Big Government is Unsustainable

For those who haven't been watching, both New York and California are facing staggering budget deficits of $15 and $40 billion respectively. Indeed, it is quite possible both estimates will turn out to be too low. It is essential that Massachusetts ponder these train wrecks while our own fiscal problems remain somewhat tractable.

The underlying cause in both states is a reliance on low-hanging fruit; California collects an overwhelming majority of its taxes from the upper quintile of earners, especially capital gains, while New York has long skimmed the cream off the financial services industry. Since roughly 79% of people are in favor of high taxes for the top 20% of earners, this was a politically perfect solution.

The problem arises however that the incomes of the wealthy are not just higher than those of the middle-class, they are also far more volatile. It is not unusual that in a bad year a business owner or investor will have negative income, and may in fact make 80% of their money in one out of five years. State government budgets, however, tend to move up rapidly and down very slowly if at all; the proposed NY budget for 2009 still includes an overall spending increase of 1%. To the extent that both New York and California took a good year as a sign to increase spending proportionally, this sort of crisis was largely inevitable.

Both states boast prime coastal cities, with enormous human, financial, and educational capital stocks. They would have the means to operate at above-average levels of spending even with tax systems similar to low-tax states. But none of this is permanently true. Buffalo was once home to the largest number of millionaires of any US city. Freight trains used to run deep into downtown Manhattan servicing vast factories and workshops where one now finds meat-market clubs and lofts serving the hedge fund kiddie market.

Just as one still finds millionaires in Buffalo and factories in Manhattan, no doubt the city will continue to have high-earning Wall Street types to peel C-notes off at will. But it could be decades before it has as many as it did in 2006, if those jobs are recreated in NYC and not NC or AZ. Raising taxes now--especially on the upper reaches--will only accelerate the unwinding. Eventually you have to raise taxes on the middle-earners, which New York's swelling basket of new taxes on iTunes, soda, event tickets, clothing, and beer does, by slightly less obvious means.

I've written here before about how the MBTA's budget deficits will eventually eat us alive; indeed, the New York MTA is now looking at simultaneous fare increases and service reductions. Our system remains tenable only because the rest of the budget is still able to make up the shortfall. But the demands on education and healthcare remain large and growing, and it is not clear we're headd anywhere different in the long term.

It used to be that state governments could run surpluses or borrow money so as to operate at a consistent level regardless of the macroeconomic situation. This provided a useful stabilizing force to the economy, and guaranteed the delivery of essential services when people needed them most. While government officials lean into their criticism of bankers and financial engineers for their greedy short-term views, they ought to spare some time to ponder their own.