Long-Term Projection Of State Budget
In order to provide insight into the nature of Delaware’s emerging structural problem, we developed a long-term projection of Delaware’s state budget assuming current-law taxing and expenditure policies are maintained through 2025. Our projections are not predictions of actual budget deficits that will occur. Based on Delaware’s history of strong budget management, it is likely that the state will take prompt action to offset emerging shortfalls before they occur.
Rather, the purpose is to develop a framework based on reasonable assumptions that that can be used to:
Measure the potential size of future adjustments that will be needed to maintain balanced budgets, and
Identify and measure the relative contributions of key revenue and expenditure related factors to the state’s projected shortfall.
The forecast is based largely on the requirements of current law, and takes into account the impact of economic growth, inflation, and demographic changes on revenues and expenditures. As such, both revenues and expenditures are projected to rise over time in our baseline projections.
This is important because, in a multi-year budgeting context, significant savings relative to our baseline projections can be achieved simply by restraining growth in funding for wages, benefits, health care costs, state employment, and governmental operations over time.
Background. The economic assumptions are an important element of the long-term forecast, mainly because of their impacts on key state revenue sources. Delaware has a diverse economy with a significant presence in a variety of dynamic industries, such as chemical and advanced materials, pharmaceuticals, financial services and biotech. The tourism industry is a major sector in the state, employing an estimated 40,000 people. Agriculture is also a large sector, with total farm production exceeding $1 billion in 2014 and farmlands accounting for 40 percent the state’s land area. Delaware also is the site of the Port of Wilmington, and Dover Air Force base - both significant sources of civilian jobs and economic activity.
Performance since the early 2000s. The state’s economy generally followed national trends during this period, expanding between 2002 and 2007, contracting during the 2008 through 2010 recession, and expanding again beginning in 2011. Though sharing in the national economy’s ups and downs, Delaware’s output and job creation trailed the nation over the full 2002 to 2014 period. The below‐average growth is partly related to global turmoil in key chemical and financial sectors, but it also reflects a loss of market share in other industry sectors.
As shown in below, Delaware’s share of total U.S. jobs fell about 2.4 percent between 2004 and 2014 — the net result of a 4.6-percent drop in the private sector share (which accounts for 85 percent of total employment) and an 11-percent rise in the government’s share. On the private sector side, the state suffered a 24-percent job decline in high paying manufacturing jobs, versus a 15-percent decline for the U.S. as a whole.
At the same time, job growth in several other high-paying sectors, such as professional services and finance, was soft or non-existent. The one private sector industry that has grown significantly in Delaware over the past decade is healthcare, which partly reflects the state’s aging population. This sector saw job increases totaling 35 percent over the decade ending in 2014, compared to 22 percent for the nation as a whole.
As a result of the net job losses in high-paying sectors, the state has seen a significant decline in per-capita income relative to the nation, as well as its neighboring states. As shown below, per-capita income was about 10 percent above the national average in 2002, but has since seen all that margin erode away. The decline has important implications for the state’s budget. Lower income growth translates into less‐elastic personal income taxes, less revenues from consumption-related taxes and generally, less robust revenue growth.
Developments since 2013. Focusing on developments since the beginning of 2013, Delaware has shown significant improvements, particularly on the job front. Non-farm employment growth in 2013 and 2014 exceeded 2 percent, before moderating to 1.8 percent in the first half of 2015. The state’s growth rate was above the national average in both 2013 and 2014, before falling back below the nation in the first half of this year. Over the past two-plus years, employment growth in Delaware also significantly exceeded that of its neighboring states (Virginia, Maryland, New Jersey, and Pennsylvania). As of July 2015, its unemployment rate had fallen to 4.7 percent, 0.8 percent below the national average.
In another somewhat positive sign, personal income growth matched the national average in much of 2014, though a more detailed review indicates that wages and other earnings earnings were slightly below average, while income from transfer payments was slightly above average. Like job growth, income personal growth fell back below the nation in early 2015, though the results may be partly distorted by harsh winter weather in both 2014 and 2015.
Based partly on the recent more positive developments in the job market, recent forecasts anticipate Delaware job growth in the longer term to be roughly similar to the national average, and to slightly exceed that of its neighboring states.
However,the signs are still tentative, and even the forecasts anticipating reasonably healthy job growth continue to expect Delaware personal income growth to lag the nation over the long term. The key to Delaware’s future economic health is whether the recent improvements in the job market are followed by more enduring gains in business investment, higher‐paying jobs, and personal income in the years ahead.
Forecast. Our U.S. forecast is consistent with the Congressional Budget Office’s January 2015 baseline projection for the U.S. economy through 2025. That forecast assumes real (inflation-adjusted) GDP growth of between 2.5 percent and 3 percent during the balance of 2015 and 2016, but then a slowdown to around 2 percent per year over the balance of the 10-year period.
Our forecast for Delaware assumes that its economy will generally follow the national pattern, with output, employment, and income growth expected to subside after 2016 in line with the projected slowdown for the nation. Under our outlook, the growth rate in Delaware is expected to slightly exceed its neighboring states, but slightly trail the nation over the next decade. As shown above, personal income — a key determinant of state tax revenues — is forecast to increase at an average annual rate of 4.5 percent between 2015 and 2015, or about 0.2 percent less than the nation as a whole.
Background. Delaware collects revenues from a variety of taxes and fees. In FY 2014, total General Fund collections were $3.6 billion. As shown in Figure 9, the largest source was the personal income tax, which accounted for one-third of total revenues received during the year. The second largest source was the corporate franchise tax15 and the third was abandoned property revenues.
Delaware’s heavy reliance on franchise taxes and abandoned property revenues is unusual and, as noted earlier, stems from the fact that the majority of U.S. business incorporations take place in the state.
The state’s dominance in this area is primarily related to its reputation for providing a high level of incorporation-related services, its large body of up-to-date business laws, and its well regarded Chancery Court, which is dedicated exclusively to corporate law issues.
The next largest revenue sources were the gross receipts tax and the lottery — each of which contributed about 6 percent of total General Fund revenues in FY 2014. Delaware is one of a relatively few states that levies a gross receipts tax, and collections from this source can be viewed as a substitute for the retail sales and use taxes that are levied in most states. Delaware’s reliance on lottery revenues is among the highest in the country, though revenues from this source have been trending downward over the past several years due to a nationwide downward trend in gambling and increased competition from gambling venues in other states.
Finally, the chart above shows that the state’s corporation income tax accounted for 3 percent of General Fund revenues, while all other sources combined accounted for the remaining 15 percent of the total.
Forecast. We forecast that General Fund revenues will increase from $3.9 billion in FY 2015 to
$5.0 billion by FY 2025, an annual average increase of just 2.6 percent. Our projections for state revenues are based on economic and demographic growth assumptions discussed above, as well as estimates of the responsiveness (e.g., elasticity) of each revenue source to changes in economic activity.
These elasticity estimates are partly based on information provided by the DEFAC Advisory Counsel in its examination of Delaware’s revenue sources, as well as our own review of each tax and how it has historically interacted with the state’s economic base. As noted below, we project that the state’s largest revenue source – the personal income tax – will grow slightly more rapidly than the economy (as measured by personal income), due to the interaction of modest growth in average incomes per return and the state’s progressive tax rate schedule.
The elastic growth in personal income taxes is offset, however, by inelastic growth from several of Delaware’s other revenue sources. Specifically, we estimate that the the franchise tax will grow only about 53 percent of the pace of personal income over the next decade. Growth from this source will be constrained by the cap on maximum fees for large companies and a general trend of business formations as LLCs as opposed to C-Corporations.
Reflecting the factors discussed previously, we assume that revenues from abandoned property will decline sharply to around $375 million in FY 2018, before returning to a moderate growth path that gets it almost back to the 2014 level by the final year of the forecast. The elasticity for lottery revenues is also very low, reflecting our assumption that regional competition and the national trend of flat or declining per-capita lottery sales will continue.
The elasticities for the remaining sources are mixed, ranging from negative (for cigarette taxes) to just under 1.0 (for gross receipts taxes). Putting it all together, we assume the weighted elasticity for all general fund revenues is 0.61.
Delaware’s General Fund supported about $3.8 billion in expenditures in FY 2014. As indicated below, the two dominant programs are public education, accounting for one-third of the budget, and health and social services, accounting for 29 percent of the total.
After these, the next largest categories are corrections (7 percent) and higher education (6 percent). All other programs (including children’s programs, executive, legislative, state operations, and natural resources) together account for the remaining 25 percent of the budget.
Looking at Delaware expenditures by function, the majority of spending is related to employee salaries, contributions for active and retiree health, pensions, Medicaid providers, debt service, grants, contractual services, supplies and materials, and capital outlay.
Forecast. We project that state General Fund costs will increase from $3.8 billion in FY 15 to
$5.6 billion by FY 2025, an average annual growth rate of 4.0 percent. The fastest-growing cost centers will be Medicaid and employee (active and retired) health insurance costs, both of which will increase at an average annual rate of about 6 percent.
The rapid increase in Medicaid reflects (1) rising costs and utilization of medical services, and
(2) significant growth in long-term care costs, reflecting above average increases in Delaware’s older population. Our estimates for employee health insurance costs take into account growth in payrolls and assumed medical care inflation. Finally, our estimates of retiree health contributions are consistent with estimates made in the most recent actuarial valuation of Delaware’s future retiree health care costs under its mostly “pay-as-you-go” program funding methodology.
Outside of Medicaid and employee related health benefits, we project that state budget costs will rise at about 2.9 percent per year, reflecting:
Annual increases in wages and salaries of about 3.2 percent, reflecting (1) average per-employee wage increases of 2.75 percent22 and (2) average population-related increases in state employment of slightly over 0.4 percent.
Annual increases in pension contributions of less than 1 percent per year. This is a relative bright spot in Delaware’s expenditure outlook. The slow growth rate reflects assumed amortization of the relatively small unfunded liability in the state’s pension system over the forecast period. The state’s main pension system is currently over 90 percent funded based on its most recent actuarial analysis. (We do note, however, that if future annual investment returns fall below the fund’s assumed 7.2-percent rate, future contributions would be higher.)
Spending for contractual services, supplies and materials, grants, debt service, and capital outlay are projected to grow at an average annual rate of 3.0 percent per year, primarily reflecting the impact of population growth and general price increases on service demands.
The chart below shows our year-by-year forecast of General Fund revenues and expenditures. We estimate that, absent corrective actions, Delaware would face annual operating deficits that could expand to $610 million by 2024-25. This represents about 11 percent of projected expenditures for that year.
Components of the Budget Gap
Policy makers confronted with the difficult choices needed to restore structural balance to their budgets often debate whether the underlying problem is a revenue problem or a spending problem. While the advisory counsel’s efforts focused on revenues, in reality, the problem has both revenue and expenditure- side elements.
Delaware clearly faces serious challenges related to its inelastic revenue system – though as noted earlier, a significant portion is the result of policies that used unsustainable revenues from abandoned property to support ongoing programs. But in addition to inelastic revenues, the state also faces serious challenges related to below-average economic growth and unsustainable spending growth in key budget areas.
The above chart breaks down the projected shortfall into its key components, showing:
Slow growth in corporate franchise taxes and a projected decline in abandoned property revenues over the forecast period accounts for 44 percent of the projected shortfall
Rapid growth in Medicaid and employee (active and retiree) health benefits account for about 41 percent of the the total.
Below-average economic growth accounts for slightly less than one-fifth of the state’s projected deficit.
All other factors combined work to reduce the shortfall by a net of $20 million. The main savings factor is very slow growth in pension contributions.
The precise size of the contribution from each of the categories depends on several assumptions, including how “normal” revenue and expenditure growth is defined. Thus, the estimates are intended to provide only a general guide as to the magnitude of each factor’s contribution to the shortfall. Though the exact contributions may be uncertain, what is clear is that factors other than inelastic revenue sources are contributing significantly to Delaware’s budget problems.
Implications — Tax Increases Could be Burdensome and Counter Productive
Our projections have important implications for policymakers as they consider how to address the looming budget shortfall.
First, they imply that even if taxes are raised to cover the gap in the near term, the rapid growth in health-related costs implies that the structural budget shortfall will reemerge in future years unless the state finds a way to restrain costs.
Second, they indicate that economic growth itself is a key factor in the state’s budget outlook. Better growth would provide dual benefits to state revenue collections. It would boost spending and income that are subject to taxes. It would also boost the elasticity of the state’s largest revenue source – the personal income tax. This is because increases and decreases in per-capita income are magnified by the state’s progressive tax rate structure.
For example, if a typical taxpayer with $60,000 in taxable income experiences a 10-percent increase in income because of expanded work hours or higher pay, the state receives a 15-percent increase in additional taxes from that taxpayer.
This suggests that an important way to improve revenue growth would be through successful implementation of pro-growth economic policies, which will boost income, consumer spending and the elasticity of the revenue system. Clearly, many factors affect economic growth, including national and global economic developments, local labor costs, the quality of the labor force, and the regulatory environment in the state. However, state and local taxes are an element on the list — especially when they get out of line. This is an important consideration given Delaware’s recent below-average income growth and already high tax burdens.
As shown below, Delaware is a relatively high tax state. Measured as a percentage of personal income, Delaware ranked 5th in terms of total state and local government own-source revenues and 15th in terms of general tax collections in 2012 (the most recent year for which data is available). Delaware’s revenue levels are also high relative to its neighbors.
The gap between its ranking for total revenues (5th highest in the nation) and taxes (15th highest) is due to the state’s heavy reliance on non-tax revenues to support its high rate of state and local government expenditures. As noted in the DEFAC Revenue Sub-Committee final report, the state has been successful in “exporting” its revenue burden through the large franchise fee and abandoned property collections, from mostly out-of-state businesses.
However, if the state offsets the declining revenue contribution from these sources by raising general taxes, the tax load on its citizens will jump significantly, potentially moving it into the top 10 states. The upward shift is important, since the state already ranks high in terms of taxes relative to the size of its economy. Such an increase could further damage the competitiveness of its tax system, which according to some surveys already ranks relatively low among the 50 states.
Raising taxes to compensate for the underperformance of the abandoned property and business franchise fee revenues would put the state in a precarious position. Tax increases would only serve to dampen, not improve the outlook for economic growth and per-capita incomes. To the extent that it is necessary to include taxes as part of the overall solution, we believe it would make sense to focus on changes that do the least damage to the competitiveness of the state’s tax system. This implies that the focus should be on base-broadening measures - such as limitations on income tax exclusions or deductions - as opposed to rate increases.
Policies to Improve Economic Growth Are the Key
Finally, it is important to emphasize the importance of economic growth to Delaware’s long-term budget situation. Delaware has a history of adopting innovative policies that have been extremely successful in drawing businesses and jobs to the state.
We have already discussed the state’s highly regarded Chancery court system, favorable incorporation laws, and extraordinary legal expertise in general corporate law, which combined have made Delaware the leading site of businesses incorporations in the U.S. Similarly, adoption of the The Financial Center Development Act in the 1980s – including its provisions removing usury laws and providing low tax rates to special purpose subsidiaries – made Delaware a major center for credit card operations and wholesale banking.
Continued emphasis on strategic economic development is a key to Delaware’s future success. Given its relatively small size, talented workforce, and strong higher education system, the state is uniquely positioned to identify and act on opportunities to, for example, build strategic alliances with the private sector, and remove regulatory and workforce barriers to potential growth. The state may also wish to consider whether its high corporate income tax rate and continued use of a three-factor apportionment formula for multi-state companies are impediments to new investment.
In short, because sluggish economic growth is an important factor contributing to Delaware’s budget problems, we believe that a high priority should be given to policies that will boost, rather than hinder economic growth in the state.