It is a truism that no single factor can be said to have caused the budget crises of 2001 and 2002. Hurricanes, lawsuits, tax cuts, education spending, a national recession, the September 11 terrorist attack … all these things arguably helped cause or contribute to the budget shortfalls. Democrats, of course, emphasize that the tax cuts pushed through by Republicans between 1995 and 1998 really caused the crisis – this has something to do with the fact that Democrats attempted to resolve the budget shortfalls by raising taxes. Republicans, on the other hand, tend to blame the crisis on a lack of fiscal discipline and poor financial planning – this has something to do with the fact that the Republicans weren’t in the majority or the governor’s mansion in 2001 and 2002. At the time, the people of North Carolina tended to find the Republican version of the story slightly more convincing and thus gave the GOP a slim majority in the House in the 2002 election.
Of course, the question of there being a “crisis” at all is a matter of perception (see Q & A: 4). It cannot be denied that baseline sales tax collections dropped sharply in 2001 and 2002 and that corporate income tax revenue also dropped between 2000 and 2002. It also cannot be denied that General Fund revenues decreased in FY2001-2002.
That being said, total General Fund authorizations increased by 1.02 percent for FY2000-
2001; by 3.34 percent for FY2001-2002; and then increased again by 3.92 percent in FY2003-2004. Only in FY2002-2003 did authorizations actually decline – by 3.44 percent, or over $500 million. Total authorizations, however, rose from $14.384 billion in FY2000-2001 to $14.914 billion in FY2003-2004.Thus taking FY2000-2001 as a baseline, General Fund authorizations only decreased by $31 million over the course of FY2001 and FY2002.
Even more to the point, in none of these years did the total budget (due to the inclusion of federal dollars) undergo an absolute decline. Thus from FY2000-2001 to FY2003-2004, the total budget increased from $24.501 billion to $29.397 billion, with no drop off in between. Moreover, even during the peak of the “crisis” in 2002, the state hired 1,000 new teachers, gave teachers a raise of 1.84 percent, spent $28 million on More at Four, and allocated another $27 million for class-size reduction (see 2002 Timeline).The year before, the state also gave teachers a 2.86 percent raise and state workers a flat $625 raise.
In spite of the economic recession, North Carolina did not cut back spending very much – thanks, in part, no doubt to the tax increases passed in 2001. Even more telling is that the burden of public employees (including federal) per 100 private employees increased between 2001 and 2003 from 18.5 to 19.2.The largest increase in public employment in North Carolina was at the state level. As the private sector was cutting positions, the state increased its number of employees by 4.1 percent. Local governments in North Carolina expanded their employment by 3.3 percent. Meanwhile, private employers cut 163,000 positions – a reduction of 4 percent. Seen from this perspective, the “budget crisis” appears to describe not so much a genuine fiscal crisis as merely a slowing in the rate of growth for the state government.
Even granting the existence of a budget crisis, we need at least to mention the impact of those hurricanes and lawsuits. North Carolina’s economy peaked in 1997 and again in 1999. In 1999, however, Hurricanes Dennis, Floyd and Irene hit the state, causing widespread damage. In response, the Legislature met in special session that December and passed the $830 million Hurricane Floyd Recovery Act (S.L. 1999-463es).
Similarly, between 1997 and 2000 the state was liable for $596 million in tax refunds stemming from the Fulton/Smith/Shaver intangibles tax lawsuits (see Q & A: 12). In 1998 and 1999, the state also paid out $799 million in connection with the Bailey/Emory/Patton lawsuits (see Q & A: 13). Each of these settlements likewise resulted in millions of dollars in loss tax revenue.
As the impact of the tax cuts grew larger, the amount of actual tax revenue increased. This correlation suggests that the tax cuts had a dynamic effect on the economy. In turn, higher rates of economic growth contributed to an increase in overall tax revenue. At the same time that the economy was peaking, the growth of the state government slowed. Thus General Fund authorizations only increased by 1.02 percent for FY2000-2001 – the year in which the impact of the tax cuts reached their zenith and the year before the 2001 tax increases went into effect. The tax cuts thus might be seen, as certainly they were by Republicans, as part of a strategy to force the government to grow in a fiscally responsible manner. What is perhaps even more interesting is that the tax cuts do not in any way correspond to the FY2003 budget shortfall. Of course, the shortfall was mitigated by the 2001 tax increases, but even accounting for this revenue, it is not as if the cuts match the decline in authorizations dollar for dollar. More likely is that the cuts stimulated economic growth, contributing to an increase in overall tax revenue.
Indeed, one could argue that if not for the Fulton settlement the FY2003 budget shortfall could have been averted entirely. Likewise, if not for Bailey, the Legislature could have set aside additional funds in the Savings Reserve Account, which would have helped the state ride out the 2001 recession. Who knows? If not for Hurricane Floyd, the economic recession might barely have touched North Carolina at all. And if not for the recession …
If all of these scenarios smack of wishful thinking, they highlight the fact that debates about what really caused the 2001 and 2002 budget shortfalls are often misguided. In short, the recession caused the budget shortfall. Recessions, however, are a necessary part of free market capitalism and cannot be prevented, but only delayed, mitigated and planned for. Moreover, in this case, the recession was a national phenomenon and not directly caused by any one thing done or not done by the state of North Carolina.
The first question we need to address, then, is whether the state adequately planned for the recession, which it should have known would come, sooner or later. One can argue this issue both ways. On the one hand, we can point to the fact that the Savings Reserve Account was, in fact, fully funded (interestingly enough, by the same people who passed the tax cuts) from FY1995-1996 to FY1997-1998. On the other, we should mention the years – FY1993- 1994 and FY1998-1999 – in which the account was barely funded at half its target level. Still, it makes basic economic sense that had the state set aside more money in the so-called Rainy Day Fund it would have had more money to spend when that rainy day came. Let it be granted, then, that fully funding the Savings Reserve Account would have helped the state respond to subsequent budget shortfalls.
So far, though, we haven’t really answered the question because we still haven’t asked the question as clearly as we might. What many critics really mean when they charge that the tax cuts of the 1990s caused the budget crises of the following decade is that the tax cuts were bad for the economy, bad for the poor, bad for the common good.
Finally, then, here is our question: “Did the tax cuts of the 1990s help or hurt North Carolina’s economy?” A necessary corollary to this question is: “Did the tax increases passed in 2001 help or hurt the economy?”
In order to begin to answer these questions we will examine three measures of economic well-being: GDP growth, employment, and tax revenue growth.
During the three-year recession, North Carolina’s state GDP remained slightly more stable than the national GDP, with annual average real growth of 1.9 percent from 2000 to 2002. Unlike the national economy, North Carolina’s growth never dipped below 1.5 percent per year. As Figure 1 indicates, the 1990s tax cuts correlated with a period of tremendous economic growth in North Carolina. Thus until the start of the recession in late 1999, North Carolina’s real economic growth exceeded the national growth rate every year except one. Overall, North Carolina’s growth advantage was a healthy 1.6 percent per year.
This is not to say that the tax cuts were solely responsible for North Carolina’s strong GDP growth. Still, it is interesting to note that the spike in the state’s GDP roughly corresponds with the period following the cuts while the decline in state GDP roughly corresponds with the tax increases. More telling is that in the aftermath of the 2001 tax increases state GDP did not rebound as in earlier years, but fell behind the U.S. average.
As might be expected, the real impact of the tax increases was not immediately visible. (The “temporary” income tax increase of 0.5 percent went into effect on January 1, 2001, while the “temporary” sales tax began on October 16, 2001.) As the effects of the tax increases trickled down, North Carolina’s GDP grew at an average rate of 2.17 percent between 2002 and 2004. During the same period, the U.S. economy grew at an average rate of 2.73 percent per year. By 2003, North Carolina’s economic growth rate was only 85 cents to the dollar of U.S. growth. In 2004, the rate of growth had fallen even further behind, slowing to 68 cents per dollar of U.S. growth. In short, it seems as if the 2001 tax increases hindered the state’s economic recovery.
By contrast, it seems that the tax cuts actually stimulated North Carolina’s economy. Figure 2 shows how North Carolina’s employment growth sustained an advantage over the U.S. economy as the tax cuts took effect. Jobs creation was slowing down until the tax cuts kicked in and reenergized the job market.
Job growth started falling only when the national recession began. Unlike the national economy, however, North Carolina’s job market took longer to recover. Again, the 2001 tax increases played a role in holding back the recovery: it was not until 2004 that employment in North Carolina actually started to expand again.
While the U.S. economy had recreated by 2003 all the jobs lost during the recession, it took North Carolina another three years to match this achievement. Thus North Carolina did not reach year 2000 employment levels until 2006.
Finally, and perhaps most important for our purposes, is the clear correlation that exists between the tax cuts and a spike in state revenue. Between FY1993-94 and FY1998-99, state budget revenues grew by 32.5 percent. From FY1998-99 to FY2003-04, revenue growth was 26.1 percent.
Similarly, it is fair to say that the 2001 tax increases caused a delay in the state’s economic rebound from the new millennium recession. Without the increases, it is possible that North Carolina’s gross state product would have reached 3 percent growth per year as opposed to the actual rate of 2.5 percent. State revenues would likely have followed the same trajectory. If we extract the initial $1 billion increase in revenue from the tax hike, state revenues could be $500 million more than they are today – all thanks to the growth effect of keeping taxes lower.