2. The State of the State
New Jersey’s recent experience contrasts sharply with its modern history. In the last 150 years, the state underwent two economic transformations, moving from an agricultural to a manufacturing economy at the turn of the 20th century and then to a knowledge-based economy by the end of the 20th century, “and each time successfully reinvented itself—by itself.” Both transformations “took place in a public policy vacuum.”
From mid-century into the 1960s, the state’s economy was robust, growing steadily and at times dramatically. Between 1960 and 1970, the state added 589,199 jobs, increasing employment by 29 percent, a record not yet surpassed. During this period, the state had no sales tax and no income tax. As the manufacturing sector declined in the 1970s, New Jersey lost jobs, while the service and information sectors began their acceleration, creating another boom period between 1980 and 1990 during which the state added 589,100 jobs. New Jersey’s fortunes began to change in the 1990s. Job growth, still robust in the financial services, technology, and business and services sectors, was not at the same level as in previous decades.
The late 1960s to the present is a period of active state, and local, government growth. In 1966 the state instituted a sales tax of 3 percent to pay for the expansion of the state’s college system. Today it is seven percent. In 1976, a nearly flat income tax was adopted (2 percent on those earning below $20,000 and 2.5 percent on those earning above $20,100) to provide supplemental revenues for schools and local budgets and to lower local property tax burdens. Today, the income tax has eight brackets with a new top rate of 10.75 percent on those earning over $1,000,000. Property tax relief was not achieved with the new income tax, and property taxes have risen each year since 1978. Numerous other taxes have been levied during this period, most recently the addition of 102 new smaller taxes and fees between 2002 and 2007. The result of this period has been the gradual erosion of the state’s economic and financial resiliency.
New Jersey’s spending growth in the late 1990s coincided with signs of anemia in the state’s economy. Between 2000 and 2005, New Jersey began to lose high-paying service and manufacturing jobs, replaced by low-paying service jobs and public-sector, taxpayer-dependent jobs. Public sector growth was most pronounced on the local level in education. Between 1990 and 2002, local government added 45,400 jobs and the state added 7,900, nearly all due to education.
Three indicators—spending (appropriations) as a percent of state domestic product (GDP), debt as a percent of GDP, and the size of federal transfers in New Jersey’s budget—capture the erosion of New Jersey’s economic resiliency and the creation of the current fiscal crisis.
Public spending in New Jersey doubled in real terms, as a percentage of GDP, between 1971 and 2008 (figure 2).
In the last ten years, the proportion of government spending to state GDP increased from 5.4 percent in 1997 to 7.05 percent in 2008 (figure 3).
Most economists agree that some level of public of spending is necessary, but too much public spending can hurt economic growth. In addition to consuming a larger portion of the state’s income, government spending dedicates resources to activities that may or may not be needed in society. Because government cannot calculate economic profit and loss, it cannot ultimately know whether alternative ways of spending money create value, and thus cannot know what resources are most urgently needed in society. What individuals want can only be revealed through voluntary trade. Government has no access to this information as it operates outside market exchange. As a result, government allocates resources according to political criteria, which does not often lead to rational allocation.
Government policy most often entails the forced migration of resources from the decentralized realm of individual decision making (markets), to the centralized control of the public sector. As more resources are transferred, however, the process of entrepreneurial discovery is gradually replaced by a command-and-control regime, which is ultimately irrational.
It is not only the amount of public spending relative to GDP that matters, but the way in which spending in New Jersey has grown, by relying on debt and intergovernmental aid. Both of these mechanisms encourage “fiscal illusion,” obscuring the full costs of policies to voters.
New Jersey state-level debt more than doubled in real terms from 4.4 percent of GDP in 2001 to 9.48 percent of GDP in 2008 (figure 4). Debt jumped between 2003 and 2006, due to the $3.3 billion tobacco settlement securitization in 2003 and a $7.3 billion debt issuance in 2006. In 2008, debt totaled $5,187 per resident, or $20,748 for a family of four.
In the last 15 years, federal grants to New Jersey have increased by 20 percent in real terms (figure 5). Today, federal funds represent roughly 24 percent of New Jersey’s budget. The largest cost driver in this category is Medicaid, since states must match part of the cost of the program.
Intergovernmental aid, as spending that is not raised through direct state taxation, creates “fiscal illusion.” Fiscal illusion occurs when the full cost of expanded spending is spread across all federal taxpayers (or over time, in the case of debt), thus diluting the perceived cost of such spending to state taxpayers and elected officials. Federal grants are designed to augment state spending in areas important to the federal government, effectively nationalizing activities that were previously in the domain of the state or local government or the private sector. Additionally, federal grants often stimulate additional state spending on federally designated activities, leading the state to expand its budget beyond what is provided by the federal grants.
Grants-in-aid became a feature of state budgets during the Johnson Administration’s Great Society and War on Poverty initiatives. Major new federal programs were created in education, welfare, transit, urban aid, criminal justice, and the arts. The magnitude and scope of new federal initiatives transformed state government finances and eroded the policy and fiscal autonomy of state governments. Between 1965 and 1969, New Jersey’s budget doubled in nominal terms from $584 million to $1.08 billion. While many federal programs were eventually scaled down or eliminated in the 1970s and 1980s, others remained, and still more were added, receiving variable levels of federal funding over the decades.
 James W. Hughes and Joseph J. Seneca, “Then and Now: Sixty Years of Economic Change in New Jersey,” Rutgers Regional Report, Issue Paper no. 20, Edward Bloustein School of Planning and Public Policy at Rutgers University, January 2004, 4.
 Ibid., 5.
 Ibid., 5.
 According to James W. Hughes and Joseph J. Seneca, between 2000 and 2005, New Jersey lost 18,700 jobs in financial services, information and professional and business services, and 117,600 high-paying advanced services and manufacturing jobs. Job growth occurred in lower-paying sectors. Education and health care gained 60,800 jobs; leisure and hospitality gained 35,900 jobs; and other services gained 16,500 jobs. See Hughes and Seneca, “New Jersey’s New Economy Growth Challenges,” Rutgers Regional Report, Issue Paper no. 25, Edward J. Bloustein School of Planning and Public Policy at Rutgers University, July 2006, 3.
 Hughes and Seneca, “Then and Now: Sixty Years of Economic Change in New Jersey,” 23.
 We use appropriations between 1951 to the present, as stated in the FY 2010 budget. See http://www.state.nj.us/treasury/omb/publications/10bib/BIB.pdf.
 The literature on government size and its effects on economic growth is voluminous. See, for example, Robert J. Barro, “Economic Growth in a Cross Section of Countries,” Quarterly Journal of Economics, 106(2) (1991); E.A. Peden, “Productivity in the United States and its Relationship to Government Activity: An Analysis of 57 Years, 1929-1986,” Public Choice 69 (1991): 153-173; James Gwartney, Randall Holcombe, and Robert Lawson, “The Scope of Government and the Wealth of Nations,” Cato Journal, 18, no. 2 (1998); and Daniel J. Mitchell, “The Impact of Government Spending on Economic Growth,” Backgrounder, no. 1831, The Heritage Foundation, March 31, 2005. On the effects of fiscal policy, see, for instance, Alberto Alesina, Silvia Ardagana, Roberto Perotti, and Fabio Schiantarelli, “Fiscal Policy, Profits, and Investment,” (NBER Working Paper No. 7207, July 1999).
 This is known as the “economic calculation problem,” and is the major reason why central planning in a socialist economy is impossible. See chapter XXVI, “The Impossibility of Economic Calculation under Socialism,” in Ludwig von Mises, Human Action, Fourth Edition, ed. Bettina B. Greaves (Irvington: Foundation for Economic Education 1996), http://mises.org/humanaction/chap26sec1.asp and Friedrich Hayek, “The Use of Knowledge in Society,” American Economic Review, XXXV, no. 4 (September 1945): 519-30, http://www.econlib.org/library/Essays/hykKnw1.html.
 Kenneth Arrow’s Impossibility Theorem demonstrates that no system of voting can convert the ranked preferences of individuals into a community-wide ranking while also meeting a certain set of reasonable criteria, such as absence of dictatorship. In other words, governments cannot possibly aggregate individuals’ preferences and make collective decisions that would satisfy everyone as if unanimity was achieved. Arrow demonstrated the limits of collective choice in a democratic system of majoritarian voting. See Kenneth Arrow, “A Difficulty in the Concept of Social Welfare,” Journal of Political Economy 58, no. 4 (1950): 328–346.
 See Israel Kirzner, Discovery and the Capitalist Process (Chicago: University of Chicago Press, 1950).
 Federal grants-in-aid change the division of responsibility within the federal system and “involve a revision of the Constitution but without formal amendment.” See Richard E. Wagner, Public Finance: Revenues and Expenditures in a Democratic Society (New York: Little Brown and Company, 1983), 466.