THE OCEAN STATE'S STRUCTURAL DEFICIT

The Providence Journal Editorial Page News, April, 1996

It’s April, time to begin final preparations for another of our annual budget "crises." Both the magnitude and the severity of the problems we face as FY 1996 comes to an end are indeed mind boggling. As most Rhode Islanders know, payroll employment fell on a year-over-year basis for every month since May of last year. The most recently-released income figures appear to bear this out, as Rhode Island ranked 49th among the 50 states in terms of personal income growth. What could be worse? Before we can lay the seeds for next year’s budget "crisis," we must deal with an estimated FY 1996 budget deficit of about $70 million.

Clearly, the state of the economy influences the state of the budget. When an economy grows slowly or is in a recession, tax revenues suffer. Entitlement expenditures tend to rise as well. Taken together, these forces either create a deficit, or make an existing deficit larger. The conventional wisdom in Rhode Island presupposes that a badly performing economy is the cause of our fiscal problems. Unfortunately for Rhode Islanders, it is what they don’t know that may well come to haunt them in the long term.

Before we can delve deeper into the issue of budget deficits, we must first solve a puzzle. How was it possible that in 1995, employment in Rhode Island fell for every month since May and income grew by less than one percent at the same time that state income tax withholding rose by 4.6 percent and retail sales increased by 3.7 percent? The answer is that it was not possible. These events did not occur. The non-survey based data dealing with tax withholding and retail sales, which appeared to contradict the survey-based labor market and income data, proved to be correct. When the labor market data were recently rebenchmarked, we discovered that 1995 employment had not fallen as we were originally led to believe. Instead, it rose by a respectable 1.5 percent. As of December, employment was 10,000 higher than previously released data indicated. What about the paltry income growth reported recently? It will be revised to reflect the corrected labor market data. Statistically, Rhode Island will now move from being one of the slowest-growing states in an underperforming region to an above-average performer in New England and much closer to the national average in terms of both employment and income growth. Furthermore, the primary basis for Rhode Island’s employment revision was the substantial amount of entrepreneurial activity taking place, in terms of both the creation of new firms and expansion by existing small firms. The first question we must ask is how this much entrepreneurial growth can occur in such a "high" business cost state. Was this because of economic development policy and the costs of doing business here, or in spite of these?

Next we come to the deficit question. If the state’s economy performed this well how can such a deficit problem exist? While our economy performed much better in 1995 than we originally thought, we are still confronted with serious problems. Primary among these is the closing of manufacturing firms (manufacturing employment was revised down by 2,000 jobs), the continued absence of new home construction (housing starts are currently at recession levels) and long-term unemployment. The absence of large "multiplier effects" from housing and manufacturing have offset many of our cyclical gains throughout this entire recovery. More importantly, though, the current deficit should not be our primary focus. Since the size of our deficit depends on the state of the economy, can you imagine what our deficit for FY 1996 would have been had our economy performed as badly as earlier thought? Our problem is not that a weak economy has caused tax revenues to collapse. Instead, given our current expenditure levels, we would have a deficit even if we were at full employment. This hypothetical, which compares current expenditures with what tax revenue would be at full employment, is what economists call the "structural deficit." Our problem is the existence of a structural deficit. The symptom of this problem is the persistent annual deficits that form the basis of our annual "crises."

While treating the problem instead of the symptom is not good politics, it is imperative that we do this at the present time. In the short-term, we must define our essential "safety net" expenditures and, when deciding where to cut spending, to carefully distinguish between investment and consumption-oriented expenditures. Spending cuts should be relegated primarily, or almost exclusively, to consumption-oriented spending. We must preserve investment-oriented expenditures since these not only increase the size of our economy, they enhance future tax revenue as well. In the long-term, enlarging our economy will occur not only as the result of preserving investment-oriented expenditures, but, hopefully, by adopting economic development policies that build on our strengths and move us toward a well-defined economic niche. It is not enough for this policy to attract physical capital. It must also preserve and enhance Rhode Island’s human capital infrastructure. The skill mismatches and long-term unemployment that have persisted throughout this recovery reflect the inadequate skills possessed by segments of our labor force. This, like Workers’ Comp, affects the cost of doing business in our state.

Hopefully, if we finally begin to deal with our structural deficit problem and focus more on investment-oriented expenditures and policies, the most myopic among us, persons who find it necessary to define a "pragmatic justification" for investments such as education and training, will finally understand that we should be planning for the future, not the past. Until Rhode Island deals with its structural deficit, it will be forced to continually react, deprived of the chance to act decisively. What Rhode Islanders don’t know can hurt them!

by Leonard Lardaro