A Review of Total State Spending, Part II: An Effective Spending Cap for South Carolina

Written by: Simon Wong and Dr. Jameson Taylor

In Part I of this series, we looked at state spending over the past 10 years. We found that:

• The total budget (General Fund + Other Funds + Federal Funds) increased by 44.5 percent over 10 years (FY2001 to FY2011).
• Spending increased every year except FY2010.
• The current $21.148 billion budget is the largest in state history.

As we concluded in Part I, “The Legislature has essentially proven it can’t stop spending, that it is addicted to spending in both good times and bad.” Thus the only way to limit state spending is an institutional control that legislators must adhere to – a constitutionally mandated spending cap.

Part I of this series posited that the best mechanism for limiting state spending is a comprehensive spending cap tied to inflation. This report reconsiders that finding and looks at several different formulas for capping governmental growth. In doing so, we discuss the pros and cons of each method and delineate five safeguards that should be integrated into an effective spending cap. At this phase in our research, we have concluded that a formula based on supply (available revenue as measured by economic productivity) rather than demand (the perceived need for governmental services) provides the best measure for limiting spending according to real economic growth. In light of this distinction, a spending cap based on inflation plus population growth is less desirable than a cap based on real gross state product (GSP), for instance. As we will demonstrate, real GSP provides a more accurate picture of the true health of the state’s economy and is a better indicator for analyzing state spending levels – which, as much as possible, should be correlated against real economic conditions. That said, questions remain regarding how a spending cap measured against real GSP would prevent overspending during economic upturns.

Existing State Spending Cap is Ineffective

Technically speaking, South Carolina already has a spending cap. Article X, section 7 of the S.C. Constitution requires that:

The General Assembly shall prescribe by law a spending limitation on appropriations for the operation of state government which shall provide that annual increases in such appropriations may not exceed the average growth rate of the economy of the State as measured by a process provided for by the law which prescribes the limitations on appropriations; provided, however, the limitation may be suspended for any one fiscal year by a special vote as provided in this subsection.

The state constitution thus limits budgetary spending according to economic growth, which is to say the economy provides an objective measure for making sound budgetary decisions. The tacit assumption here is that the budget should not grow during recessionary periods. In practice that has not been the case. Instead, the Legislature has overspent during boom times. When the economy has cooled, however, lawmakers have avoided making tough cuts. The result is that spending has increased with virtually no regard for the state’s actual economic health.

The state constitution also does not specify the mechanism by which spending should be limited. Two basic questions are left unanswered: What is the best way to measure economic growth? And how is spending subject to the cap to be defined?

Statutory language governs the terms of the constitutionally mandated spending cap. This language can be changed at any time by revising existing state law. Thus the formula used by the state to limit spending can be changed without having to amend the constitution. The current formula (S.C. Code of Laws 11-11-410) is as follows:

The limitation on state appropriations prescribed in subsection (A) is an amount equal to either those state appropriations authorized by the spending limit for the previous fiscal year increased by the average percentage rate of growth in state personal income for the previous three completed calendar years or nine and one-half percent of the total personal income of the State for the calendar year ending before the fiscal year under consideration, whichever is greater. As used in this section, “state personal income” means total personal income for a calendar year as determined by the Budget and Control Board or its successor based on the most recent data of the United States Department of Commerce or its successors.

The method chosen by the state Legislature to limit spending thus relies on personal income growth. This is an approximate measure of economic growth and is used by 11 other states in their spending cap formulas. For example, South Carolina, North Carolina, and Maine all use personal income as a means of limiting spending. South Carolina caps spending at 9.5 percent above personal income. North Carolina caps spending at 7 percent of personal income while Maine’s formula limits spending to a 10-year average of personal income growth, or a maximum of 2.75 percent annually.

South Carolina’s cap is correlated against two different measures, relying on the larger of the two to limit spending:

1) Average personal income growth as based on the last three calendar years; or

2) 9.50 percent of total personal income for the prior calendar year.

An Inaccurate Measure of the State’s Economy

The formula used to set the current spending cap leaves much to be desired. According to a study on state spending limits by the Mercatus Center at George Mason University, South Carolina’s current method for limiting spending is only partially effective. “Those TELs that limit budget growth to state income growth seem to have a statistically significant impact on both state spending and state and local spending,” observes the report. Whereas, “TELs that limit budgets to some share of income had no statistically significant impact on either state-only spending or on combined state and local spending.” In other words, the first part of South Carolina’s formula (as based on personal income growth) is theoretically sound. The second measure (as based on prior calendar year total personal income) is not.

But this is not to say that a spending cap as calculated against personal income growth is advisable. The Mercatus report finds mixed results regarding such a formula, concluding that it may serve “as an excuse for policy makers to spend up to the limit, rather than as a binding constraint on spending.”

In South Carolina’s case, the cap is set at such a high level (e.g., 9.5 percent of total personal income) that it is entirely ineffective. This point comes out clearly when we compare the effects of South Carolina’s cap to Maine’s. Since Maine implemented its 2.75 percent spending cap formula in 2005, average yearly total state spending growth has dropped by 5.58 percent (FY95-2005) – to 3.75 percent per year (FY06-2010). In particular, Maine’s General Fund average yearly growth rate declined from 4.96 percent to 0.37 percent. By contrast, since implementing its spending cap in FY85-1986, South Carolina’s total state spending has increased by an annual average of 5.71 percent (300.7 percent cumulatively), with General Fund spending increasing 2.74 percent annually (96.7 percent cumulatively).

Just as important, personal income does not provide an accurate measure of the state’s economic health. In addition to income from wages, personal income includes: 1) personal dividend income; 2) personal interest income; and 3) personal current transfer receipts. These three components of personal income do not necessarily indicate an increase in the state’s productivity or attractiveness as a business environment. For instance, dividend income is often derived from stocks and bonds sold in other states, or even other countries. Moreover, personal income includes government transfer payments, such as federal and state Supplemental Security Income, food stamps, direct relief, earned income tax credits, state public assistance medical care payments, federal hospital and medical insurance benefits, and adoption assistance. Thus, personal income, relative to other indicators (such as gross state product), does not specifically measure the health of South Carolina’s economy. Instead, it serves as a very general proxy of the income levels of people who pay taxes in South Carolina, regardless of the source from which this income is derived. In short, personal income does not measure the value of goods and services produced by South Carolina’s economy.

Does Not Include the Majority of State Spending

State law also restricts the spending cap to a narrow range of expenditures that accounted for only 32.75 percent of total state appropriations in the FY10-2011 budget. The spending cap does not apply to the total state budget, but only to all “nonfederal and nonuser fee revenue items.” For the most part, this means the General Fund, the Highway Trust Fund, and Education Improvement Act funding. The spending cap also does not apply to local funding – for instance, county, municipal, and school district budgets.

Actual spending subject to the legal cap was about $7.3 billion in FY09-2010. Yet the theoretical spending limit for FY09-2010 was $13.501 billion. The theoretical cap was thus almost twice as high as actual spending. This is hardly a cap at all and helps explain why budgetary spending hit an all-time high in the midst of the worst economic downturn since the Great Depression.

Here, it is important to recall that the state budget is made up of three components: the General Fund, Other Funds and Federal Funds. As indicated above, the General Fund, the Highway Trust Fund and the Education Improvement Act are the only revenue sources subject to the state spending cap. This explains, in part, why the General Fund is increasingly shrinking as a share of the total budget – falling to 24 percent of the FY10-2011 budget. It may also help explain why the General Fund is subject to greater scrutiny than the Other Funds part of the budget. Yet, Other Funds revenue (derived from fines and fees) has skyrocketed, making up 37 percent of the FY10-2011 budget. Over the past 10 years, Other Funds revenue has even exceeded federal funding as a share of the state budget. For this reason, an effective spending cap must include Other Funds (fine and fee) revenue.

Similar considerations explain why an effective spending cap should also include federal funding, especially insofar as new federal programs are helping to fuel state spending. Thus, our analysis of each type of spending cap includes all three components of the budget, including federal funding. In addition, we have included a second data set that treats federal funding as a constant not subject to the cap.

A Review of Six Different Types of Spending Caps

Given that the current budget cap is completely ineffective, we want to look at several different mechanisms for limiting spending. These are as follows:

1) Inflation plus population growth (demand based)

2) Inflation only (demand based)

3) Gross state product in all industries (supply based)

4) Gross state product in private industries only (supply based)

5) Real gross state product in private industries only (supply based)

6) Real gross state product per capita in private industries only (supply based)

We will explain each metric in detail. But the following table provides a quick snapshot of our findings. Our analysis uses FY01-2002 as a baseline and projects spending out to FY2011. As stated, we apply the cap to total state spending (including federal funds).