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ONE-ON-ONE - May 2006
by Ed G. Lane
'The Budget Is the Ultimate Policy Statement'
State Budget Director Brad Cowgill talks about the factors involved in overseeing Kentucky's finances
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Brad Cowgill
Prior to being appointed budget director for the Commonwealth of Kentucky, Brad Cowgill practiced law with Stites and Harbison, PLLC, concentrating in corporate matters and commercial litigation. Cowgill has also been highly involved in local business and civic issues, serving on the boards of the Kentucky Chamber of Commerce, the Greater Lexington Chamber of Commerce, the United Way of the Bluegrass, and Lexington Community College, among numerous other organizations. He has been active in the leadership of the Governor’s Scholars Program, Lexington United, the Better Business Bureau and Bluegrass Tomorrow. In 1984, he was recognized as Lexington’s “Outstanding Young Man.” A native of Lexington, Cowgill earned his bachelor’s degree from Vanderbilt University and his juris doctor degree from the University of Kentucky. |
Ed Lane: The biennium budget process is over. After the governor’s recent vetoes, approximately how much will general fund expenditures be in FY 07 and FY 08?
Brad Cowgill: It’s about $18 billion spread across two years. The governor’s vetos were primarily, but not exclusively, in the capital budget. A dollar of reduced bonding normally reduces annual debt service by about 10 cents. There were $370 million worth of vetos in the capital budget; on an annualized basis that is a $37 million reduction in debt service.
Not all of the reductions were in the general fund; some of the vetoed bond issues were “agency bonds” that have a revenue stream pledged to support the debt or income generated by the project itself.
EL: The general assembly approved $2.38 billion in bonds and the governor cut about $370.3 million of that, or 15.8 percent of the authorized amount.
BC: Yes, the governor has been concerned about the high level of debt that has been authorized in the last two sessions. The new debt authorized by the legislature, in our opinion, was excessive. The governor didn’t take any particular joy in having to veto a number of projects for the purpose of reducing long-term debt.
Long-term debt service tends to make a government’s budget less responsive to new opportunities simply because debt service is the one financial commitment government has to fulfill. Bonds also impose a burden on young people who will be repaying that debt generally over a period of about 20 years. And the governor has also been concerned at the level of risk that debt poses to the state if it experiences a dramatic business cycle.
EL: It’s one issue to borrow the money to build a facility. Once built, the state has to manage the building and pay for operating costs that go on year after year.
BC: You are exactly right. In addition to debt, there is a long-term operating cost burden. One of the things we have not done well in Kentucky is to maintain the buildings that we’ve already built. There’s always a lot of enthusiasm for new brick-and-mortar projects which create new naming opportunities and create a lot of advertising value. A large number of buildings all over the state are capable of fulfilling their original mission if they were only well maintained.
EL: How were the governor’s vetoes determined?
 BC: The governor believed it was imperative to reduce the total amount of debt that had been authorized by the general assembly: $2.38 billion is an all time high for the state of Kentucky. The state had just set a new record last spring when the general assembly authorized $1.9 billion in debt. In a mere 12 months, the state exceeded its previous record and the increase was enough that we felt it would threaten the bond rating. The governor felt he had no choice but to veto some projects and reduce that debt.
There were three principles that guided veto selections. First, he wanted to retain projects that had a direct impact on new opportunities for individuals. Second, the governor wanted to spread projects widely across the state in the interest of fairness. The third focus was on economic development opportunities – the speed in which development would occur and how strong its impact would be.
EL: What are the key factors evaluated by bond rating agencies?
BC: Three things rating agencies look at are structural imbalance, the rainy day fund, total volume of debt. The rainy day fund is one of those items where the most the governor can do is to propose a budget to the legislature that advances good fiscal management objectives. After the general assembly has adopted a budget, there’s not a whole lot for the governor to do by way of his veto power because the rainy day fund – like the structural imbalance – is largely an operating budget issue.
EL: What is the current balance in the state’s rainy day fund?
BC: Right now it’s $119 million and it increased to that level last summer when the state ended FY 05 with a very strong $214 million surplus. The governor was very concerned that the rainy day fund had been depleted to a level that made it almost insignificant in terms of the protection it afforded and insignificant to our bond rating. State law limited the amount of the deposit that could be made; the new deposit was $90 million.
EL: $119 million isn’t really that much for an emergency reserve. What is an optimum level?
BC: NASBO (National Association of State Budget Officers) recommends a rainy day fund of about 2.5 percent of general fund revenue. We consider $300 million to be a good target. There have been times that much money was in our rainy day fund; then, along came bad economic times and we used it.
The rainy day fund has become more and more important from a fiscal planning perspective by virtue of the fact the Fletcher administration has cut so much flab and inefficiencies out of the agencies of government. The effect is that our rainy day fund has become the main mitigator of risk. There was a time in the state’s history there was enough buoyancy in our agency budgets. If we encountered a downturn then in our revenue cycle, we could simply scale back without doing any real harm.
Over the course of the last two and a half years, the Fletcher administration has dramatically reduced the cost of general government operations. This year, for example, state government will spend $142 million less in government operations than the legislators appropriated in spending this year. That is absolutely unprecedented and that is real dollars.
EL: To what do you attribute higher efficiency levels?
BC: The governor simply brought into public service a collection of cabinet secretaries that exhibited a lot of private sector experience. The governor made the efficient operation of government the principal objective of the administration over the first year and a half. The cabinet secretaries on whom this responsibility ultimately fell simply saluted to the boss and said, “Yes, we’ll do it.”
As you may remember, Gov. Paul Patton had predicted that if Kentucky did not do a tax increase state government would be under water by $1 billion by June 30, 2005. On June 30, 2005, the Fletcher Administration was running a $214 million surplus, largely as a result of savings and efficiencies that had been produced in those first 18 to 20 months of the administration.
EL: Did the general assembly’s failure to pass a budget in FY 05 help the administration save money?
BC: There were some significant benefits – although I would tell you that the disadvantages outweighed the advantages. You are correct in observing that there were some advantages, one of which was that the governor had almost complete control over the budget. We ran the government for a period of about nine months beginning July1, 2004 through about March 2005 with no budget at all. By using executive orders as our control device, we were able to have such a large surplus by the end of that fiscal year.
EL: Keeping Kentucky’s budget in structural balance (assuring future revenues can meet recurring expenditures) is probably the top priority of the executive branch of state government. Where do you have concerns about structural imbalance in the budget and what are you doing to overcome that?
BC: Structural imbalance usually focuses on the second year of the biennial budget. If you planned your budget correctly, you would be able to treat that second year as if it were a box and you would know that the revenue being generated in that box would be at least as great as the expenditures that the general assembly is going to make.
Unfortunately, the second year of the state’s biennial budget (FY08) is imbalanced by about $580 million. This is a high level of structural imbalance, and roughly as large as any structural imbalance the state has had in the past.
FY 08 is balanced in the sense that financial resources and expenditures are nearly the same. The problem is that a lot of the money being spent in the second year is surplus revenue (savings) carried forward from the previous fiscal years. Bringing this money in from outside the box is the structural imbalance.
EL: Restated, you are saying that $580 million in surplus funds for FY 07 will be rolling over into FY 08. So even though the state has the revenue in FY 08 to spend, it doesn’t have sustaining revenues for future fiscal years.
BC: That is exactly right. Our administration saved a lot of money this year and last year, so by the end of this fiscal year on June 30, 2006, the state will be carrying forward about half a billion dollars of surplus cash. This is absolutely an unprecedented amount of cash to be carrying forward from one year to another. When the state enters the next biennium beginning with FY 09, we are going to have to sustain the commitments funded in FY 08.
EL: How do you define structural imbalance?
BC: When I use that term a lot of people’s eyes glaze over. Structural imbalance refers to a situation in which government has made an ongoing financial commitment which is not sustainable based on the future projected revenue. That is the condition that accurately describes the budget in the second year of this next biennium.
Structural imbalance is a very difficult condition for a governor to correct through veto. Structural imbalance is primarily a problem on the operating side as distinguished from the capital side of the budget. The general problem that causes structural imbalance is that government is simply spending too much money.
EL: The options are either reduce personnel or streamline the government.
BC: True. But in this case, the administration has already done that. If we thought more streamlining over the course of the next biennium was possible we would have already budgeted the reduction.
Public education is the single biggest item by far in the state budget. The idea of reducing structural imbalance by any personnel-related initiative is ultimately limited by the fact that the state is funding a lot of school districts, but it doesn’t have direct management responsibilities.
EL: Why was $17.5 million in bond cost cut from repairs on the lock and dam system on the Kentucky River?
 BC: The governor’s action on the Kentucky River bonds for locks and dams was primarily motivated by a concern for the total volume of state debt. One of the things we looked at was whether any veto would actually impact the rate of progress on some of these projects. The general assembly had authorized two Kentucky River bond issues: one was $17 million and another was $33 million. It seemed very unlikely that within this particular biennium that the river authority would be able to spend the entire $50 million dollars. This gets into a very complicated question as to whether the general assembly should authorize bonds within a biennial budget in an amount sufficient enough to fund the entire project, even if they expect the project can’t be completed within that biennium. There are advantages and disadvantages on both sides.
Our concern again has been on the state’s credit when the bond rating agencies look at each of the bond issues. We don’t think we are actually restraining the progress of the water project, and if additional money is needed beyond the $33 million issue, then the general assembly can authorize that in a subsequent session.
EL: Let’s discuss the impact of the “prevailing wage” laws on state budgets. Why is the Fletcher administration trying to do away with the prevailing wages concept?
BC: There is a great demand for the construction of more state projects, including university buildings and schoolhouses. There is a limited amount of revenue available to pay for those structures. It is natural to want to construct these structures at the very best price we can. That calls our attention to the current effect the prevailing wage law has on the cost of construction. A study indicates that cost would be increased between 6 to 7 percent by the prevailing wage law.
EL: How much would the $2 billion of capital expenditures be reduced by competitive bidding?
BC: The 6 percent figure on top of that figure would probably not be accurate for two reasons. The first is, included within the $2 billion are a lot of projects that do not involve any construction at all. Projects that do involve construction include material and in some cases land acquisitions which would not be affected by prevailing wages. Out of the total $2 billion, we could prepare a ballpark estimate. In any event, the savings would be a very, very large figure.
EL: The savings could have funded a number of additional projects.
BD: Exactly. Our feeling is the prevailing wage law is an idea whose time has come and gone. Higher labor costs have not achieved any noticeable change in the quality of the projects, largely because in Kentucky the contractors who build public construction projects are the very same contractors who build private construction projects. So the quality we get in public construction in Kentucky is the same.
EL: Would you say the prevailing wage basically takes the free market economy out of the bid process and the state has to pay the higher rates?
BC: The prevailing wage law creates an artificially high minimum wage for specific occupations on specific public projects in specific counties. It means in some cases that we’re paying $30 an hour to people who merely sweep the floor. Clearly the unions have advocated prevailing wage laws because they tend to favor the employment of union contractors, but it’s had a very negative affect in Kentucky. It means that Kentucky is paying more and getting less.
It also means we are exporting a lot of jobs to tradesmen from other states. The cost of doing business in Kentucky is lower than in nearby states. By virtue of that fact, Kentucky firms should be more competitive when it comes to performing public projects. But the prevailing wage which requires higher-than-market wages unfortunately denies the Kentucky contractors and their employees the benefit of their competitive advantage, so that they are likely to lose the bid to a union contractor that comes in from another state.
EL: You review monthly economic and tax collection data from around the state. How well is Kentucky’s economy performing?
BC: Since Gov. Fletcher was inaugurated, the Kentucky economy has been on a fairly strong up-tick. That fact is primarily a result of national forces beyond our control.
Economic development in Kentucky could have slowed if the companies here and elsewhere did not have confidence in the quality of the government’s general management. Our economic development cabinet has done an exemplary job identifying opportunities for the state. The repeal of the corporate license tax, in particular, will have a positive impact on economic development for decades to come.
The Kentucky economy is not growing at a rate equal to the national average. The growth and the steadiness are a very positive trend, even if the economy is not growing as fast as the national average right now. Generally speaking, things happen a little later in Kentucky than they have elsewhere. Our prediction for the next two years of this biennium is quite positive with growth somewhere in the 4 to 5 percent range.
A continued weakness in Kentucky is employment. We have added a tremendous number of jobs in the past two and a half years, but unemployment in Kentucky is still greater than the national average.
Education levels in the state of Kentucky are probably the most significant challenge in terms of the economic growth of the state. I continue to be concerned about the outmigration of some of our best and brightest students and skilled people.
EL: The state’s budget revenue forecasts are prepared by the Consensus Forecasting Group (CFG). How is that set up and how do they forecast?
BC: It is a collection of economists, independent of state government and drawn largely from academe, and staff provided by the Legislative Research Commission and by my office. The CFG meets periodically for the purpose of making forecast of revenue into the general fund and into the various restricted funds based on economic trends.
EL: Have the CFG’s estimates been reliable?
BC: Yes, the CFG’s track record is slightly better than the national average. It’s been particularly good over the course of the past 18 months. No matter how confident we feel about the economy, it’s always possible that we’ll encounter a condition like Katrina or 9/11 that will change all of our economic expectations.
EL: Gov. Fletcher is proposing a special session to modify the alternative minimum tax on small businesses. Please explain the governor’s concern.
BC: As part of the tax modernization, the corporate income tax was completely re-written so that is no longer merely a tax on net income. It is a tax on net income, gross receipts, or gross profits, depending on which of the three calculations results in the lowest amount of the tax. The alternative minimum calculation is on the gross receipts and gross profits of a business. Businesses are permitted to choose whichever will help reduce their taxes, but they have to pay one or the other if that amount is higher than the tax on net income.
The idea of the alternative minimum tax calculation was to create an obligation on the part of business taxpayers to pay something even in years when they have no net income at all. The object was to create some level of stability in our revenue stream. The rate of corporate taxation was reduced from 8.25 percent to 6 percent, and that has been made possible in part by this minimum taxation calculation.
When the governor prepared the budget back in December, he decided to use some of the surplus funds to provide a tax break for small businesses. The proposal he made was to completely eliminate the AMC for companies whose gross receipts were less than two million. For companies whose gross receipts where $2 to $10 million, the companies would get a proportional reduction in their AMC obligation. That proposal was ultimately approved by the legislature and is part of the enacted budget. Clearly, the governor did not veto any part of that proposal.
What arose in the middle of the session was a new tax plan which focused on gross profits instead of gross receipts. That plan seemed to be more popular in each of the two houses, even though they were ultimately unable to reach an agreement on the details of the plan.
EL: How have higher gasoline prices increased road fund revenues?
BC: When we prepare the budget, the Consensus Forecasting Group looks not only at the quantity of gasoline expected to be purchased but also the retail price at the pumps. The amount of tax will vary with the price of the gasoline. The legislature believes Kentucky should issue new road bonds. Seventy-five million dollars in road bonds was included in the governor’s budget. The legislators increased that to $350 million.
The legislature believed correctly that if we are going to be issuing $350 million of bonds then we needed to stabilize and render a more predictable amount of money that would come into the road fund from the gasoline taxes. I usually use the word “ratchet” tax. The rate won’t go down, it can go up. It doesn’t look as if the action taken by the legislators will actually affect the total amount that drivers will be paying because our prediction was that the rate of taxation on gas would have gone up under the old formula anyway.
EL: Specifically, what improvements has your office made to make government financial issues more transparent for Kentucky’s citizens and taxpayers?
BC: The general role of the budget office has been transformed in the two and a half years that I have been there, and probably the year or so before I got there. The budget office traditionally had been more focused on the task of taking a policy and translating that into a program and a budget initiative.
In recent years, the budget office’s primary responsibility has been to find ways of running an existing program more efficiently and getting as much program as possible out of a fairly limited amount of dollars. Our office had to work extremely hard to figure out a way to get through the next biennium within the available dollars and continue to provide the essential services that Kentuckians depend on.
If there is a single thing I believe in, it is the information that we are dealing in should be available to all Kentuckians and we’ve made as much of that available as we can on the Web site of the budget office and will continue to do so.
EL: Gov. Fletcher’s health was a major concern just a few months ago. What change in the governor have you noticed since his return to work?
BC: The governor is very much back in good health. His strength and general level of weight has come back, he looks very good and the enthusiasm has returned to his voice. His sense of humor has returned. The governor wanted to be kept up to date and wanted the people in his administration to know where he stood on things, so even when he was laid up in bed he was still very active.
EL: Do you have a closing comment?
BC: I have come to realize the budget is really the embodiment of so much of what Kentucky aspires to be. It is the ultimate policy statement. There is a quotation that originates in the Bible and it says, “Where your treasure is, there will your heart be also.” That expression applies especially to the budget aspect of state government. Where your money is, that’s where your goals are and so we want the budget, which is ultimately a marriage of appropriations and revenue, to be an accurate description of the state’s ultimate goals.
Ed G. Lane is chief executive of Lane Consultants Inc. and publisher
of The Lane Report.
edlane@lanereport.com
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