Surplus Expenditures in Colorado (IP-10-1999)

September 1, 1999
Issue Paper
By Barry Poulson
Executive Summary
This issue paper examines the disposition of surplus revenue in Colorado. The ev
idence reveals that special interests now determine the disposition of most of t
he surplus revenue. The result is less efficient and equitable budgetary decisio
ns than would have been made in the absence of surplus revenue.
Beginning with the first statutory tax and spending limit introduced in 1978 Col
orado taxpayers have viewed surplus revenue as excess taxation to be returned to
taxpayers through either tax refunds or tax cuts. However, most legislators do
not view surplus revenues as excess taxes to be returned to taxpayers. Rather th
ey view the surplus revenue as a fund to be expended in ways that maximizes thei
r own political agenda.
From the very outset legislators found ways to circumvent and ignore the statuto
ry limits imposed on the growth of state spending. This continued even after the
statutory limit was tightened from 7% to 6% in 1992. The surplus revenue above
the statutory limit was allowed to accumulate as reserve funds to finance non ge
neral fund expenditures. They have transferred and diverted more than $2 billion
of surplus revenue to fund capital construction projects.
The constitutional TABOR (Taxpayers Bill of Rights) limit became the binding con
straint on the growth of revenue in 1997, when the sum of population growth and
inflation was below the statutory limit on the growth of state spending. For the
first time legislators did not have the luxury of accumulating surplus revenue
in non general fund accounts. The first response of the legislature was to seek
approval from voters to spend a portion of the surplus revenues. That initiative
was soundly defeated, requiring the legislature to rebate the surplus revenue t
o taxpayers. Nonetheless, legislators have continued to increase spending at a r
ate above that which is sustainable under the TABOR limit.
Since the TABOR limit was triggered the Legislature has responded by passing tax
rebates and tax cuts that have very little to do with the generation of the sur
plus revenues. This has permitted legislators to pursue a political agenda benef
iting a variety of different interest groups, without seeking voter approval. Th
e surplus expenditure reports prepared by the Legislative Staff reveal that the
major concern of legislators is with the distribution impact of these measures o
n different interest groups.
The political nature of these measures is revealed when we ask a counterfactual
question. The legislators could have designed a direct expenditures program that
would have accomplished the same objective in benefiting these interest groups
as that achieved through tax rebates or tax cuts. However, the legislative histo
ry of the 1990's reveals that legislators were rarely able to muster the votes r
equired to finance direct expenditure programs to benefit special interest group
s. Voters have consistently turned down proposals to increase taxes necessary to
finance expenditures above the TABOR limit.
Thus, the TABOR Amendment has had a perverse outcome, the generation of surplus
revenue has facilitated surplus expenditures that would not have passed muster t
hrough the regular legislative budgetary process. The decision of legislators to
use surplus revenues to fund surplus expenditures through direct expenditures,
tax rebates, and tax relief has resulted in budgetary decision that are less eff
icient and less equitable than those that would have been made in the absence of
the TABOR limits. This suggests the need for a major overhaul of the budgetary
reporting and decision making to reflect the impact of tax and spending limits o
n the budgetary process. The reporting recommendations are designed to make the
budget more transparent and provide both taxpayers and legislators the informati
on they need to make more rational budgetary decisions. The policy recommendatio
ns are designed to bring revenue and expenditures growth into line with the TABO
R limit.
Reporting Recommendations
Provide a comprehensive summary of the total state obligations and the growth of
those obligations over historical and projected budgetary periods.
Provide a comprehensive summary report of tax expenditures along the lines of th
at utilized in other states.
Provide a comprehensive summary report of surplus expenditures consistent with t
he TABOR Amendment.
Policy Recommendations
Cut income tax rates to 4 1/4% to bring revenue growth in line with the TABOR li
mit.
Reduce the statutory cap on the growth of spending to 5% to bring expenditures g
rowth in line with the TABOR limit.
Maintain a rainy day fund equal to 5-7% of general fund expenditures.
Stop using accounting tricks to evade tax and spending limits
Rent Seeking and Surplus Expenditures in Colorado
Introduction
This Issue Paper reveals that special interests now determine how most of the su
rplus revenue is disposed of in Colorado. The result is less efficient and equit
able budgetary decisions than would have been made in the absence of surplus rev
enue.
In order to explore the disposition of surplus revenue we introduce the concept
of surplus expenditures, and distinguish this from the concept of tax expenditur
es. The issues raised by surplus expenditures in Colorado are then explored. The
paper concludes with recommendations for reform in budgetary reporting and deci
sion making in Colorado.
The Concept of Surplus Expenditures
Surplus expenditures are the result of a law (or an administrative or judicial i
nterpretation of a law) that benefits a special interest group in the form of di
rect expenditures, or tax refunds, or tax cuts that offset surplus revenue. The
concept of surplus revenue is analogous to, but different from, that of tax expe
nditures. A tax expenditure is defined as a reduction in total revenues that res
ults from a law (or an administrative or judicial interpretation of a law) that
allows a group of taxpayers to pay less tax. There is now a substantial literatu
re on tax expenditures relating to both state and federal budgetary processes.[1
]
Many of the issues involving surplus expenditures are relevant to, but extend be
yond, tax expenditures. As the term surplus expenditures implies, the relevant b
ase against which to measure these expenditures is the revenue surplus. This is
a crucial distinction because from a taxpayers perspective the opportunity cost
of the surplus expenditures is the foregone income they would have received in t
he absence of excess taxation. In contrast the opportunity cost of tax expenditu
res is often expressed as the alternative revenue available to the government in
the absence of the tax expenditures.
This distinction between surplus expenditures and tax expenditures in turn raise
s the issue of the concept and definition of a revenue surplus. This issue is es
pecially complicated at the federal level by many problems in the federal budget
, not the least of which is unfunded liabilities in the entitlement programs. At
the state level these problems also exist, but the states have a long history w
ith revenues surpluses, and have converged toward a consensus in defining and me
asuring that surplus .
At the state level there is an important distinction between budgetary surpluses
that simply result from the excess of revenue above expenditures, and surpluses
that result from tax and expenditure limits. In the case of Colorado both statu
tory and constitutional limits are imposed on the growth of revenue and expendit
ures. In this context we can define a constitutional surplus as the excess of re
venue and/or expenditures above that which is permitted by law.
We will see that in Colorado expenditure of this surplus has taken many forms. A
t certain points Legislators have chosen to ignore the spirit, if not the letter
, of the law in finding ways to spend the surplus revenue. More recently, surplu
s expenditures have taken the form of tax refunds to specific taxpayer groups. L
ike tax expenditures, surplus expenditures have also taken the form of tax credi
ts, deductions, exemptions, exclusions, credits, preferential tax rates, tax aba
tements, and tax deferrals that provide preferential treatment to selected taxpa
yers. Whatever form they take, surplus expenditures should be viewed as a form o
f government spending.
It is in the context of a constitutional surplus that the concept of surplus exp
enditures becomes an important budgetary tool. This is certainly true in Colorad
o, where laws now provide preferential treatment to selected taxpayers based upo
n the magnitude of the surplus revenue generated. In contrast to tax expenditure
s, taxpayer groups may or may not receive preferential treatment depending upon
the size of the surplus.
Toward a Theory of Surplus Expenditures
There are competing theories used to explain such budgetary decisions. The appro
ach in the mainstream economics literature is to assume that if the government w
ishes to benefit a particular group, it makes a rational decision of the optimum
way to benefit that group based upon benefit cost analysis. A rational choice t
hen involves a comparison of the costs and benefits of direct expenditures, tax
expenditures, or surplus expenditures in benefiting these groups. Much of the li
terature on tax expenditures is written within this framework.[2] However, there
is little evidence to suggest that legislators follow this welfare maximizing b
udgetary decision process.
An alternative approach in explaining these budgetary decisions are political mo
dels that assume that politicians do not ignore their self interest. Political m
odels assume that citizens have an input into the tax and spending decision made
by politicians as well as the constitutional rules of the game for fiscal polic
y.
A self interested politician will attempt to minimize the political cost associa
ted with raising a given budget or revenue. Political cost may arise from opposi
tion to taxes by taxpayer groups as well as individual voters. The politician ca
n minimize these costs by shifting the tax burden to citizens who are less sensi
tive or less active in their opposition. The use of a tax will then depend upon
the tax price defined in terms of these political costs. The political response
to this input from taxpayer groups as well as individual citizens is reflected i
n the use of different tax bases, rate structures, and special provisions of the
tax law such as tax expenditures and surplus expenditures.[3]
This political model is especially important in understanding the difference bet
ween surplus expenditures and tax expenditures. Politicians may have greater lee
way in pursuing a political agenda through the use of surplus expenditures than
they would have through the use of either direct expenditures or tax expenditure
s. Thus the generation of surplus revenues may result in budgetary decisions tha
t are more influenced by special interests, and thus less efficient and less equ
itable than those that would have been made in the absence of surplus revenue.[4
]
Direct Expenditures
Because Colorado was one of the first states to impose tax and spending limits i
t has a long history with surplus revenues above those limits. A statutory limit
of 7% growth in state expenditures was introduced in 1978, after a decade of do
uble digit growth in state spending that began in the late 1960's. The 7% limit
resulted in the first tax refunds to taxpayers in the late 1970's, and effective
ly constrained the growth of state government for several years . However, by th
e mid 1980's Colorado was in the midst of the worst recession of the post WWII p
eriod. While the private sector contracted, the public sector expanded at an eve
n higher rate. Legislators simply ignored the 7% limit, increasing government sp
ending in some years at double digit rates. There were some years in which the o
nly growth in output and employment was in the public sector.
In the 1980's legislators increased a wide range of taxes to finance this expans
ion in government programs. State income taxes were boosted significantly as a r
esult of federal tax reform in 1987. Federal tax reform closed many loopholes an
d expanded the tax base. Since Colorado income taxes are linked to the federal i
ncome tax base, the result was a significant windfall of increasing income tax r
evenues for the state. In 1987 the state replaced the graduated rate structure w
ith a flat 5% income tax. But this was not a revenue neutral tax rate, it captur
ed a significant share of the windfall created by federal tax reform, and impose
d a heavier tax burden on Colorado citizens.
Clearly our fiscal constitution in the 1980's failed to constrain the growth of
state spending and taxes. In response, citizen taxpayer groups began to organize
to impose a more stringent budgetary constraint through the citizen initiative
process. Special interest groups spent far greater amounts of money, and mobiliz
ed far more resources in opposition to these initiatives to limit government spe
nding. Nonetheless, taxpayer groups struck the right chord with voters, winning
a larger share of the votes with each successive initiative.
The Legislature responded to this taxpayer pressure in 1991, amending the statut
ory limit to reduce the cap on spending growth from 7% to 6%. In the 1990's stat
e revenues have been increasing at rates in excess of 6%. Since the statutory li
mit does not constrain this growth of revenue, the result has been a substantial
buildup of surplus revenue above the statutory limit.
General fund expenditures have actually grown more rapidly than 6% per year in t
he 1990's due to exceptions from the limit. These exceptions include final court
orders, new programs resulting from federal mandates, and Medicaid over expendi
tures. In a kind of shell game, these exceptions from the limit then become part
of the base for calculating the limit in the following year. The following tabl
e shows how these exceptions resulted in appropriations growth above the 6% limi
t in the 1990's.
Table 1. Exceptions From the Six Percent Appropriations Limit (millions of dolla
rs).
Fiscal Year
Court Orders/ Federal Mandates
Medicaid Overexpenditures
Appropriations Growth Rate (Percent)
FY 1997-98
$6.6
$10.0
6.40%
FY 1996-97
$18.8
$0.0
6.48%
FY 1995-96
$49.6
$0.0
7.44%
FY 1994-95
$3.4
$19.1
6.10%
FY 1993-94
$7.5
$83.5
8.9%
Source: Colorado Legislative Council Staff Memorandum, March 12, 1999.
In 1992 a constitutional provision was enacted through citizen initiative, the T
abor Amendment, that limits the growth of state revenue to the combination of in
flation and population growth. That limit was not triggered until FY 1996-97. Un
til that year the binding constraint on state fiscal policy was the statutory 6%
limit on expenditures growth.
The TABOR amendment has a quite different impact on state fiscal policy than the
statutory limit.
Under TABOR, taxpayer approval is required to increase taxes. In this sense the
Tabor Amendment has worked in exactly the way in which it was designed, giving t
axpayers the final say on proposed increases in taxes. In 1992 Governor Romer su
pported a referendum to increase sales taxes earmarked for public education K-12
. That referendum was soundly defeated by the voters. Citizens in Denver voted o
n a proposed increase in sales taxes to fund the construction of light rail, and
that proposal was also defeated. Other proposals, such as an increase in sales
taxes to fund highway construction, have been taken off the drawing boards becau
se it was clear that they could not muster taxpayer support. At the local level
proposed tax increases are defeated about as often as they are passed by voters.
The TABOR limit on revenue growth is more stringent in the current environment,
constraining the growth of revenue to 5% or less. In contrast to the statutory l
imit, TABOR does not permit the state to accumulate surplus revenue above that l
imit, unless taxpayers approve such expenditures. TABOR requires that surplus re
venue be rebated to taxpayers, and this has occurred in each of the last two yea
rs. For FY 1996-97 the General Assembly voted to refund $139 million to comply w
ith the TABOR requirements. For FY 1997-98 revenues were $563 million higher tha
n the TABOR limit allows. The Legislature submitted to voters a referendum to sp
end 40% of that surplus and rebate the remainder to taxpayers. That referendum (
Refernedum B) was defeated, requiring the Legislature to again rebate the entire
surplus to taxpayers. Over the next five years the state is projected to genera
te $5.1 billion in surplus revenue over the TABOR limit.[5]
In the long run the TABOR Amendment will constrain the growth of state spending
as well as revenue. However, in the short run legislators have been able to incr
ease spending at rates far in excess of the limits imposed by TABOR. There are s
everal reasons for this more rapid growth in expenditures. The first reason is t
hat legislators play a shell game with surplus revenue above the limit. Refunds
above the limit are finance not by the current surplus, but rather from the next
years anticipated surplus. Like the kiting of a check, this permits the legisla
ture to spend the current surplus.
There is a second reason for the rapid growth in state expenditures, the accumul
ation of surplus revenues in reserve funds has permitted the state to increase s
tate spending in excess of that permitted by the TABOR Amendment. If we focus on
total appropriations, which includes capital expenditures, rather than on Gener
al Fund appropriations, we get a better picture of expenditures growth.
Table 2. Total Appropriations Growth (percentage compound annual average growth
rates).
Department/Function
FY 79/80 to 97/98
FY 85/86 to 97/98
FY 90/91 to 97/98
Agriculture
Corrections
Education
Gov./Lt. Gov./OSPB
9.1
12.7
7.2
3.1
9.1
14.4
6.9
-3.7
12.1
11.8
7.7
-14.0
Higher Education
Human Svcs/Health Care
Judicial
4.8
10.3
8.2
5.1
10.6
6.8
5.4
11.1
7.0
Labor and Employment
Law
Legislative Branch
Local Affairs
4.2
9.2
4.9
9.1
4.5
7.9
4.3
5.3
5.5
3.9
1.8
6.0
Military Affairs
Natural Resources
Personnel
Public Health and Environment
10.1
7.3
4.0
8.5
9.9
6.2
3.5
8.1
9.7
7.2
5.5
5.9
Public Safety
Regulatory Agencies
Revenue
State
NA
8.4
8.8
11.7
9.4
7.8
4.7
7.7
7.0
6.6
4.6
7.8
Transportation (highways)
Treasury
Capital Construction
21.6
5.5
10.8
4.8
8.4
7.8
7.9
3.6
5.9
Total State Appropriations
8.4
7.5
8.1
Tabor Limit*
6.1
5.1
6.2
NA: Not applicable
* Tabor Limit is calculated as the sum of inflation and population growth. The a
verage annual growth in inflation in each of the three periods was 4.4%, 3.4%, a
nd 3.8% respectively. The average annual growth of population in each of the thr
ee periods was 1.7%, 1.6% and 2.4% respectively.
Source: Colorado Legislative Council Staff Issue Brief, January 23, 1998.
During the 18 year period from FY 1979/80 to FY 1997/98 total state appropriatio
ns grew on average 8.4 percent per year. The growth rate permitted by the TABOR
limit, which is equal to the sum of inflation and population growth, was 6.1 per
cent per year during the period. What is most surprising is that total state app
ropriations grew at almost the same rate, 8.1%, in the 1990's, when more stringe
nt tax and spending limits were imposed. This rapid growth in state expenditures
is ubiquitous across the different state departments, there are only a few that
have grown at rates consistent with the TABOR limit.
With rapid growth in the Colorado economy, legislators continue to take a sangui
ne view of state finance. They have transferred or diverted over $2 billion of G
eneral Fund money to finance capital construction over the next five years. But,
these increases in state expenditure are not sustainable in the long run becaus
e the state is now spending reserve funds.
Using the projections of state finance by the Legislative Staff, it can be estim
ated that if the state continues to increase general fund expenditures and trans
fer funds into capital projects at the rate that they did the past two years, th
e state will exhaust reserve funds and incur a deficit in the state budget withi
n the next five years. At that point under current law the TABOR limit will beco
me the effective constraint on spending as well as revenue growth. The reason is
that the Colorado Constitution requires a balanced budget with no debt carryove
r from one fiscal period to the next. The Legislature will have to reduce spendi
ng growth to the revenue growth permitted under TABOR in order to maintain a bal
anced budget.
Tax Refunds
The following table provides estimates of surplus revenue by source under the TA
BOR Amendment for FY 1998-99. The individual income tax accounts for more than 2
/3 of the surplus revenue; and the individual and corporate income tax combined
account for about 72% of the surplus revenue. The sales tax accounts for 15% and
the other miscellaneous taxes and fees account for the remainder of the surplus
. There are of course conceptual and empirical issues in measuring the source of
surplus revenue, but it is fair to say that income taxes account for most of th
e surplus revenue generated.
Table 3. Estimated Amounts of Excess Revenue by Source, FY 1998-99
Revenue Source
FY 1998-99 Excess Revenue (millions)
Percentage of Total Expenditures (%)
Individual Income Taxes
$523.098
69.02