MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

YOU DECIDE: Where did the surplus come from?

By Dr. Mike Walden
North Carolina Cooperative Extension Service

You've seen the headlines. The state may have as much as a $2 billion budget surplus for the upcoming fiscal year. But wasn't it in just the last few years that the state was facing budget shortfalls? What happened to cause the state's fiscal fortunes to turn around?

Before I answer this question, a little background on the meaning of a state budget surplus is useful. North Carolina does budgets for the General Fund (essentially all spending outside of transportation) on a two-year cycle. Last year, during the long session of the General Assembly, the budget was developed for the fiscal year ending this June 30 as well as for the next fiscal year (July 1, 2006 to June 30, 2007). Revenues and spending had to be projected for both years.

This year the General Assembly is back for the short session, where legislators review the budget they developed for 2006-2007. Between last year when the budget was planned and today, the revenue picture brightened to the point that an extra $1 to $2 billion is expected for the next 12 months. Rising corporate profits, improved individual investment gains and better than expected job growth are behind the good news.

Yet this isn't the first time the state has experienced an unexpected budget surplus. In fact, state revenues generally jump in the years following a recession, just like they plunge when the economy goes into a downturn.

A big reason is how state income tax revenues change with the economy. When the economy is bad, corporate profits plunge and take with them corporate income taxes. Investment earnings also slide, so individual income taxes stumble.

Both these money sources reverse and boom when the economy pulls out of a recession. Plus, there's one other factor at work to pump up tax revenues: “bracket creep.” Bracket creep occurs when a booming economy pushes taxpayers into a higher tax bracket. This means some of the new income generated by the improving economy is taxed at a higher tax rate.

Preventing the boom and bust nature of North Carolina's revenue system has been a longstanding issue in the state. Proposals include indexing state income tax brackets to inflation so as to reduce bracket creep, reducing the reliance on volatile revenue sources like corporate profits and investment earnings, and saving some of the added tax revenues when times are good to be used when times are bad.

The last recommendation has been given various labels, such as rainy day fund, business cycle reserve, or banking the surplus, and it recognizes a standard problem.

When the state is flush with revenues, there is a strong incentive for those revenues to be used on new or expanded programs or on reducing taxes. However, later when the economy slips and revenues fall, budgetary levels can't be supported. The options then are higher taxes or spending cuts, both of which are difficult in challenging economic times.

A rainy day fund, or business cycle reserve, would result from a rule requiring revenue growth above a certain level to be set aside for the next recession. Fully funded rainy day funds could total several billion dollars. North Carolina has a version of this concept, but it has not been funded to the level some financial experts would advise.

So although there's reason to cheer about the state budget surplus, there's also reason to worry — because it won't last. What we do to smooth out future surpluses and deficits may be more important than how we use today's excess funds. You decide!

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Dr. Mike Walden is a William Neal Reynolds Professor and extension
economist in the Department of Agricultural and Resource Economics of North
Carolina State University's College of Agriculture and Life Sciences. He
teaches and writes on personal finance, economic outlook and public policy.
His You Decide column is provided every two weeks by the Department of
Communication Services. Earlier You Decide columns are available on the Web
at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm
Related audio files are at
http://www.ces.ncsu.edu/depts/agcomm/writing/walden/index.html