Now you see it, now you don't: Arizona's vanishing budget surplus

Arizona has enjoyed flexibility in its state budget-building for the last several years, thanks to a revenue spike that piled up into a welcome and useful surplus. That flexibility is disappearing, however, as revenues lag compared to the recent past. The state's current budget concerns are indicative of how much the sagging housing market can affect a state economy that is still healthier than most, and it shows that doldrums in the national economy may be deeper and longer-lasting than previously thought, according to W. P. Carey School economists Dennis Hoffman and Tracy Clark.

Arizona has enjoyed flexibility in its state budget-building for the last several years, thanks to a revenue spike that piled up into a welcome and useful surplus. That flexibility is disappearing, however, as revenues lag compared to the recent past.

The state's current budget concerns are indicative of how much the sagging housing market can affect a state economy that is still healthier than most, and it shows that doldrums in the national economy may be deeper and longer-lasting than previously thought, according to experts at the W. P. Carey School of Business.

Until mid-2007 approached, it had been thought there would be an estimated $530 million surplus in the state's $10.6 billion budget, which runs from July 1, 2007, through June 30, 2008. As recently as May 2006, Republicans in the state legislature had used a $1.1 billion revenue surplus number to argue that tax cuts would spur growth.

In June 2006, Gov. Janet Napolitano signed into law a budget providing a 10 percent income tax cut over two years and at least three years of property tax savings. Now, with disappointing revenue flows, state leaders think the 2006-2007 budget, when final numbers are tallied, might end up being in the red.

Was the talk of a $530 million surplus overblown in light of what a small percentage that amount is of a $10.6 billion budget? "Very good question," says Dennis Hoffman, professor of economics and director of the L. William Seidman Research Institute in the W. P. Carey School of Business.

"A 5 percent forecast error on a very volatile revenue base is not very high. The basic problem is that the apparent surplus vanished in less than three months' time. The close of the fiscal year 2007 showed very slow revenue collections — resulting in downward revenue estimates for fiscal 2008."

Declining housing market reduces revenues

The worst drop-offs were in sales taxes and income tax revenues, and these trends may relate to the national housing and mortgage credit downturns. Generally, homeowners whose home values are on the decline are less confident and do less consumer spending. Also, Hoffman points out, the drooping housing market has hurt employment in Arizona.

"What does this mean for the housing factor in this budget year?" Hoffman asks. "Housing will clearly be a drag on revenues." A sound analysis of state tax revenues must take into account Arizona's ongoing overall growth into a bigger economy versus temporary fluctuations in real estate and stock markets, according to Tracy Clark, research economist with the W. P. Carey School of Business.

"The discussion over the last several years has revolved around the increased funding needs versus tax cuts and how much of the surplus is permanent versus how much is transitory," Clark says. "The majority of the surplus is in retrospect likely to have been transitory." Clark says that until now construction employment had not fallen, mainly because there was such a backlog that builders were busy playing catch-up.

"Job losses for real estate agents, mortgage processors and a myriad of other real estate jobs started much earlier and have been much deeper," Clark says. "Thus, while the overall economy has been significantly impacted by the housing slump, tax revenues are just beginning to feel the pinch and things will definitely be getting worse before they get better. The housing slump appears to have impacted illegal immigration as well, reducing it."

Feeling the effects of last year's tax cuts

Although most of the decrease in revenues is because of slower consumer spending and the housing-price and construction-job slump, the fact that Arizona cut taxes last year has had some impact on lowering 2006-2007 revenues. The two-year reduction of the income tax involves 5 percent in 2006-2007 and 5 percent in 2007-2008.

"The impact of that tax cut will be fully felt in fiscal year 2008 and that will contribute to budget tightening pressures," Hoffman says. Clark agrees. "Some previously passed tax cuts go into effect this fiscal year. It is not clear whether the tax cuts came out of permanent or transitory revenue, which influences what impact they will have."

"The picture would likely have been significantly worse if there were further tax cuts because cuts tend to come in relatively stable sources like income or property while volatile sources like sales become a larger and larger fraction of total revenue." Clark says the state may have to dip into its "rainy day" fund before the current downturn is over.

"We should avoid draining it like we did last time," Clark says. "There was a recognition that most if not all of the anticipated surplus was coming from temporary sources, which tempered the calls for further tax cuts." As always, balancing a government budget involves attention to spending and to tax rates. Where does this leave a proposed $28.5 million cut in Arizona's corporate income tax?

"Again, policymakers will be forced to choose whether to cut spending or delay tax cuts," Hoffman says. Clark says the budget problems put the corporate income tax cut proposal off the table. "Corporate tax relief is a perennial topic, however the majority of tax relief will always go to individuals because they vote," Clark says.

Also troubling is a leveling off of revenues from the state capital-gains tax. According to Hoffman, gains grew steadily in the late 1990s, plunged in 2001 and 2002, then boomed from 2003 to 2005. Have capital-gains revenue realizations peaked?

"Yes, but they may not crater," Hoffman says. "Wall Street will provide a boost to gains — provided that the market does not tank. Our W. P. Carey forecasting model suggests that both Wall Street and real estate contribute to the capital gains flows in Arizona."

Clark agrees that "at least for a while," capital gains have peaked. "The party is clearly over in the real estate market, and while stocks have been doing well lately they can't make up for the boost provided by real estate in the last several years," Clark says.

Heading for a recession?

A decrease in anticipated tax revenues usually means there may be a recession. Is Arizona in or heading for a recession? "The chances of a national recession remain 1 in 3 in my opinion," Hoffman says.

Arizona's overall economy remains strong.

— Dennis Hoffman, professor of economics

"We are dealing with the aftermath of a huge run-up in real estate prices. Residential real estate activity has slowed dramatically and so too have revenue collections, but a longer term look suggests that tax collections and spending will simply revert to a long term trend ... Arizona is facing a slowing economy but the consensus seems to be no recession unless the national economy slips into recession," Clark says.

"Arizona is clearly stronger [than the U.S. economy] with employment growth still in the top five states." Clark says the nation most likely will avoid recession. "The risk factors are all on the downside, but unless the third quarter is significantly worse than expected, most economists are calling for a near miss rather than an outright recession," Clark says.

And according to Hoffman, "The reversion of revenue growth back to long run trend offers an opportunity for the state to re-examine spending and taxing priorities. Policymakers may have to focus on those tax and spending measures that position Arizona for future growth. And they may no longer have the luxury of paying cash for school construction. It may be a good time to re-examine a tax base that has become increasingly reliant on very volatile sources of revenue while spending needs are stable and predictable."

"We currently are seeing a significant decline in the growth of revenue rather than an outright decline. Slowing revenue growth has indeed been a harbinger of a slowing economy, and if the slowing is pronounced enough, of a recession. The analysis is complicated this time around because of the significant impact of capital gains on the overall growth of revenue.

Until the dotcom stock run-up and the real estate boom, capital gains was a significant but not determining factor in revenue growth. In the current climate it is certainly possible revenues could slow significantly more than would otherwise seem warranted by the condition of the overall economy."

Bottom Line:

• Many of the factors that influence projections of a state surplus have weakened over the last few months.
• There has been a slowdown that encompasses housing prices, home sales and housing employment, including construction and jobs revolving around real estate sales.
• Even the once-booming revenues from capital gains have, at the least, leveled off.
• The slump is likely to last until the end of 2007 or into 2008, so third-quarter numbers will be greeted anxiously.
• Restraint will be the key word when it comes to tax cuts and to state spending, including pay raises and capital improvements. Any cut in the corporate income tax seems very unlikely.