Saturday, July 22, 2017

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8. Policy Recommendations

New Jersey statehouse

Today, New Jersey is overburdened with legislation and a complex system of taxation. In spite of constitutional constraints, poor fiscal choices have prevailed for a period of decades. Increases in spending have been partially obscured to voters via debt, intergovernmental aid, and budget gimmicks. By using non-tax sources of revenue, the state and municipal governments sustain spending growth beyond what taxpayers might otherwise support, through fiscal illusion. When they do not bear the full costs, state taxpayers may demand more public spending than if they paid for spending in full.

New Jersey must reform its fiscal institutions—the rules under which elected officials budget. A recent Mercatus study ranked New Jersey 43rd in fiscal policy.[115] Re-establishing fiscal prudence requires a) constitutional rules that constrain state and local government spending and b) policies that promote the best use of public money. Other states have been successful in constraining spending and, as a consequence, may be more resilient during periods of crisis.

1. Create Effective Constitutional Rules to Constrain Spending

Colorado’s Taxpayer Bill of Rights (TABOR) is regarded as the most successful constitutional constraint on government spending in the United States.[116] TABOR restricts growth in tax revenue and spending to the sum of inflation and population growth. It is a simple rule and thus, hard for elected officials to avoid and easy for taxpayers to evaluate. For example, if inflation is 3 percent a year and population growth is stable, government can only increase spending by three percent in nominal terms. If tax revenues increased more than 3 percent in that same year, the surplus is rebated to taxpayers. If government wants to spend beyond this level, they must ask citizens through ballot measures (i.e., citizen initiatives).[117]

TABOR limits have been considered by many other states since TABOR was enacted in 1992.[118] Interestingly, TABOR was enacted through the citizen initiative process. TABOR is an extension of the statutory budget limits put in place in the 1970s. TABOR has been very effective at controlling spending, returning billions to Colorado’s taxpayers. By relying on direct democracy and operating under a simple rule, TABOR fosters discipline in spending. Legislators must present the amount, the purpose, and time in which they intend to spend funds to citizens well in advance of the ballot measure. When a tax surplus results and taxpayers decide funds should be returned to taxpayers, the state is forced to reduce the level of taxation within the limit set by inflation and population growth. TABOR automatically forces government to reduce taxation to the level that reflects the amount citizens wish to spend.

In addition to reflecting voters’ preferences, direct democracy forces transparency in public policy. When elected officials operate under a specific mandate limiting how much they can spend and must ask voters to spend more, this creates an explicit contractual relationship between taxpayers and elected officials. Taxpayers have a clearer picture of how funds are spent, since they must explicitly approve spending and taxation on ballots.[119]

RPCGDP-CO ($)

RPCS-CO ($)

RPCGDP-NJ ($)

RPCS-NJ ($)

1993

37,290

3,821

43,936

2,640

1994

38,456

3,863

44,436

2,700

1995

39,324

3,921

44,893

2,572

1996

40,221

4,177

45,696

2,594

1997

44,114

4,230

46,548

2,511

1998

45,882

4,395

48,214

2,577

1999

47,953

4,706

48,722

2,698

2000

47,820

4,447

49,344

2,792

2001

47,078

4,639

49,958

2,948

2002

46,652

5,124

50,086

3,080

2003

46,452

4,764

50,789

3,055

2004

47,101

4,496

51,883

3,037

2005

48,397

4,491

51,899

3,419

2006

48,694

4,719

52,545

3,291

2007

48,513

4,895

53,108

3,548

Percent Growth, 1993-2007

30.10

28.12

20.88

34.39

RPCGDP-CO: real per capita GDP in Colorado in 2007 dollars
RPCS-CO: real per capita spending in Colorado in 2007 dollars
RPCGDP-NJ: real per capita GDP in New Jersey in 2007 dollars
RPCS-NJ: real per capita spending in New Jersey in 2007 dollars
Sources: CO CAFR, NJ CAFR, US Census, and BEA
Table 2

TABOR’s effects on government growth are noticeable. Between 1993 and 2007, per capita real public expenditure increased by 28.12 percent in Colorado. Over this same period, real state GDP increased by 30.1 percent. The increase in real public spending tracked the increase in real income. The opposite picture emerges in New Jersey, where, during the same period, real spending increased by 34.39 percent and state GDP increased by only 20.88 percent. Public spending in New Jersey increased by far more than its GDP (see table 2). While real per capita spending has increased in Colorado, spending has not overtaken real GDP growth.

TABOR has constrained government by giving taxpayers a say in the level of spending and taxation. Between 1998 and 2008, two out of the six ballot measures seeking approval to spend excess revenues were passed, and four defeated.[120] Taxpayers judged four measures directed funds to undesirable uses. Between 1992 and 2008, eight ballot measures proposing tax increases were introduced, and one passed. Four property tax ballots were introduced between 1996 and 2006, and two passed. Both measures provided tax relief to specific groups, such as the elderly. The defeated measures proposed property tax increases. TABOR also requires voter approval for general obligation debt. Between 1995 and 2005, of the four ballot measures to raise debt, two passed.

As an effective spending constraint, TABOR-type rules are often resisted by legislatures and interest groups.[121] Constituencies that have actively tried to amend it criticize TABOR as “undemocratic,” arguing fiscal decisions should be left to elected officials. In 2000, Amendment 23 was passed, establishing a constitutional mandate for education spending. The amendment allows education spending to increase faster than TABOR’s rule (inflation plus population growth).[122] Moreover, in 2005, Referendum C was passed, suspending TABOR temporarily. The adoption of Referendum C shows that TABOR is a very constraining rule and that voters who have an interest in higher government spending would like to see it repealed.[123]

New Jersey should amend its constitution and adopt a taxpayer bill of rights limiting spending growth to the sum of inflation and population growth.[124] New taxes, spending, or debt initiatives should be put to voters at the ballot. When state GDP per capita grows faster than inflation, the share of public spending can be reduced over time by simply following the rule (provided taxpayers do not vote for extra spending and taxation). Currently, spending in New Jersey is 7 percent of GDP. Over time this may be reduced, particularly considering that New Jersey’s rate of population growth is falling.[125] The political reality of adopting such an amendment cannot be ignored. It took three attempts to amend Colorado’s constitution and pass TABOR, itself the result of the initiative process and institutional entrepreneurship on the part of taxpayer groups and citizens. It is likely that constituencies that benefit from spending, such as teachers’ unions, will actively oppose such an amendment to New Jersey’s constitution.

2. Reform Public Expenditure

Constitutional rules such as TABOR constrain the growth of public spending over time. If we subtract out federal transfers from New Jersey’s budget and apply a TABOR rule to New Jersey’s spending over time, New Jersey’s budget growth is flattened (figure 10). It is possible that New Jersey taxpayers would have voted to expand spending beyond this amount, but they would do so by explicitly choosing a higher level of taxation at the ballot. Instead, New Jersey’s spending growth was achieved through fiscal illusion, masking the true costs of new programs to taxpayers.

Figure 10

Figure 10

Reducing New Jersey’s budget through programmatic cuts faces several practical difficulties. First, much of the budget is mandated by the New Jersey Supreme Court and federal policies. Budget reform is intertwined with school reform and affected by federal actions and policies. However, by following certain principles, the state may begin to identify areas and current activities that may be devolved to local government or privatized. For instance, economist Arthur Seldon established four categories of spending, ranging from goods and services that cannot be provided by the private sector (because it is impracticable or uneconomic) to services that can.[126] This analysis provides a basis for showing that government budgets most often have enough room to reform spending.[127]

A second reason to reduce spending is to simplify New Jersey’s system of taxation. In FY 2009, New Jersey finds itself with almost nothing left to tax. Property taxes are among the highest in the nation; the income tax is extremely progressive. Fees and smaller taxes have grown rapidly in recent years. It is very difficult to finance more spending out of the current tax base. The state and local governments have almost no margin of safety, and it is becoming less sustainable to continue the present trend in public spending. At this stage, it is likely that increases in marginal tax rates (on property or income, for instance) would not yield more revenue.

3. Create a Tax Environment that Favors Growth: Broad Bases and Low Rates

New Jersey has a high-rate, narrow-based system of taxation. It is a discriminatory system containing many exemptions, exceptions, and deductions. Such a system imposes economic costs: administrative, compliance, and behavioral. Summing these costs shows that for each extra dollar of tax revenue raised, the cost to the private sector is greater than the dollar of lost savings or consumption. The objective of tax policy is not only to reduce these costs while meeting revenue goals, but also to make the system as friendly as possible to entrepreneurship and trade. The current tax system in New Jersey is likely to drive taxpayers into tax avoidance (changing behavior or decisions to avoid taxes), tax evasion (failure to pay the tax owed), or tax flight (leaving the state).

Most of New Jersey’s revenues come from four sources: corporate, income, sales, and property taxes.

The Corporation Business Tax is a flat rate of 9 percent, which accounts for 10.5 percent of revenues, roughly $3.08 billion in 2007. The Corporation Business Tax has remained set at 9 percent since 1980 (the corporate tax was raised five times between 1959 and 1975, from 1.75 percent to 7.5 percent). Corporations are subject to the alternative minimum tax.

The Gross Income Tax accounts for 40 percent of the state’s total revenues, $11.7 billion in 2008. The income tax is highly progressive, with rates ranging from zero percent (for the tax-free zone below $10,000) to 10.75 percent (see table 1). All revenues are dedicated to the Property Tax Relief Fund to offset property taxes, with the majority distributed as school and municipal aid and the smallest portion of the fund as rebates to homeowners. The terms of eligibility and size of the homeowner rebate program have changed several times since 1976. Income tax revenues are particularly dependent on high income earners and Wall Street bonus cycles, making this revenue source vulnerable to economic downturns. In 2005, nearly 40 percent of New Jersey’s income tax revenues came from those earning over $500,000.

In some years, property tax rebates are limited to only the elderly and disabled, or those earning under a particular income threshold. The idea behind the fund—that income tax revenues would limit the rise in local property taxes—has failed to work in practice. Over the past 33 years, income taxes have increased and rates are more progressive, and property taxes have risen each year since 1978. While state income taxpayers put an increasing percentage of their income into the Property Tax Relief Fund, they receive less of it back as homeowner rebates.

The Sales and Use Tax is the second largest source of revenue for the state, representing 29.4 percent of revenues or $8.6 billion in 2007. The sales tax, created in 1966 at a rate of 3  percent, contains many exceptions and thus has a very narrow base. Some exemptions include clothing, food, prescription drugs, newspapers, recycling equipment, and farm supplies.[128] The narrow base and many exceptions have led the state to raise the rate of the tax multiple times, most recently to 7 percent in 2006.

The Local Property Tax, levied by municipalities for the operation of local government, accounted for $20.9 billion in revenues in 2006. Exemptions include government property and nonprofits. In 2004, the legislature created Health Enterprise Zones to exempt medical and dental facilities in underserved areas.

Tax Rates Revenue ($b) in 2007 Percentage of total state revenue
Income tax (state) 1.4% to 10.75% $11.7b 40%
Corporate (state) 9% $3.08b 10.5%
Sales (state) 7% max $8.6b 29.4%
Property (local) Range[129] $20.9b N/A
Excises (fuels, cigarettes, & insurance) N/A $2.04b 6.9%
Other N/A[130] $1.15b 4.9%
Table 3

In addition to these primary sources of revenue, motor fuel, cigarette, and insurance excise taxes each account for about 2 to 3 percent of revenues. New Jersey’s remaining taxes each bring in less than 1 percent of revenues. They are discriminatory, targeting highly particular services and activities, including cosmetic medical procedures (rate of 6 percent), hotel/motel occupancy (rate of 7 percent, except in some tourist areas), a domestic security fee on rental cars ($5 per day), nursing home assessments (rate of 6 percent), outdoor advertising (rate of 6 percent), vehicle tires ($1.50 per tire), and sports and entertainment districts (rate of 2 percent). Between 2002 and 2007, the state instituted roughly 102 new taxes and fees (see table 3).

Adding to the negative effects of the tax system’s narrow bases and high rates, the state also offers tax incentives. The Urban Enterprise Zone program offers incentives to businesses to locate in designated cities. New Jersey’s corporate tax offers tax incentives for filmmakers, neighborhood revitalization, and economic recovery projects.  Rather than creating a general, non-discriminatory environment, exceptions and breaks benefit some areas, businesses, and taxpayers at the expense of others. A fundamental flaw of tax incentive policy is that it presupposes legislators know which activities are economically or socially beneficial.

High tax rates and narrow bases create distortions as people change their decisions or put resources toward compliance, leading to a loss of value creation in society. Reform of New Jersey’s tax system should follow a few basic principles. The revenue system should move towards generality in taxation. When all activities face the same low tax burden, it enables individuals and businesses to pursue the broadest range of activities and plan ahead without regard to taxation. Individuals and businesses do not spend resources toward finding loopholes and undertaking activities that promise tax breaks. Rather, they invest and produce in order to create economic value. The least distortionary tax system is one that is broad-based and low-rate. This system raises higher amounts of revenue at a lower cost to economic activity than one with high marginal rates and narrow bases.

Proposals for tax reform often stem from elected officials in need of more revenue or aim at benefiting some constituency. When designing tax policy, one must keep in mind that the natural tendency is for the tax system to be used to satisfy many different goals at the exclusion of sound taxation. The progression of tax policy and spending in New Jersey reveals that much of this system evolved due to the political pressures applied by interest groups to increase spending in certain areas, education in particular. Tax reform must not only consider how the level and kinds of taxes affect individual behavior, but that the tax system is subject to the motives of elected officials.

For this reason, the generality principle should guide tax reforms in order to constrain majoritarian politics to prevent the natural tendency toward discriminatory usage of the taxing authority. The assumption that government requires a certain amount of revenue per period and that reform should determine the right taxing arrangement to generate that revenue should not be the aim of tax policy.[129] Rather, it is important to design a tax system that is the least distortionary to economic activity and that resists the influence of interest groups which aim to use the tax system to further their own private interest.[130]

To move New Jersey to a broad-based, low-rate system of taxation, exemptions, deductions, and breaks should be removed from its main revenue sources: corporate, sales, and income. This will enable the state to expand its taxing base, while lowering (and in the case of the income tax, flattening) the rates of tax. In the case of the income tax, a broad-based, low-rate tax system implies the same rate on all sources of income, for all persons, with no exceptions for any reason. Deductions, exclusions, and exemptions “drive a political wedge between those who are subjected to positive rates… and those who are differentially favored by zero rates.”[131] Importantly, exemptions, deductions, and exclusions from the tax base lead to higher rates of tax on a narrower base.

A tax system that is based on a broad base is also more stable, less subject to economic fluctuations (such as Wall Street bonus cycles or downturns in particular markets). Further, a system that is broad-based with low rates does not induce dramatic behavioral changes—for example, leading high-income earners to leave, change their activities to avoid paying taxes, or evade taxes. In the case of the sales tax, failure to tax all goods equally leads to efficiency losses as individuals engage in substitution to goods and services that are not taxed.

An example to follow for New Jersey is New Zealand, which embarked on a vast tax reform in the late 1980s and early 1990s. The country had high marginal tax rates as well as many exemptions and excises. The tax reforms increased the incentives to engage in market activity because marginal rates on income were reduced (the top marginal income tax rate was halved from 66 percent down to 33 percent) and the base was broadened (the new value-added tax covers almost all sales transactions at a flat, uniform rate). The tax system was designed to be a coherent structure that would minimize deadweight losses and reduce administrative and compliance costs (e.g., most taxpayers don’t even file a tax return anymore). Almost 20 years later, the tax system in New Zealand remains inspired by the broad-based, low-rate approach. The 1999–2008 Labour Government increased the top marginal tax rate on income (to 39 percent) and made a few adverse changes to the system, however.[132]

4.  Re-introduce Competition to Local Government

The existence of 566 municipalities is often offered as evidence of inefficiency in New Jersey’s local governments. It is argued that economies of scale can be achieved through the merger of smaller towns. There is truth to this. New Jersey’s municipal boundaries have been set in place since the 1950s. There is no reason to think their current arrangement is optimal. However, the state government does not know what the optimal number should be. This can only be decided by citizens on the local level. And the optimal number can only be revealed when municipalities are fiscally autonomous, by scaling back state aid and lifting mandates.

In the 1930s, many municipalities experienced fiscal stress and ended up in default. The state began a gradual program of awarding aid to municipal governments. The effect was to remove the need for municipalities to merge, dissolve, or consolidate services. State aid created a relationship of fiscal dependence with many municipal governments. The current number of municipal governments is not a cause of wasted public dollars, but a consequence. Other factors, including the advent of zoning, which eliminated the possibility of citizens incorporating new towns, helped make permanent New Jersey’s present boundaries.

The consolidation of small towns (many of which do not receive high amounts of state aid) or the regionalization of services and their provision by the state level will not save the state money. Local autonomy is incompatible with state aid and state mandates. Reducing spending and finding the optimal number of municipalities is best achieved by reintroducing fiscal competition in New Jersey, which includes letting municipalities discover other ways of providing public goods (privatization, service sharing)  and allowing local governments to compete for citizens and businesses. Reintroducing competition and markets is the surest way to reduce spending by cutting costs. Education and government services are good candidates for competition, where outsourcing, open tender, chartering, and vouchers can be used. Some spending should also be reduced through budget cuts.

5. Clarify the New Jersey Constitution’s Education Clause

The legislature should consider amending the New Jersey Constitution to clarify certain clauses, in particular the education clause. The New Jersey Supreme Court has determined the policy direction of the legislature in providing public education through the Abbott decisions. In an effort to guarantee that students in poor districts receive the same quality of education as students in rich districts, the court directed the legislature to dedicate an ever-increasing amount of tax revenues to the 31 court-designated districts. In spite of this massive reallocation and the growth of the income tax in New Jersey, there has been little improvement in educational outcomes. Various resolutions have been introduced. In 2004, Resolution 38, sponsored by Senator Leonard Lance, described how the legislature should provide and fund a “thorough and efficient system of free public schools.” The resolution did not pass, but was reintroduced as Resolution 44 in 2008.


[115] Ruger and Sorens, Freedom in the 50 States. Fiscal policy includes local budget constraints—the extent to which local governments depend on their own resources rather than grants from higher levels of government.

[116] For an in-depth treatment of  TABOR, see Barry Poulson, “Tax and Spending Limits: Theory, Analysis, and Policy,” Issue Paper 2-2004 (Golden, CO: Independence Institute, 2004); Barry Poulson “Colorado’s TABOR Amendment: Recent Trends and Future Prospects,” Americans for Prosperity Foundation (July 2004); Poulson, “Local Tax and Spending Limits in Historical Perspective,” Americans for Prosperity Foundation (2006); and Poulson, “Colorado’s Taxpayer Bill of Rights (TABOR) Amendment: An Experiment in Direct Democracy,” Americans for Prosperity Foundation (2009).

[117]117 New Jersey does not currently have an initiative or referendum process. Legislation was introduced in 2001–2002 proposing a modified form, limiting what citizens can place on the ballot to issues of government reform and procedures to limit the frequency of initiatives. See Craig B. Holman, “An Assessment of New Jersey’s Proposed Limited Initiative Process,” Brennan Center for Justice at NYU School of Law (December 2000), https://www.policyarchive.org/bitstream/handle/10207/8720/njproposedlimited.pdf?sequence=1/.

[118] See Barry Poulson, “Tax and Spending Limits.”

[119] This stands in contrast to taxpayers as auditors:  monitoring spending by reading budgets in an attempt to figure out post-appropriation, how government dedicated funds to various spending programs.

[120] For a history of Colorado’s ballots, see http://www.leg.state.co.us/lcs/ballothistory.nsf. See also Poulson, “Colorado’s Taxpayer Bill of Rights (TABOR) Amendment: An Experiment in Direct Democracy.”

[121] California abandoned a TABOR-like proposal in the 1990s, known as GANN. See http://www.cato.org/pub_display.php?pub_id=2871.

[122] For more on Amendment 23, see http://www.state.co.us/gov_dir/leg_dir/lcsstaff/2003/FinalReports/03GallagherFinalReport.pdf.

[123] Barry W. Poulson, “What Is at Stake in the Current Battle over Colorado’s Tax and Spending Limits?” Issue Backgrounder (Independence Institute: March 2009), http://www.i2i.org/articles/IB_2009_C_a.pdf. Ironically, the suspension of TABOR came at the time of the 2008 recession, which has limited the capacity of the state to increase its spending.

[124] A constitutional amendment may not be obtained at first. It took three ballot measures before the Colorado legislature voted in favor of TABOR (54 to 46).

[125] In 2007 population increased in New Jersey. However the rate of growth is declining. By 2009, it is possible that New Jersey is experiencing negative population growth. More people are moving out of New Jersey than moving in. Between 2000 and 2006, New Jersey lost 377,000 residents to other states. See James W. Hughes and Joseph J. Seneca, “New Jersey- Outward Bound” New Jersey Star Ledger, July 20, 2007.

[126] Arthur Seldon, Individual Liberty, Public Goods, and Representative Democracy, in The Collected Works of Arthur Seldon, volume 5 (Indianapolis: Liberty Fund, 2005).

[127] See table 4 in appendix C that applies the Seldon approach to the New Jersey state budget.

[128] State of New Jersey Department of the Treasury Division of Taxation, 2007 Annual Report, 47-50.

[129] James Buchanan, “The Power to Tax: Analytical Foundations of a Fiscal Constitution,” The Collected Works of James Buchanan, Vol. 9 (Indianapolis: Liberty Fund, 1980), 68-71.

[130] This may mean changing the level of public spending as there is no reason to assume the current level of tax revenue and public spending in New Jersey as optimal.

[131] Ibid., 407. As Buchanan notes, “One of the most disturbing features of several modern income tax “reforms” has been the removal of persons from the tax rolls, a step that necessarily sets up the parameters for exacerbated distributional politics.”

[132] See Frederic Sautet, “Why Have Kiwis Not Become Tigers: Reforms, Entrepreneurship, and Economic Performance in New Zealand.” The Independent Review 10 (2006): 573-597.