Arizona is in an enviable position among many states -- what to do with a $1 billion revenue surplus? During lean times, political battles are common as legislators squabble over what to cut in order meet the state's constitutional mandate to balance the budget. But as the current sparring taking place in the state Capitol shows, good times can lead to dissension as well.

Instead of fighting over what to trim from the budget, Republican legislators and Democratic Governor Janet Napolitano are facing off over how to spend the revenue windfall. Political ideology no doubt will dictate how the surplus will be spent, and that may or may not coincide with what some economists say is the most prudent use of the money. But first, politicians have to assess the realities of the situation.

Arizona is not the only state with this dilemma. Data suggest that the flow of estimated income tax payments is strong nationwide -- strongest in states that have experienced rapid acceleration in their real estate sectors. Not all states impose a state income tax, but those that do will be seeing an improving fiscal position this spring. But how much of the revenue should be used to support new permanent expenditures or permanent tax cuts?

A temporary lift

"The state has to realize that $300 to $400 million of the revenue bonanza is temporary, and should be looked at as purely temporary. To spend it as if it were permanent doesn't just border on insanity -- it's over the line, it's crazy," says Elliott D. Pollack, president of Elliott D. Pollack & Co., an economic and real estate consulting firm in Scottsdale, Ariz.

 

Pollack says the temporary nature of the surplus can be attributed to the state's strong housing market, and economic history offers ample evidence that housing markets do not boom indefinitely. As he points out, in 2005 Americans took about $100 billion out of their homes in home equity loans and about half of the money went into retail markets -- the economy's main engine.

"If you take that down to Arizona, you'd probably have $100 million flowing to the state in disposable income that is simply going to go away, probably as early as this year, because people aren't going to take that much money out of their houses again," he says.

Dennis Hoffman, professor of economics at the W. P. Carey School of Business, agrees with Pollack that a portion of the surplus is of a temporary nature. But his research also shows there is a substantial amount of income that is being generated in capital gains, in servicing real estate transactions and in the purchase of consumer durables, and it is going to take a few years for the impact of the recent explosive growth in Arizona to play itself out. While the real estate market may not be as red hot as it has in been in recent years, Hoffman predicts it will continue to be quite vibrant. Unless prices and sales plummet -- and there is no historical reason to believe they will -- Arizona residents likely will continue to enjoy substantial capital gains and related income from real estate in the coming years, Hoffman says.

Hoffman says state revenues have been growing at probably the fastest rate he's observed since he began looking at the data 23 years ago. Hoffman has watched as two full business cycles rolled through: one with a tax increase (1990), and another with a major tax cut (1995), as well as some other reductions in the late '90s. He also observed state revenues stagnating in 2000 and 2001. Indeed, the income tax bill (the annual amount owed to the state) for residents of Arizona was just under $2 billion in 1999 and was no higher, three years later, in 2002. Then the upswing, in tandem with the robust real estate market, began. In 2004 resident income taxpayers owed $2.6 billion and the bill will eclipse $3 billion in 2005.

"It's reasonable to believe income tax revenue will continue to grow from today's $3 billion base. It won't grow as rapidly as it has in the last few years, but it will continue to grow," Hoffman said.

One-time opportunities

Both Hoffman and Pollack advise that legislators and the governor take advantage of the surplus to address some outstanding issues.

Unlike the federal government, the state's government must submit a balanced budget. In times when expenditure demands exceeded revenues, the state had to find money to cover itself. Because raising taxes is politically anathema in Arizona, state leaders covered shortfalls by dipping into the budget stabilization fund and relying on accounting rule adjustments to delay some payments.

"When the good times come back, the issue is what to do with the money," Hoffman says. "From a budgeting perspective, it's rational to think longer-term, replenish the rainy day fund, and reverse some of the accounting gimmicks that were instituted over the last few years to get the budget balanced. I believe that the Legislature and the governor are making proposals to do both of those things."

Even after that is done, there still could be a large surplus burning a hole in state leaders' pockets. For Pollack, deciding what to do with that money comes down to a question of priorities. But he fears that putting more money in the hands of lawmakers will result in more waste, because, he says, bureaucracies by their nature spend down their resources.

Development incentives?

Rather than creating permanent expenditures, Pollack proposes that the state government use the surplus in a way that will aid economic development. His choice is to cut personal property taxes on businesses, particularly those that come from out of state -- known as export businesses.

"You want to cut taxes on those industries where businesses have choices about where they want to locate, whether in Arizona or New Mexico or New York or California," he says. "Dillard's isn't going anywhere. It's going to be here. But Motorola could locate in a lot of places. You have to deal with those issues, making the state as attractive as possible, bringing in as many jobs from those companies that can locate to other places as you possibly can. You do that by making the place friendly for business, especially for the export businesses."

Not everyone agrees that the state should offer these inducements, however.

"The problem with one-time giveaways -- and that's what they are -- is that they rarely are the big draw," says Robert Mittelstaedt, dean of the W. P. Carey School of Business. "Companies look at all of the attributes an area offers, and tax incentives become the icing on the cake -- or in some cases, the icing on a free cake you threw in needlessly."

Mittelstaedt points to Google as an example. "Google has said publicly they came here for a desirable environment, an educated work force and reasonable costs," he says. "They didn't seek incentives ahead of time."

Hoffman also advises against using the surplus to make permanent expenditure obligations. He believes there is another way to use the surplus to help the economy -- using the money for one-time initiatives that would yield a rate of return over time. These investments might include improvements to the public infrastructure, such as roads, bridges and highways. He also suggests putting the surplus into such things as the new medical school or some other science and technology enterprise.

Mittelstaedt agrees. "In the long run companies don't want one-time breaks, they want reasonable tax levels that are stable and predictable," he says. "They want a good environment for their employees to raise families and they want an existing work force that meets their needs and an area that will continue to attract and retain good well-educated/trained employees. If you work to put those things in place, then you should focus on selling the long-term proposition and use limited or no special deals other than things that are self-financing, like low-interest bond guarantees for plant construction."

Taking the long view

Hoffman views infrastructure investments as key to this longer-term strategy and is also unwilling to recommend tax incentives to stimulate development.

"I'm not opposed to growth, but I'm not sure we need to figure out more mechanisms to get more people to move Arizona. The in-migration of people is relentless. Second, we are already a low-tax state, and there are no signs that this fact is about to change."

Hoffman says people value a public infrastructure that is efficient and delivers the services residents need and want. In the past, government investments bolstered Arizona's infrastructure, such as the water systems and dams that allowed the state's largest urban center, Phoenix, to grow and prosper. 

"Arizona will no doubt continue to grow in the 21^st century, but we need to be turning our attention to quality growth," Hoffman says. The state should be looking at investing in science and technology, water technology such as desalinization and energy independence in the form of solar power -- areas where there is both opportunity and competitive advantage. And the right kind of investments will be even more enticing to businesses than tax incentives, he says.

"We have to understand that there is a balance between proactively creating a business climate with low taxes and free-market incentives, and allocating sufficient resources to sustain and develop initiatives that require public support -- especially in endeavors with longer-term payoffs. We have been pro-active in the fiscal arena and have established tax rates that are not onerous in comparison with other states, but we also need a sound, stable, reliable public infrastructure that nurtures Arizona's growth," Hoffman says. "Policymakers need to position the Arizona economy for the future. My preference is to see our leaders invest strategically. Frankly, it may turn out that there's enough money to do a little of both."

 

But the danger of getting it wrong is real. Does anyone remember California after the dot-com crash and what happened to the Golden State's revenues?