For savers, compounding interest can be a great thing. It helps to accelerate the rate of increase of your money in the bank.
For state budgets, however, the concept of compounding budgetary increases can rapidly create out-of-control spending obligations.
For state budget writers tempted to think it safe to increase spending by, say, 4.5 percent annually during this slow recovery instead of a more responsible rate of growth, it is important to remember how seemingly small annual differences in spending growth rates can snowball into big differences in a short period of time.
For instance, comparing state budget growth of 4.5 percent annually to 3 percent per year yields significantly different results in just five years. Beginning with the $20.18 billion FY 2012-13 budget as the baseline, an annual 4.5 percent growth rate would balloon the state budget to $25.15 billion by FY 2017-18. Conversely, a more fiscally responsible growth rate of 3 percent annually yields a far more manageable FY 2017-18 budget of $23.39 billion – a full $1.76 billion less (see Figure 1).
Furthermore, the cumulative difference in dollars spent during that five year span would add up to $5 billion.
Imagine the financial challenges that could be addressed with an additional $5 billion not being consumed by annual General Fund expenditures: State debt could be paid down, unemployment insurance debt to the federal government could be repaid, unfunded pension and retiree health benefits could be significantly reduced, etc.
And just as important, budget writers need to exercise restraint during periods of strong economic growth. To illustrate, we can examine state budget growth during the economically robust years between FY 2003-04 to FY 2008-09. The average annual growth rate of spending during that time was 7.5 percent, with two of those budgets growing more than 9.5 percent year-over-year.
Compare that with a more responsible rate of growth tied to a rolling three-year average of the combined annual rate of population plus inflation growth, as has been proposed in recent Taxpayer Bill of Rights (TABOR) legislation. Under such a TABOR scenario, average annual spending increases would have been just under 4.3 percent. Moreover, by FY 2008-09, spending under a TABOR would have been a manageable $18.4 billion, a full $3 billion less than the actual budgeted amount of $21.4 billion. Of course, the onset of the recession revealed the $21.4 billion to be pitifully unsustainable (see Figure 2). Plus, the total savings over that time would have been more than $10 billion.
The evidence is clear: Even seemingly modest differences in annual growth rates of spending add up to significant differences in state budget spending commitments in a short period of time. State budget writers should always be aware of the power of compounding spending commitments, and how any given year’s budget not only affects the current year, but sets up future budgets on an unsustainable path.