State governments are enormously complex entities. In the U.S. our 50 states represent an extraordinary heterogeneous group in their geographic size, population, natural resource endowment, climate, altitude, access to navigable water and a myriad of other factors. Each state has its own constitution and statutory framework that defines how it operates. Due to federalism, the joint relationships that states have with the federal government and local governments to provide services mean that states are aptly described as "complex systems," defined by the Business Dictionary as "consisting of many diverse and autonomous but interrelated and interdependent components or parts linked through many (dense) interconnections."
The financial operations of states require hundreds of non-General Fund accounts—special revenue, enterprise and trust funds—to deal with all of the activity. Because states differ from each other so significantly, and other factors, I am skeptical of the value of attempts to boil down state government fiscal performance into bite size chunks, as in the Mercatus Research publication "Ranking the States by Fiscal Condition, 2016 Edition," and generally regard these activities as Quixotic exercises fraught with data problems and ripe for misinterpretation.
Providing rankings for the fiscal performance of states is a popular endeavor. But what constitutes good financial performance and by whose criteria? The optimal amount of cash, budget solvency, long-run solvency, service solvency, and trust fund solvency (the five broad performance areas evaluated by Mercatus) do not have established norms that can be universally applied to all states. The selection, weighting, and aggregation of a relatively small number of balance sheet and income statement metrics would be expected to vary considerably depending on who constructed them and for what purpose. Creditors would establish criteria substantially different from taxpayers, pensioners, and vendors.
Additionally, the economic characteristics of each state figure prominently in its financial performance and financial metrics. The Federal Reserve Bank of St. Louis, in "The Growth and Volatility of State Tax Revenue," by Gary C. Cornia and Ray D. Nelson, said that "Because state economies do not react uniformly to the national business cycle, state officials must take care that they tailor policy proposals to the unique characteristics of their economy."
The Mercatus state ranking system implies that each variable can be evaluated independently of all others. Higher performance is always achieved by being on the "correct" side of the distribution for each metric, as far from the median as possible. All variables are weighted equally, meaning that a cash metric is as important as a service metric. All states are regarded as the same, whether big or small, and no allowance is made for whether additional cash may be a necessity, as in an oil dependent state, or a waste, as in a state with a stable service-based economy. All performance is regarded as linear, as opposed to real-world situations, where the increasing lack of cash can create risk that grows exponentially as the number of days cash on hand declines to a precious few days. In the Mercatus system, more cash is always better than less, and less debt is always better than more, without regard for the unique endowments, strategies, and tradeoffs confronting a given state.
Not long ago we reviewed eight states, all with S&P AA ratings, which had enormous dispersion in per capita income, per capita debt, the percentage of their pensions that were funded, population growth rates and a variety of other economic and financial statistics; but which still were evaluated at the S&P AA rating level. The fact is that states have a large number of important criteria that contribute to credit quality, and weaknesses in one or more areas can be offset by strengths elsewhere. Thus, good fiscal performance can be attained through more than one set of public policies that may have differing implications for the performance of Mercatus' 14 metrics. For example, states with greater infrastructure needs may be wise to carry more debt and endure a lower Mercatus ranking, rather than choose to neglect critical investment needs.
Think tanks, business groups, lobbyists and politicians are fond of blowing their horns when their state fares well in someone's ranking study. Poor rankings provide ammunition for calls to cut taxes, limit debt, or engage in other financial strategies that meet the needs of the special interest group, but not necessarily the needs of, or the will of the voters. Survey output with rankings makes for great soundbites. A continual refrain in Illinois has been the lack of business competitiveness and a popular mantra is that the state is a "high tax" state. In "The Illinois budget crisis in context: A history of poor fiscal performance," Thomas Walstrum, a business economist for the Chicago Fed, shows how Illinois has been a low-expenditure, low-revenue state that lost control of its expenditure controls in the mid-1990's when the pension crisis became more severe. The state remains a "low-revenue" state, however, and is not a high tax state so much as a high expenditure state. Understanding what drives performance is supported by context.
A deficiency of this particular study is that it uses two-year old data. Using FY2014 data, Alaska captured Mercatus' #1 rank for Budget Solvency. The price of oil plunged a week after the close of FY2014 and Alaska has subsequently been torched by a severe decline in severance tax revenue, pushing the state to consider the unthinkable—the adoption of a personal income tax. Additionally, Alaska has burned through most of one of its reserve funds, leaving resources sufficient for only about one more year of budget stabilization, and the state is considering legislation to use the Permanent Fund, heretofore held in sacred trust to pay dividends to Alaska residents. The use of more robust metrics, for example, revenue volatility and degree of dependency on a single economic tax source, would have given the Mercatus ranking system greater usefulness.
State fiscal performance rankings, in concept, can be useful. The path towards developing a system that captures the many nuances and unique features of each of these 50 highly diverse entities, however, is fraught with statistical and methodological problems. The output can reflect the ideology of the author of the ranking system. Ultimately, many of these ranking systems may simply be an ill-advised shortcut when a more complete analysis is needed.
Chris Mier is managing director in the Analytical Services Division at Loop Capital Markets.
