A great deal has been made lately of state government financial woes ó how much is the revenue shortfall and whose budget will be cut, and by how much. A lot of focus is on political posturing and the assorted squabbling that comes with it, short term patches with the possibility of the state trying to raise more revenue, and the casino gambling option lurking about somewhere. But we seem to be losing sight of the big picture. With the state's roughly $9 billion budget, there's lot of cash at stake. So the questions I'd like to raise are pretty fundamental ones: What incentives are there for our tax revenue to be spent the right way? And what is the right way? I'm not going to be presumptuous enough to proclaim that I have a grand scheme that provides a specific solution to every problem. But I will point out an important aspect of our state and local tax and expenditure structure that leads to pork spending and an inefficient public sector ó and ultimately to lower standards of living for Kentuckians.
I'm taking as a given that a primary goal of state government ought to be to promote the improvement of income and material standards of living for people in the commonwealth. As is well known, Kentucky falls short in this regard. Gross state income per capita for the entire U.S. in 2005 was $41,729 and only $33,220 for Kentucky. Sure, many things in life other than dollars are important, such as health and a clean environment. But these things frequently come along with increases in income. It's important to recognize that income simply represents the ability to acquire goods and services. Thus, fundamentally, its source is productivity in producing those goods and services. This realization focuses the goal on improving the productivity of citizens in the state.
To promote this goal, Kentucky needs to embrace the best way to increase productivity (and income) ever known in history ó open and competitive markets. Both casual empiricism and careful econometric study support the idea that economies based on the free market increase the incomes of individuals in those economies. The reason is that, essentially, market economies present powerful incentives for individuals to engage in productive activity. However, certain government institutions and practices are critical to support this system. This is what our tax revenue is for. Both an institutional and physical infrastructure are important for market economies to flourish. The former includes a well-functioning legal system that has clear and strong property and contract law and also a good criminal justice system. The latter include things like fire protection, road repairs, streetlights, primary and secondary education, sewage and water services, utility rights of ways, and drainage. Note that many of the latter are local in nature, and the former tends to be broader, statewide in nature.
To support a market economy, it is important that governments provide this infrastructure in an efficient manner, yet many aspects of Kentucky state and local government would indicate that we do otherwise. For example, much of the physical infrastructure noted above is local in nature and is likely to vary from place to place. Thus, rather than try to dictate these things from afar, it is best to establish incentives for local governments to get it right. But we do not do so in Kentucky. Kentucky government takes much of the power out to the hands of local government because most tax collection and spending power and is centered on state government. For states in the United States as a whole, state tax revenue as a share of state and local revenue is 55.2 percent. Kentucky's is well above that at 69.5 percent and is one of the highest in the nation. Local governments simply don't have the revenue to devise and implement the infrastructure that best suits them. There is a similar story for school funding. Nationwide, local funding accounts for 43.4 percent of primary and secondary schooling expenditures. For Kentucky, the figure is only 29.7 percent.
Much of our centralization of government in Frankfort perhaps stems from dissatisfaction with and mistrust of local politicians and the resultant political pressure to move power out of their hands. Yet this likely comes at considerable cost. Local politicians must lobby in Frankfort to obtain funding for local projects. The cost of these projects is spread among the taxpayers of the entire state rather than just the local residents. Thus, each politician sees the opportunity to get others to pay for local projects, and this leads to too many and inefficient projects being funded. In other words, we get a lot of political pork instead of good infrastructure. This inefficiency could be penalized and deterred if residents have the opportunity to move to neighboring locations and bring their tax money with them. But taxes are paid and funding decisions made in Frankfort, so locational mobility does not have this effect.
In short, the centralization of funding impedes the process of local governments selecting an efficient local infrastructure to support the private sector. While it is difficult to say a priori what the specific shortcomings are in local projects, the incentives are in place to generate lots of them. Rather than trying to identify them one by one in 120 counties, let's just get the incentives right. The former is too much like the Soviet model ó and we know where that leads.
While it's important to get through this period of budget uncertainty, all the posturing and playing of strategic politics distracts us from what's really important. Serious reform in Frankfort is important to get state and local politicians' incentives right ó and to move the commonwealth forward.
John Garen is department chair and Gatton Endowed Professor of Economics at the University of Kentucky.