How (and How Not) to Cap Government Spending

A WEAK LIMIT IS WORSE THAN NO LIMIT

If the last few legislative sessions prove anything, it’s that almost nothing can compel state lawmakers to exercise spending restraint. A report released by the National Association of State Budget Officers (NASBO) revealed South Carolina increased state spending by 26.5 percent from 2010-11. The most recent budget is a little under $22 billion, making it the largest budget in state history – a remarkable achievement given the ongoing economic downturn.

The best – indeed the only – mechanism for limiting state spending is a comprehensive spending cap. But while some spending caps have the potential to limit government spending, some are phony. And phony “spending caps” are worse than nothing: they create the impression that government officials have taken action against unrestrained spending when they haven’t.

For instance, South Carolina state government is currently governed by a “spending cap” – one that’s based on personal income growth, with a cap of 9.5 percent. But this “cap” is so generous as to be completely meaningless: in 2011, the largest budget in state history still fell shy of the “cap” by $6 billion.

Only marginally better is a bill pre-filed for the upcoming legislative session. It would cap General Fund revenue at a rate of 6 percent or the increase in population plus inflation, whichever is lower. In addition, all General Fund revenue over the cap would go into an automatic Income Tax Rebate Fund, which would provide a tax credit against individual and corporate income tax liability. While the bill has merits – and it’s certainly  stronger than some other proposed caps – it’s too weak to put a hard limit on excessive government spending. It doesn’t let government hold on to excess revenue; that’s good. But it only caps General Fund growth, not revenue from fines and fees or from the federal government; and it has the potential to allow government to grow faster than incomes.

So – as lawmakers debate the best way to limit government spending, bear in mind these four principles:

1) A spending cap needs to cap all spending – not just General Fund spending

State lawmakers routinely speak of “the budget” as though it were only the General Fund. But it isn’t. There are three revenue sources that make up state spending: the General Funds, Other Funds (fines and fees), and Federal Funds. Of these three, the General Fund is the smallest.

A spending cap needs to cover every single dollar that the state spends. If it doesn’t, the spending cap is meaningless. Why? Because if state lawmakers find that they don’t have sufficient revenue to fund some pet project or program, all they have to do is fund it with fines and fees, which they can raise commensurately. In short: A spending cap that affects only about a quarter of the budget isn’t worth the paper it’s written on.

Fines and fees and Federal Funds have been increasing at a breakneck pace. The reason is plain: state lawmakers can raise total revenue – and thus their ability to fund their favorite programs – without taking the political risk of straightforwardly raising taxes. In actuality, fines and fees come straight out of the taxpayer’s pocket, as do federal dollars. So any spending cap that hopes to impose real fiscal restraint will have to cover 100 percent, not 25 percent, of all state spending.

2) The government should never grow faster than South Carolina’s economy

Many proponents of spending cap recommend that the cap be tied to inflation and population growth. The thinking behind this is that it will allow government to spend the same amount of money next year that it’s spending this year, while allowing the budget to grow in order to accommodate increased demand on services stemming from population growth. In essence, it freezes the size of government relative to the population in place.

There’s a major problem with that model, though. Government can get no bigger – that’s true. But it’s never forced to get any smaller, even if the citizens of the state become less able to pay for government. While a spending cap based on population growth and inflation is better than no spending cap at all, it’s premised on a false assumption.

The false assumption is this: that government should expand to accommodate increased demand on services resulting from population growth. But is it always responsible to increase your spending on the basis of increased demand, even if you’re no more able to pay for it? A household, for example, can’t increase spending according to demand – “demand” meaning what members of the household think they need. The same applies to government.

Instead of basing spending caps on increased demand, the state should increase spending limits only on the ability of taxpayers to pay. In other words, state government should never grow faster than the rate at which South Carolinians grow wealthier. If South Carolina is 2 percent poorer this year than it was last year, it should not have to pay 5 percent more for government – no matter how fast the population is growing.

The problem with a spending cap based on economic growth is that it would allow for fairly large spending increases during boom times. But government shouldn’t necessarily grow at the same rate at which the private economy grows: economic growth is the absolute maximum cap beyond which any spending becomes irresponsible and unsustainable. Government spending increases should probably be much less than economic growth, but under no circumstances should they ever be more.

3) Every dollar collected over the spending cap must be returned directly to taxpayers

Any spending cap that does not come accompanied by an automatic taxpayer refund is not a serious spending cap. The idea of a spending cap should be to put an absolute limit on the amount of money that can be taken from taxpayers in any given year and return the rest to taxpayers. Many spending cap proposals involve placing excess revenue into one or another kind of “reserve fund” to be used for some allegedly noble purpose. There are two problems with these “reserve funds”: (a) government doesn’t have a right to take more than what it needs from taxpayers, and (b) government revenue is fungible – meaning that any money allocated to a “reserve fund” will simply free up some other pot of revenue that will then be used to subsidize more government excess, and the end result will be that government growth isn’t checked at all.

Any spending cap that allows surplus revenues to be spent isn’t a spending cap at all.

4) A spending cap is a good start – but it’s not a solution for bad priorities

Even the best spending caps contain one flaw: it takes at its base the current size of government, and makes adjustments based on that. But what if the current size of government is far too large? What if government is currently taking far too much out of the private economy? In fact, there are excellent reasons to believe that government is too large now, and that our current tax burden is crippling the ability of South Carolina to grow more competitive. Even if South Carolina got wealthier, and the budget cap increased, there is no reason to idealize the present size of government relative to the underlying economy. The only optimal size of government is that which funds only the core government services and lets taxpaying citizens save or invest the remainder.

Creating a budget cap, whatever else it might do, won’t force politicians to limit government to its role. Only an informed, active citizenry can do that.