The Delaware Budget Trifecta: Revenue Stability, Spending Discipline and Value Creation

This past quarter for me was dominated by the conclusion of two processes: a macro-level examination of our State’s revenue system and a micro-level review of my office’s workflow and resource utilization. If that is not a topic sentence that grabs you, I suspect the rest of this read might require a little exertion on your part.

So, let’s jump right in using two related questions that I get asked all the time:

1.  How bad are our budget issues in Delaware

2. Do we have a spending problem or a revenue problem?

In the latter case, I always give the same answer: “Yes.” In the former instance, I usually remind people that you can drown in 6 inches of water; it’s not the depth but the duration that matters. I am not trying to be cute with these responses, although they do seem to get people’s attention. I simply believe that they are the truest answers that I can give.

In my view, both our revenue system and our spending constraints are flawed in design, and that leads to poor decisions and outcomes from a budgeting perspective. More importantly, the focus on too much or too little expenditure or income tends to overlook the obvious nexus of the two: value. What are we getting for our money? Finally, the obsession with micro-managing the annual budget leaves little oxygen in the room to deal with the long-term aspects of our fiscal picture. This is where the real trouble lies.

If you watched our latest budget debate, the concept of return on investment did not make it to center stage. Rather, the political sides seemed to have arrived at the statehouse seeing our fiscal quandary as either too much spending or too little revenue. Democratic legislators generally argued for more money, whether a greater share of the realty transfer tax, more fees at the DMV or a new income tax bracket. Republicans countered with a unanimous call for a 5% across the board cut in expenditures. Ultimately, to avoid stalemate, they had to do a little of both. Emphasis on “little.”

I say this not to undercut the efforts of our General Assembly. I respect and honor our legislators for their significant and sincere annual exertions. I believe, however, that the system in which they operate is defective and that the flaws of that system cost them great time and effort accomplishing what amounts to trivial adjustments in our budget from year to year.

The upside of these observations is that our structural problems do not lack for structural solutions. We just need the financial imagination to conceive them and the political will to implement them.

Cue the Advisory Council on Delaware Revenues.

The Revenue Side

When I last wrote to you I alluded to the then un-concluded work of this body, a bi-partisan panel of current and former officeholders, academics and budget officers convened by our Governor to study our state revenue system’s adequacy, predictability and economic impact. Strict partisans will not find the Council’s report as a whole much to cheer. Those interested in serious, large scale thinking on how to improve our budgeting and long-term finances should take notice, and heart.

In the revenue case, the report makes clear that we have come to rely on a portfolio of income streams that is “doubly narrow.” Personal income and our corporate franchise (in which I include our unhealthy reliance on abandoned property), account for more than 70 cents of every $1.00 of our operating funds. The rest of our revenue sources, a baker’s dozen or so that we regularly report, contribute a few pennies each, maybe a nickel here and there, by way of comparison. A well-balanced and diversified portfolio this is not. And that raises concerns about adequacy when the economy weaves and bobs.

Moreover, in virtually all cases, the bases of our revenue streams have become narrower over time, not broader. Whether corporations or individuals, we have come to collect a greater share of taxes from a fewer number of higher payers. Revenues at the margin therefore have become subject to greater swings based on the actions of a relatively small number of taxpayers who can choose to (legally) defer or otherwise not recognize income in a given year. More revenue volatility means more annual scrabbling for minor make-wholes and patches to our budget – a disruptive and unpredictable process.

The structural fix for these shortcomings is to take an active approach to re-constructing our revenue portfolio on a revenue neutral basis (i.e., same amount of money, but different pockets). The specific suggestions here are too numerous to cover in this letter, but the key ideas are to:

– broaden the base of the personal income tax via elimination of major deductions coupled with an offsetting across the board cut in rates and the elimination of the estate tax;

– manage the corporate franchise fees targeting a certain growth rate with predictable fee increases that the market will bear;

– reduce or even eliminate our corporate income tax while raising our gross receipts tax by an equal amount; and

– cut back our reliance on escheat/abandoned property over time in favor of greater dependence on own source revenue from a property tax, ideally administered at the county level in exchange for more local control of education spending and/or transportation expenditures.

Politically speaking, these recommendations provide something for everyone to hate. Practically speaking, they constitute a revenue portfolio that is more robust, more predictable and more conducive to economic growth. Moreover, in the aggregate, the portfolio is designed to grow over the long-term at a rate that approximates inflation plus population growth.

In an uncertain world, a sound revenue system that keeps up with predictable demands on spending can command a premium from individuals and businesses alike who will take more risk, make more investments and, dare I say, create more jobs. It also makes it easier to isolate and focus attention on our spending issues and critically the value we are getting for our money.

The Expenditure Side

The foregoing is only half a loaf. The Advisory Council also concluded that our current constitutional limit on spending is inadequate and that we need enhanced fiscal controls embedded in our legal framework. While it sounds fiscally responsible to have an annual balanced budget requirement, that limitation embodies short-term restraint at the risk of long-term profligacy. And we have the data to prove it.

It boils down to this: when the economic cycle is hitting on 12 cylinders our revenues go up, often by a lot. Rather than put some of this newfound wealth away to anticipate the cooling of the economy, our “balanced budget” rule allows us to spend it all in the year received. And therein lies the rub. New heights of spending established in good times are very difficult to descend from in bad times. If anything, demands on public services tend to run higher when the economy is sick.

In the past, it has been our good fortune to get through these troughs in the business cycle by finding “silver bullets”: first, bank franchise taxes (now at a third of the share they once contributed to the general fund); then racino money (now at half its peak percentage contribution); and most recently, escheat or abandoned property (still in excess of 10% of operating revenues, but down from as much as 16%). Having your cake and eating it too is great until there’s no more cake.

Recently, our core revenue growth (think personal income, corporate franchise and a combination of business taxes) has not fully recovered coming out of the Great Recession and our existing “silver bullets” are fading with no new cartridge found to load in the chamber. This has created the current budget “crisis.”

The inescapable background fact, however, is that our state and local governments already spend an amount per person that is among the highest in the nation – greater than 43 other states and 20% above the U.S. average. Twenty percent is a lot. We also do the lion’s share of that spending at the state level – 80% as opposed to the state average of 55%. In other words, there is a significant amount of spending done by our state government that merits scrutiny. And that scrutiny is minimal.

Spending as we all know is an intoxicating experience. Who does not relish a great vacation, a night on the town or, in the case of my daughters, an afternoon at the mall? The joy of later getting the credit card statement and analyzing that spending, well, not so much. Realistically, we are not going to have great success making performance auditing of our collective spending “fun” for our General Assembly, but we do need to create an incentive to make oversight both a perfunctory and rewarding process.

The genius of adding to our budget framework a “fiscal governor” that limits spending to the long-term growth rate in inflation and population is that it only provides our government with the means to carry on with the programs we have today. It insures that we meet current service levels in the future by tracking increases in price levels and headcount, but nothing more. If policymakers want to fund new initiatives, then they must find the dollars to support their projects through more efficient use of the monies we already have.

“Extraordinary” revenues in this new system, whether from a surging economy or spikes in silver bullets, will be constitutionally set aside in a “budget smoothing” account and applied when the business cycle turns down. This automatic balancing of revenues and spending over the ebbs and flows of our economy will free up the time that our legislators ordinarily are required to expend on short term budget fixes to be applied to the far more productive exercise of auditing spending performance and identifying efficiencies. In a word, creating “value.”

The Value Proposition

If you’ve followed me this far, the questions I hope you have at the forefront of your mind now are two-fold: Are there really efficiencies to be gained? And, if yes, how do we unlock that value?

The first question goes to the heart of the value equation – are we getting our money’s worth? I’ve noted above that we do an awful lot of spending at the state level with a combined amount of state and local spending well above the norm. Do we get superior results for our superior spending?

For the bulk of our expenditures in the four categories that comprise the lion’s share of our spending – education, healthcare, safety and infrastructure, the answer is consistently “no.” At best, we get an average return.

Our students’ test scores, matriculation rates and college preparedness measures are decidedly mediocre using a comprehensive set of national measurements. Our population enjoys neither longer nor healthier lives than the average U.S. citizen. Our per capita rate of violent crime is higher than all but three other states and our largest city is ranked one of the most violent in the country. The quality of our roads, bridges and water is, as the Governor has made clear, poor and certainly not markedly above average.

On the whole, there is no getting around the fact that when it comes to state spending our output is not commensurate with our input. This is not a sustainable formula over the long-term, much less a boon to prosperity and economic growth. We need to make a rapid transition to focusing on value and devising a means to generate it.

That is where my direct experience in government ties in. I want to discover for myself if and how we realize more potential and productivity in operating our public sector. In the last four months, that is the exercise that we have commenced in the Treasurer’s office.

Admittedly, mine is an agency of no more than two dozen souls with a direct budget in the millions, not the tens of millions much less the hundreds of millions. However, the same civil service rules apply to my personnel as apply to the workforce of the rest of our state government. The same procurement rules govern my office’s engagement of goods and services. And, the State Treasurer goes through the same budget process as the rest of our state divisions and branches. The scale may be smaller, but the same challenges are present.

When I write you next, I will look forward to spelling out the processes that we are going through to identify efficiencies, increase productivity and ultimately generate more value from the resources that we have. It’s one thing to talk about creating value; it’s another to actually do it. That topic deserves a newsletter in its own right, and, to be fair to my staff, the changes we will be working through should be embraced internally before they are broadcast externally.

That said, I will preview one conclusion. I do not think value creation is an act of “ideation” – some brilliant thought or revolutionary concept that instantly makes government more productive; rather, I contend that value creation is a function of perspiration. Productivity gains will be realized one employee, one contract, one resource at a time through rigorous review and alignment of incentives.

Let’s have at it. Dog Days indeed.

Yours,