By WOODS BOWMAN

How much is a surplus? A different viewpoint, a different answer

Agreement on the optimum size of the cash reserve the state should maintain and how it should be computed is rare — among both politicians and economists. Responding to the article by Richard Kolhauser on this question (July issue), Rep. Woods Bowman, an economist, argues that a huge cash reserve is unnecessary if the state is conservative in its income and spending projections.

HOW MUCH tax relief can Illinois afford to give its citizens in a year when each monthly report from the state comptroller trumpets another record cash balance?

Tax cut proponents have been calling the large cash balance a "surplus" and using it as evidence that their proposals are affordable. The Bureau of the Budget has countered by claiming the size of the cash balance merely represents a prudent financial cushion (see "How much is a surplus?" by Richard Kolhauser, Illinois Issues, July 1980, p. 4). This article will provide a comprehensive overview of this debate and will attempt to answer the question of how large a cash reserve is necessary for the prudent operation of state government.

In trying to understand the debate, three technical points should be kept in mind:

1. The basic equation relating the various concepts is:

where the necessary cash reserve serves much like the minimum balance you prefer to keep in your family checkbook. The amount which should be set aside as a "necessary cash reserve" is a matter of judgment. It is not a purely technical question with a purely technical solution. As the management styles, practices and philosophies of policymakers differ, so will the desired necessary cash reserve differ.

2.  The state segregates its money into many different funds. The general Funds* is by far the largest single block of cash, and it is natural that the debate has featured this balance. However, there are several other important funds, linked to the general funds, which must be examined before any meaningful conclusions regarding the fiscal health of the state can be drawn.

3.  Cash balances do not appear out of thin air. They accumulate because revenues are increasing more rapidly than expenditures. Situations like this can be expected to happen from time to time because nobody can accurately predict revenues and expenditures year after year. A pattern of regular and persistent revenue growth in excess of expenditure growth will eventually produce a true surplus, no matter what amount one chooses as a prudent "necessary cash reserve."

Ideal to follow

The Bureau of the Budget has alleged that the ideal is to always have enough in general funds in order to (1) pay out when obligations are due; (2) meet increases in costs or to offset decreases in revenue because of unforeseen events; and (3) help maintain investor confidence in Illinois finances.

Without question, paying obligations when due is a prime reason for maintaining a cash reserve. The state's balances reached an all-time low, and difficulties were experienced in timely payment of bills during fiscal year 1975. By a quirk of fate, Dr. Robert Mandeville, who is now budget director, was deputy comptroller on September 19, 1975, when the state comptroller's report stated: "The Comptroller has established as a reasonable cushion a $100 million reserve at the end of any given month." Allowing for an approximate 50 percent growth in general funds expenditures over the past five years, one might consider a $150 million cushion reasonable. The current comptroller, Roland Burris, has said on a number of occasions that he feels that even $200 million is reasonable.

Every working day money flows into the state treasury. On about 60 percent of these days the amount of money flowing in exceeds the amount of money flowing out to pay the bills. The cash reserve is only needed to cover the days during which the outflow exceeds the inflow. During the last fiscal year there were only two days that outflow was $100 million or more in excess of inflow. Clearly $200 million should be an adequate cushion for bill payment purposes.

There are ways to prepare for unexpected

*As generally used the "general funds" includes the General Fund, the Common School Fund, Federal Fiscal Assistance Fund and the (now defunct) Federal Public Works Assistance Fund. These funds are interchangeable, so they may be lumped together for purpose of analysis.

4/October 1980/Illinois Issues

increases in cost or decreases in revenue besides accumulating a large surplus. Perhaps the most common method is to budget on the basis of conservative expenditure and revenue estimates. In Illinois this method has been used with profound effect. It has been the principal means by which the current cash balances have been accumulated.

Every one of the last four fiscal years has produced more revenue than the estimated amount in the governor's budget book. This year is no exception. According to the most recent estimates prepared by the Illinois Economic and Fiscal Commission (using the same national econometric forecasting services as the Bureau of the Budget), the state can expect $86 million more than the Bureau of the Budget used as the basis for the fiscal year 1981 budget. To appreciate just how large this cushion is, consider that the governor's budget book for fiscal year 1981 shows an expected growth in general funds from all sources (including federal funds) of $671 million. Thus, the cushion amounts to 13 percent of anticipated revenue growth.

The Bureau of the Budget has provided an additional cushion by regularly overestimating expenditures, especially those in public aid programs. During each of the last four fiscal years the Illinois Department of Public Aid has spent substantially less than was appropriated to it. Cumulatively, this has amounted to $294 million, approximately half of which would have been funded by state general revenue and the rest by federal sources. The current budget provides a generous allowance for increasing public aid caseloads due to the current economic crisis, so an extra cash reserve should be unnecessary.

It is unwise to expect a cash reserve, however large, to carry the state indefinitely through an economic crisis. Any person eventually will use up his savings account unless he lives within his means. Similarly, a state must cut expenditures if it is to weather an economic crisis which lasts longer than one fiscal year. There is no need for an additional cushion in the cash reserve because a cushion has already been built into the budget with overcautious revenue and expenditure projections.

Maintaining investor confidence in Illinois is a matter of vital importance. There is no question that bond rating firms look at the cash balance when evaluating the state's credit worthiness. The Bureau of the Budget alleges that a cash balance of 5 percent to 7 percent of general funds expenditures is prudent. The annual Fiscal Survey of the States prepared by the National Governor's Association (NGA) and the National Association of State Budget Officers (NASBO) is cited as the authority for this statement. While this sounds modest, it amounts to a $400 million to $600 million cash reserve.

Severity of change

In arriving at their recommendation the Survey authors do not give any justification for their target figure in terms of the fiscal performance of the states surveyed. Indeed, according to their own data, two triple-A rated states, Tennessee and Utah, had cash balances of 2.5 percent or less. Alaska, on the other hand, reported a cash balance of 60 percent, and it has the lowest A rating awarded by most of the rating services.

Robert Muller of E. F. Hutton implied that adequate cushions in revenue and expenditure projections can accomplish the same thing as a massive cash reserve

Other sources, which also cite a 5 percent cash balance rule of thumb (such as The Appraisal of Municipal Credit Risk, Moody's Investors Service, 1979), are more explicit and indicate that chronic budget deficits tend to occur with greater frequency when the cash balance falls below 5 percent. A budgetary cushion is an alternative to a large cash balance as a means of preventing chronic deficits, and Illinois has maintained such a cushion. Therefore the rule of thumb recommended by the NGA and the NASBO is too high for Illinois.

In recent testimony before the Illinois Economic and Fiscal Commission, Mr. Robert Muller, vice president for municipal bond research for E. F. Hutton and Company, explained, "It is the size and severity of change in financial position [cash balances] that is important as well as whether the state is relatively better or worse off at roughly the same point in the economic cycle versus the last cycle." He called special attention to the controlled rate of expenditure growth in Illinois and looked with favor on "continued tight controls in the current year and a budget which allowed for welfare related increases during a recession." He regarded the general fund balances as a bellwether of the ability of the state to match expenditure growth to revenue growth. He implies that adequate cushions in revenue and expenditure projections can accomplish the same thing as a massive cash reserve.

Given the expenditure controls that we now have, $200 million is probably an adequate cash reserve. A careful reading of the governor's budget message for fiscal year 1981 reveals near agreement on this figure. In that message he proposed a "tax dividend" program which would have returned about $115 million to the taxpayers of Illinois. It was not enacted, but presumably the governor felt the state could afford this largess. Had his proposal been enacted the state's available balance in the general funds would probably be about $285 million at the end of this fiscal year (see Kolhauser, Illinois Issues, July 1980, p. 4). Thus, we are not very far apart on the amount that constitutes the necessary cash reserve — $200 million versus $285 million.

Balance of all funds

To find the cash surplus of the state, the necessary cash reserve must be subtracted from the available balance.

On June 30 the available balance in the general funds was $483 million. This figure is artificially inflated by $93

October 1980/Illinois Issues/5

million due to the new corporate personal property tax replacement money which is earmarked for distribution to units of local government. Subtracting this amount (which is not really available to the state) leaves $390 million as a true available balance in general funds.

The balance in the general funds is only part of the story. There are five special state funds from which the governor may transfer surplus balances to the general funds, thereby augmenting the available balance in general funds. The five special state funds are the Agricultural Premium, Fair and Exposition, Fire Prevention, Metropolitan Exposition Auditorium and Office Building, and Vehicle Recycling. At the close of fiscal year 1980 there was $100 million in surplus balances which, according to the comptroller, was available for transfer to the general funds. The governor made transfers in fiscal years 1977 and 1978 when the balances in the special state funds were approximately one-half of the current levels. In fiscal years 1979 and 1980, he made no transfers, which permitted $100 million to accumulate.

Suspension of transfers

In addition there are five debt service funds: Anti-Pollution, Capital Development, Public Welfare Building, School Construction, and University Building Bond. The law provides for a mandatory transfer of general funds monies into these funds unless the governor determines that sufficient balances exist in them to meet the state's contractual debt obligations, in which case, he can order transfers into these funds suspended. He has as recently as fiscal year 1978 ordered transfers suspended, but more recently has not used his suspension authority. Consequently the comptroller estimates that nearly $49 million was available for suspension of transfers in fiscal year 1980 and is still available in fiscal year 1981. If that authority were used, the general funds available balance would rise by an equal amount.

The total balance available for state purposes consists first of the $390 million in general funds. To this figure must be added the $100 million aggregate surplus in the five special state funds and the $49 million which would become available if the governor exercised his suspension authority with respect to the five debt service funds. These amounts combine to yield a true "combined funds" available balance of $539 million.

Starting with an available balance of $539 million and subtracting the necessary cash reserve of $200 million leaves a true "combined funds" surplus of $339 million. To put this figure in perspective: $339 million is equal to 4.6 percent of general funds expenditures for fiscal year 1980. It is more than the combined expenditures of the departments of Conservation, Law Enforcement, Public Health, and Rehabilitation Services in fiscal year 1980. This amount of money could be withdrawn without jeopardizing the state's ability to pay its bills. Given our present budget procedures it would not be needed for a rainy day, and, depend-upon how the money was used, it could be withdrawn without jeopardizing the state's good bond ratings.

Therefore, that $339 million represents a true surplus, and it should be eliminated. In the business world, this would be a profit, but government is not a business. Government obtains its income by taxing its citizens. Its money is their money. If government has a surplus, it is either taxing its citizens too much or inadequately serving them.

If government has a surplus, it is either taxing its citizens too much or inadequately serving them. Disposing of a surplus, however, is not as simple as it sounds

Disposing of a surplus, however, is not as simple as it sounds. For example, it should not be used to finance new programs or salary increases because they represent ongoing costs, and the surplus — once depleted — will not be available in the future to maintain the higher levels of expenditure. Bond rating services would look askance at a sudden rise in the rate of expenditure growth while the surplus was being depleted because they would wonder whether a new long-term trend was developing where expenditure growth would outpace revenue growth.

Options for surplus

Several options are available for disposing of a surplus which would not jeopardize our bond rating.

1.  The surplus could be used to cushion state finances during the phase-in period of major tax relief programs. The governor has already used a portion of the surplus to cushion the successive reductions of the sales tax on food and medicine and the phase-in of sales tax exemptions on business machinery and agricultural equipment. The surplus cushion will allow breathing room while the state adjusts its future expenditures to match reduced revenues.

2.  The surplus could also be used to assist our capital construction program by permitting us to pay cash on the barrel head for once in a lifetime purchases. For example, we could buy a new State Office Building in Chicago for cash and save the financing cost.

3.  Illinois has one of the largest unfunded liabilities in its public employee pension system in the country. The surplus could be used to help reduce this liability.

Each of these proposals requires a one-time expenditure commitment. Each of them will save the taxpayer money in the long run. What we really need is a public policy for evaluating and disposing of surplus funds in a rational way which will benefit Illinois taxpayers.

Woods Bowman is a member of the Illinois House of Representatives (Democrat, 11th District) and has a Ph.D. in economics from Syracuse University. He is also a member of the Economic and Fiscal Commission.

6/October 1980/Illinois Issues