AZ state spending: Up or down?

Spending by state government in Arizona is on the rise. But when viewed over the last 15 years, adjusted for both inflation and population growth — and measured against how much money taxpayers earned in Arizona — the increase in state spending has not kept pace, according to Dennis Hoffman, director of the L. William Seidman Institute, and Tracy Clark, associate director of the JPMorgan Chase Economic Outlook Center.

Spending by state government in Arizona is on the rise. This year, for the first time, outflow from the state treasury topped $10 billion. Since 2001, nominal state spending has been increasing an average of 8.1 percent a year. But over the last two or three years growth in spending has risen at a double digit rates. But when viewed over the last 15 years, adjusted for both inflation and population growth — and measured against how much money taxpayers earned in Arizona — the increase in state spending has not kept pace, according to researchers at the W. P. Carey School of Business.

In a recently issued white paper, Dennis Hoffman, director of the L. William Seidman Institute, and Tracy Clark, associate director of the JPMorgan Chase Economic Outlook Center, analyzed changes in various measures of both income and state spending in Arizona from 1991 to 2007. They found that government spending as a percentage of taxable income actually has fallen over the last 16 years.

Indeed, if government spending had kept pace with the growth of taxable income in Arizona, the state budget would be about $1 billion higher than it is today, according to the researchers. "In comparison with the most accurate measure of state income growth, Arizona s spending growth certainly has not been out of line," Clark said. "If you look at it over time, you get a picture that says state spending has not grown as fast as our ability to pay."

A missing ingredient: Capital gains

In Arizona, as well as most US states, spending by state government is a matter of considerable concern and debate. Critics contend that state government is growing too rapidly, outpacing what taxpayers can afford. The Arizona Constitution limits government expenditures to 7.4 percent of personal income, as measured by the US Commerce Department's Bureau of Economic Analysis.

But aligning spending constraints with personal income provided by the federal Bureau of Economic Analysis offers an incomplete picture, Hoffman and Clark point out. Why? It is the taxable income base that provides the source of funds to support spending, and taxable income data include capital gains — realized mainly through sale of stocks and real estate — which the personal income numbers do not.

And in Arizona, capital gains have been substantial, especially during the stock market surges in the late 1990s and real estate run-ups that occurred recently. "Capital gains are relevant," said Clark. "Number one, they are taxable. Number two, they have been growing rapidly. And number three, they are an increasing portion of the taxable income in the state."

Using the total income data, the researchers found that in the 2007 fiscal year, expenditures from the state's general fund represented only 3.8 percent of total incomes earned by those who pay all of their taxes in Arizona and those who pay a non-resident portion to Arizona. Spending as a share of total incomes has been falling fairly steadily since it peaked in the recession year of 1992 at 6.9 percent. But a significant amount of this total income is earned by filers who earn money outside Arizona and who are not counted as part of personal income according to the federal Bureau of Economic Analysis.

When only the (combined resident and non-resident) income earned within the State is considered, the general fund share is 6.7 percent in 2007, down from 8.2 percent in 1992. These statistics come from an abstract of the individual tax returns filed with Arizona Department of Revenue. The data is aggregated into groups based on variables like Federal Adjusted Gross Income, filing status and whether returns are from in-state or out-of-state filers.

Non-residents count

Armed with this database, Hoffman and Clark were able to highlight another factor left out of the commonly used federal statistics: income from non-residents. And the data suggest that the average incomes of taxpayers who earn at least some portion of their incomes in Arizona is an astonishing $500,000. The total incomes of filers who file as non-residents in Arizona was estimated at $126 billion in the 2007 fiscal year, and has grown at a staggering 17.1 annual percent rate since 1990.

Even after representing the number on an inflation-adjusted per capita basis, the number has grown significantly over the years, with an inflation-adjusted per capita rate of 10.9 percent annually between 1990 and 2006. And the share of this total income reported as 'Arizona income' has grown at a 5.8 percent inflation-adjusted per capita rate of growth, more than double the rate of increase in inflation-adjusted per capita income for residents, which was 2.5 percent during this period.

Several decades ago, non-resident income was thought to be mostly wages earned by construction workers who would come to Arizona for a limited time and maintain residence elsewhere. But at least since the early 1990s, construction workers have been found to be less mobile. A new phenomenon appears to be at work.

"We distinguished part-year residents — those transitioning here or maintaining part-time residency — from taxpayers reporting income as non-residents. These are people who live elsewhere and are doing business in Arizona. It appears that a lot of them are engaged in lucrative business activities such as buying and selling real estate," Hoffman said. "Non-residents and capital gains are driving significant Arizona income increases."

How much does the state spend?

In assessing the relationship between incomes and state expenditures in Arizona, it is also important to look closely at the spending side of the equation, according to the researchers. The most commonly cited statistic is the general fund or the aggregate of all state spending. But Hoffman and Clark say that is only one of several ways of measuring spending.

Various expenditures logically could be excluded from state spending calculations, according to the researchers. One-time or miscellaneous costs, mainly payments ordered in the settlement of major lawsuits, constitute one category. Another is the Students' FIRST (Fair and Immediate Resources for Students Today) school building program, which was established in 1998 after a court found Arizona's school construction funding to be unconstitutional. And another is the dedicated education fund established under Proposition 301.

Passed by voters in November 2000, Proposition 301 increased the statewide sales tax by six-tenths of 1 percent for 20 years to provide additional resources for education programs. The researchers separated out each of these spending factors to determine whether the picture of state spending increases would change. While there were variations in the categories, the overall trend in the past 16 years was not affected, they found.

"The broadest measure — the total of the general fund and Proposition 301 — has had the largest inflation-adjusted per capita adjusted gain at 2.1 percent per year, while the most narrow measure — general fund less Students' FIRST and miscellaneous expenditures — has had the smallest inflation-adjusted per capita advance at 1.2 percent per year," Hoffman and Clark write in the paper.

Which of the measures is most relevant is a matter of philosophy, according to Clark. He said an argument can be made that Proposition 301 should be excluded from the spending totals. "That money wouldn't be there if it weren't for that initiative. It's not money appropriated by the governor and the legislature.

It's money that was approved by the voters," he said. Similarly, the Students' FIRST program is a special fund set up for school construction, which otherwise would be paid for by long-term borrowing. "If you believe that kind of spending should be done through capital borrowing, you wouldn't want to include it in spending growth," Clark said.

Storm clouds on the horizon?

The research in the paper reveals that the rapid growth trajectory of capital gains income and Arizona income reported by non-residents has been an important 'source' of General Fund revenues. While it is likely that the State will continue to enjoy injections of revenues from these sources, it is also true that non-resident income and capital gains income are far more volatile than is ordinary wage and salary income.

"General fund dollars are used to pay the costs represented by students in classrooms, prison beds, AHCCCS [Arizona Health Care Cost Containment System] clients, etc. — predictable expenditures," Hoffman said. "Matching a significant, volatile source of funds with a growing, predictable list of 'uses' may be cause for concern. Indeed, it was precisely this mismatch between sources and uses that confronted Arizona policymakers in 2001 and 2002.

Fortunately, the State s budget stabilization fund is fully funded today so Arizona is in better position to weather any unanticipated adverse revenue shocks." By presenting different measures of both government spending and income, the issues can be brought into sharper focus, according to the researchers. "What you want to make sure of is that you are not outstripping people's ability to pay," Clark said.

Bottom Line:

• As a percentage of taxable income, state spending adjusted for population growth and inflation has been declining in Arizona. In 1992, all state expenditures represented 6.9 percent of resident and non-resident income. In 2007, they had fallen to 3.8 percent.
• The widely used personal income data supplied by the U.S. Bureau of Economic Analysis does not account for capital gains, which is one of the driving forces behind income growth in the last two decades.
• Income growth turns out to be much higher when it is calculated using data from the Arizona Department of Revenue, rather than the U.S. Bureau of Economic Analysis. This is because the state agency accounts for all taxable income, including capital gains, which are omitted in the federal data.
• The calculation of how much state government spends will depend on whether certain programs — such as those mandated by the voters or the courts — are included. Using the broadest measure and adjusting for inflation and population growth, state government spending in Arizona has increased 2.1 percent annually over the last 16 years.
• Economists use inflation adjusted numbers and per capita numbers to measure variation that occurs apart from variation caused by inflation or just by changes in the number of people residing in the state. Inflation adjusted measures are sometimes referred to as "real" or expressed in "constant" dollars.