentives to encourage new investment and job creation. But despite the quick payoff of landing a new facility, the best course in a recession is not creating new incentives to land the latest footloose corporation. Rather, because funds are tight, it is all the more important to re-examine your portfolio of incentives and add monies only to initiatives that are working. If most induced-investment is happening in fast-growing metro areas and very little in struggling rural communities, why keep subsidizing the former and not the latter? Would this incentive be defensible without the incentives competition with other states? If not, then why do it? Use incentives within an agreed-upon plan and within a legislative framework to discourage ad hoc actions where policymakers are more likely to be taken to the cleaners by companies playing competing jurisdiction off against each other. Likewise, it is not anti-business to require sunset reviews of incentives or to require performance contracts to increase the return to the public sector.

4. Make tax reforms to balance the sometimes competing goals of equity, efficiency, sufficiency, and competitiveness.

Innovative state policymakers who wish to confront today’s business climate challenges regarding taxes must avoid pursuing the traditional tax reform approaches—enacting more tax preferences and making cuts in overall tax rates without considering the larger picture. What should be done instead? To start, state taxes and fiscal policies do affect the economic climate for business in a state. But good services help as well. Yet, it is not easy to combine all the appropriate goals of a far-sighted tax policy. For example it is important to avoid either starving the public sector of essential revenues or burdening businesses with unnecessary tax burdens and complexity. Although the agenda for development-enhancing tax reform is complicated and particulars will differ from state to state, options can be summarized in a few simple recommendations:

* Reframe the debate about taxes and business climate so that adequate tax competitiveness becomes only one of a number of important features of a quality fiscal system.

* Review the ways that changing conditions affect a specific state’s tax structure and develop a reform approach that creates a better fit between a state’s fiscal system and its underlying base.

* Explore more comprehensive tax reforms rather than adopting inadequate, only-just-getting-by solutions. [1]

* Curb wasteful tax expenditures and close loopholes.

* Cooperate with other states around uniformity issues, taxing multi-state corporations, and restraining the incentives “arms race.”

* Create a tax system with greater predictability, a broader base, more equity, and greater simplicity.

5. Focus on your homegrown economy; do not let recruitment drive your economic development strategy.

When business within your borders is failing, it is tempting to look elsewhere for economic relief. The idea of replacing an ailing firm with a healthy one of equivalent size can be particularly attractive when you are facing a plant closing. Indeed, outside investment is an important shot in the arm for a state or local economy. But most jobs are still created by one’s homegrown economy. And when you focus most of your attention on recruitment you make a high stakes wager that has little likelihood of paying off. By making it the center of your economic development strategy you risk squandering scarce development capital that could be used to build the fundamentals of your economy, encourage local businesses, and ultimately, create a business environment that is able to attract firms. Businesses also, typically, do not move when their locations make sense. So, strengthen existing business, promote entrepreneurship, and make wise investments in schools, workforce development initiatives, universities, and the physical infrastructure.

6. Create realistic and measurable objectives that reflect your real development goals.

Most development programs are measured by comparing how much was spent to how many jobs were created. Even in the midst of a downturn, this indicator should not be the sole criterion. Sound development strategies should focus on long-term implications of employment and growth; create jobs that enable families to achieve decent standards of living; modernize firms so they can remain competitive; and manage growth to preserve the quality of life of area communities. Thus, appropriate benchmarks for success must be customized. What are the state’s main opportunities and threats, its vulnerabilities and challenges, its assets and liabilities? These should be the priority targets for action, not a one-size-fits-all job creation standard.

7. Provide direct labor subsidies if job creation is a prime imperative.

One of the paradoxes of the field of business incentives is that most development subsidies are capital-based, but are supposed to create jobs. Such subsidies are less efficient than labor-targeted efforts. This does not mean that labor subsidies are inherently good; it just means that they are more direct ways of creating jobs. A successful example of an employment subsidy was the Minnesota Emergency Employment Development (MEED) program. Passed in 1983 in response to the state’s worst depression since the 1930s, MEED began as a two-year $70 million program to create temporary jobs in government and nonprofit agencies as well as permanent jobs in the private sector. MEED offered employers up to $4/hour in wage subsidies and $1/hour in benefits for twenty-six weeks for hiring people who have been state residents for at least one month, are unemployed, and are currently ineligible for unemployment insurance and workers compensation. Since its inception, MEED enrolled about 45,000 people, with more than 64 percent filling private sector jobs. An internal evaluation documented that—by the end of the three-year program—the initial $100 million cost would be partially offset by reductions in general assistance payments and increases in state tax revenues. It created over 18,000 permanent jobs (more than was projected) at a net cost per permanent job of around $3,100.

8. Invest in community leadership and assistance to unemployed workers, while selectively helping declining, but viable firms.

There is always a great danger of throwing money at the symptoms of economic decline. Most energy and money should be invested in helping individual workers and local communities develop the skills required to sustain economic development. You need to carefully identify those few struggling but viable firms and furnish them with appropriate assistance. Programs like Oregon’s Rural Development Initiatives, Inc., http://www.rdiinc.org/index.html the manufacturing extension services in most states, the Canadian Industrial Adjustment Services, and Ohio Employee Ownership Center http://dept.kent.edu/oeoc/ at Kent State University point the way forward.

9. Use limited government resources to direct and leverage other development services.

Government does not need to foot the bill for all business development services. Loan insurance schemes like the highly successful capital access programs and linked deposit programs can stimulate more entrepreneurial lending by banks. Working with industry trade associations, nonprofit community development corporations, and other public providers like community colleges can stretch dollars and increase the scale of activities. For example, many state industry modernization programs have successfully experimented with using small matching grants and limited startup services to create flexible manufacturing networks of groups of firms in similar sectors to explore joint efforts to advance their competitiveness.

10. Give frontline staff more power to make decisions and to respond flexibly when delivering services.

When budgets get tight and demands for services mount, most agency chiefs ask their staffs to work a little harder, produce a little more, and try to cut unnecessary expenditures. But trying to impose higher performance standards without addressing the “how to’s” of improving the quality of services and seeking bottom-up innovation will be self-defeating. Labor-management committees have proven particularly effective in meeting public sector management and service needs and responding to hard times.

President Nixon Points the Way

Clearly, the Development Report Card for the States points out many affirmative actions that can be taken by states. One major obstacle faced by states, however, is that they do not control monetary policy. They cannot run deficits. Rainy day funds are so small that they more equipped to balance a state’s fiscal resources over the life of a business cycle than to truly stimulate flagging economies when times are bad.

In an economic downturn during his term, President Nixon instituted federal revenue sharing and promoted public job creation in the wake of large employment loss. It is vital that today’s federal leaders also step forward to prevent a “double-dip” recession and to address state governments’ fiscal woes.

The recent Bush stimulus package and its tax cuts may have helped to avoid a deeper downturn. Now, however, the President is calling for making the cuts permanent. This option threatens to create long-term federal budget deficits, as well as make the tax code far more generous for the affluent. It will starve domestic budget priorities and will balance the federal government’s books on the backs of the states, given the growing fiscal demands of the war on terrorism.

A better course for safeguarding economic recovery is through Congressional enactment of an anti-recessionary package for state and local governments. Congress could deliver the aid in a way that takes into account, in any given state, the level of unemployment, the population, and its fiscal capacity. It could also provide transparent “no-strings-attached” assistance to speed the program’s implementation. Or, it could add to existing federal program items, increase the federal share of Medicaid, etc.
A New Federal-State Partnership To Combat Future Recession

The federal government could make such a program permanent. (Just as President Bush desires to do for his already enacted tax cut.) By the time the President and Congress determine that the scale of an economic problem is large enough to merit action, states whose economies lead the downturn are already hurting. Deficit financing must be well-timed with the business cycle if it is to make a different in pump-priming a struggling economy. There is a danger that it will take too much time to craft a federal response on case-by-case basis that the fiscal stimulus will be so late that it will actually be pro-cyclical and inflationary in many states.

In the early 1980s, economist Roger Vaughan offered a solution to this dilemma in his book for the Council of State Planning Agencies, Inflation and Unemployment: Surviving the 1980s. He proposed a federal partnership with states. By building on the rainy day funds that most states already possess, a more decentralized and responsive approach to counter-cyclical programs can be found. The federal government would provide a pool of matching funds that states could draw from on the basis of their need and their own contributions.

More specifically, according to Vaughan, an ideal stabilization program would draw on four sources.

State contributions. Contributions from a state’s general revenues triggered automatically by the performance of the economy. When economic growth was strong and revenues large, contributions are large. During weaker periods, contributions decline and shrink to zero whenever growth falls below normal.

State-local borrowing. In those states where it is permissible, bonds could be issued during periods of low interest rates for capital projects undertaken when the local construction sector enters a recession.

Local contributions. Local jurisdictions could pay into the fund during periods of growth in order to draw on it during recessions. Direct participation by cities would insure that the funds meet local needs and encourage fiscal responsibility by local governments.

Federal contributions. Rather than continuing to rely on existing but erratically funded stabilization programs, the federal government could distribute grants each year among states according to their own contributions with some allowance for local fiscal effort.

With these four pillars in place, each state could control its own counter-cyclical response. When unemployment and growth indicators hit a certain agreed threshold, monies from its stabilization fund could be released. Typically, the counter-cyclical fund would have three major goals:

1. reduce the idle capacity in construction and manufacturing through well-planned public works projects;

2. provide jobs for the cyclically unemployed through public employment and training efforts and subsidies for private sector job hiring; and

3. maintain public services through anti-recessionary fiscal assistance. [2]

Such a partnership would allow faster responses to economic downturns. Its sharing of costs establishes the right sorts of incentives between all levels of government. It would redistribute some public spending from peaks to troughs. It would allow state discretion on customizing its own counter-cyclical response. For instance, should it provide more for public works or for state-local fiscal assistance? And it could still be augmented by additional federal actions, akin to many of the current federal proposals, if the downturn was especially large and chronic.
Conclusion

It will not be easy to act on these recommendations. The federal policy suggestions run against the grain of the times. And, at the state level, resource constraints will likely require many unpleasant cuts in programs that protect the economically vulnerable, as well as those that build long-term development capacity. Politics also will intervene. Crucial budget information, such as the tax incidence of different fiscal reforms or performance outcome data on development programs, will often be lacking.

Yet, a start needs to be made. And after the dust settles following this crisis, states should prepare for the next downturn. They could hold hearings on what was learned this time around. What worked and what didn’t? What budgeting and performance review systems should now be put in place? How might the state’s rainy day fund be improved? How can public employees become empowered to foster greater innovation and productivity in government services? How might creative states devise better stabilization strategies, such as reducing idle capacity in construction and manufacturing (e.g., public works), providing jobs for the cyclically jobless and the hard to employ (e.g., wage subsidies, public employment and training, etc.), and maintaining quality public services (e.g., increased productivity, sensible program cuts, anti-recessionary aid, etc.)?

These are all important questions for the future, because, whatever happens this time around, it is unlikely that we have banished the business cycle in the so-called “new” economy. Hard times may not be here to stay. But they will return.
Endnotes

[1] It also should be pointed out that many states cut their taxes too much during the recent boom time, assuming that revenues would be adequate over the course of a business cycle. Unfortunately, these cuts appear to be unsustainable. Moreover, the tax increases enacted recently by the states are still dwarfed by the scale of the earlier tax cuts. One could, thus, argue that the states should consider restoring these lost revenues.

[2] Additional detail on this sort of proposal can be found in Vaughan’s book and in “Federal and State Roles In Economic Stabilization,” hearings before a subcommittee of the Committee on Government Operations, House of Representatives (November 29, and December 12, 1984).

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