I. The State Budget for The Biennium 1995-97

Expenditures The 1995 General Assembly approved total net General Fund appropriations of $8.84 billion for the 1995-96 fiscal year (FY) and $9.16 billion for the 1996-97 FY. These funds support a variety of activities that protect and enrich the lives of Connecticut's citizens. Specifically, state dollars are used to conserve Connecticut's natural resources and improve its environment; to safeguard and educate its children; to assist the frail elderly, the disabled, and the poor; to prevent crime; and to promote economic development. Specific programs in these areas are discussed below.

This budgetary review will focus primarily on the General Fund, since it is by far the most significant source of appropriated state spending. It should be noted, however, that the Legislature also provided for net Transportation Fund appropriations of $804.5 million in FY 1995-96 and $837.2 million in FY 1996-97 for purposes of building and maintaining Connecticut's roads and bridges. In addition, the state maintains a number of smaller dedicated funds for other governmental purposes. The chart and table that follow present a summary of state appropriations by function of government for FY 1995-96 and a comparison of FY 1995-96 and FY 1996-97 for all appropriated funds.

The overall growth in General Fund spending has been kept relatively low over the 1995-97 biennium. The appropriated spending increases are 4.4% in FY 1995-96 and 3.59% in FY 1996-97. Note that these growth figures do not include funds for financing the FY 1989-90 and FY 1990-91 deficits through the Economic Recovery Fund (ERF), which is discussed below. When ERF funding is included, the resulting budget growth rates are 2.3% for FY 1995-96 and 2.5% for FY 1996-97.

Revenues

State expenditures are supported by a variety of revenue sources. These include taxes on personal income, corporate income, and the sales of goods and services as well as other more narrowly defined taxes. Revenues are also derived from gaming, licenses, permits and fees, commodities and services, interest and dividends on state investments, and federal grants.

One of the most significant changes approved by the 1995 General Assembly was a tax cut, which will affect state revenues in FY 1996-97. Specifically, the change involves a reduction in the Personal Income Tax rate for certain levels of taxable income and a credit of up to $100 for Property Taxes paid. With the potential revenue from the sale of the state lottery, the General Assembly authorized this tax cut with its associated revenue loss of $200 million in FY 1996-97. These tax reductions are provided for as follows:

Effective July 1, 1996, the Personal Income Tax rate of 4.5% is reduced to 3% on the first $4,500 of income for single filers, the first $9,000 for joint filers, and the first $7,000 for head of household filers. Income over this level is taxed at the normal 4.5% rate. Implementation of this reduction will occur in July of 1996 rather than in January to delay the budgetary impact until FY 1996-97. The associated revenue loss for FY 1996-97 is estimated to be $100 million.

In addition, a $100 Property Tax credit may be applied to the state Income Tax on Personal or Real Property Tax paid on a taxpayer's primary residence in-state or on a motor vehicle. The credit claimed can not exceed the taxpayer's total tax liability and becomes effective for taxes paid on the October 1995 Grand List. Revenue loss for FY 1996-97 is estimated to be $100 million.

Programs with the Highest Growth Rates Approximately two-thirds (an estimated 66%) of the state budget supports four main expenditure categories: (1) entitlement programs, including AFDC and Medicaid - 36%; (2) grants to towns for education - 13%; (3) total state debt service - 10%; and (4) the Department of Corrections (prisons) - 7%. Expenditures in most of these areas have grown substantially in the past ten years. For example, principal and interest payments on the state debt have tripled since 1985, increasing from $323 million in FY 1984-85 to almost $1 billion in FY 1994-95. Debt service, like entitlements and programs that fall under court orders, can not be cut by the legislature. They are in a very real sense "untouchable." Entitlement programs, such as AFDC and Medicaid, must be supported by state dollars in order to qualify for federal matching funds, pending any federal changes to these programs. In addition, there are numerous court orders and federal mandates that fuel spending growth by requiring the state to meet certain expenditure and service delivery levels. Such areas include mental retardation, children and families, and corrections.

Potential Problem Areas

Over Projection of Revenues: Currently, a deficit of over $20 million is projected for FY 1995-96. This deficit may rise due to lower than expected revenues primarily from slow wage growth, poor retail sales experience, and proposed federal tax changes that could have an impact on state income tax receipts. Revenues will be closely monitored in the second half of this fiscal year to capture and report these potential shortfalls.

The second year of the biennium, however, is of even greater concern. The budget for Fiscal Year 1996-97 incorporates speculative revenue sources and revenue projections that may prove overly optimistic in light of current estimates for economic growth in Connecticut. The major revenue categories (Income, Sales, and Corporation taxes) have been budgeted for growth of over 5% (after base and rate adjustments) in Fiscal Year 1996-97. The overall state economy is expected to grow at a rate of no better than 2%. In addition, reductions in anticipated federal revenues (in the form of matching funds), primarily in Medicaid and AFDC, could place further pressure on an already strained state budget. Based on the congressional proposal being negotiated with the President at this time, in the Medicaid account alone the state may experience a federal reimbursement shortfall of up to $50 million in Fiscal Year 1996-97. In addition, a proposed 50% reduction in the federal capital gains tax could result in a state income tax loss of approximately $100 million over the biennium, depending on the timing of this change. Because the state income tax is based on reportable federal Adjusted Gross Income (AGI), reducing reportable federal capital gains by 50% - - as has been proposed by Congress -- will reduce a taxpayer's state income tax liability.

Selling a Partnership Interest in the Lottery: Since its inception 24 years ago, the state lottery has proven to be a valuable source of state revenue. Over that period, ticket sales have totaled more than $7 billion, resulting in state revenue of $2.9 billion. This represents a state return equal to 42% of gross sales. The lottery has consistently provided annual state revenue in excess of $200 million and for Fiscal Year 1996-97, the lottery (including Powerball) is budgeted to raise $277.5 million. Connecticut's lottery ranks near the top of the nation in terms of per capita profits. In 1993, for example, Connecticut ranked third in the nation in this category.

The budget for FY 1996-97 is balanced on the assumption that the lottery will be converted to a quasi-public corporation and a partnership interest in the corporation will be sold to private investors. To raise the revenue necessary for FY 1996-97, $160 million of revenue enhancement anticipation notes (RANs) would be sold. The notes are expected to result in an interest obligation of about $9 million. The $160 million represents a new revenue item over and above the $277.5 million in budgeted lottery revenue for FY 1996-97. Repayment of the RANs would be accomplished through the sale of a partnership interest in the lottery. Failure to adopt this strategy could leave the FY 1996-97 budget with a revenue shortfall of at least $160 million.

The additional state revenue generated by the sale of a partnership interest in the lottery is predicated on an expansion of total lottery revenues. Lottery revenues would be increased, in theory, by expanding lottery gaming, improving management of the lottery, and adding a new 10% state gaming tax on lottery net revenues. Increasing the lottery's future cash flow is fundamental to attracting private investors, and the potential to attract private investors supports the state's borrowing of $160 million to meet projected FY 1996-97 revenue and expenditure estimates.

However, privatizing a portion of the lottery raises a number of federal tax and regulatory issues. For example, would private ownership interest in the lottery subject the Connecticut Lottery Corporation to the 35% federal corporation tax? Would existing regulatory restrictions on private lottery advertising prohibit the Connecticut Lottery Corporation from advertising its games? How would the sale affect the state's credit rating? In addition, selling a share of the lottery to private investors could compromise Connecticut's continued participation in the Multi-State Lottery Association�s (MUSL) Powerball game. MUSL is opposed to lottery privatization in any form. In FY 1996-97, Powerball is budgeted to contribute $67 million in state revenue.

In order to cover the FY 1996-97 budget gap, there is a need to raise revenue quickly. Therefore, it is likely that the state legislature will be asked to vote on this proposal before many important questions are answered. Accordingly, passage of the proposal is speculative at best. This issue will be closely monitored due to its potential to create a significant budget shortfall in FY 1996-97.

Extending Payments on Our Debt: A three year extension in the term of repayment of Economic Recovery Fund (ERF) notes is also incorporated within the budget for this biennium. In 1991, the state issued $965.7 million to finance an accumulated deficit with payments on the debt due to end in Fiscal Year 1995-96. The General Assembly agreed to refinance $240.7 of the $328.1 million final payment. This refinancing will produce an additional $28.8 million in interest costs for extending the payment term for three years. The rating agencies have already expressed their concerns about this payment postponement.

The Uncompensated Care Tax: In order to help finance the cost of uncompensated care, the state assesses hospitals with an 11% tax on gross earnings and a 6% sales tax on hospital services. Through these tax revenues, the state reimburses hospitals for a portion of the care they provide to people with little or no health insurance. Furthermore, due to federal reimbursement rules, the state has used the hospital taxes to leverage additional federal funding through the Medicaid Disproportionate Share Hospitals (or DSH) program.

According to the Office of Fiscal Analysis, the budget for Fiscal Year 1995-96 includes a total of $330 million from these hospital taxes. However, only $240 million will be paid back to the hospitals for uncompensated care, along with an additional $25 million specifically designated for distressed suburban hospitals. The remaining $65 million in tax revenues would stay in the General Fund. Similarly, in Fiscal Year 1996-97, the state would collect about $346 million in hospital taxes and redistribute $254 million (plus the $25 million for the suburban hospitals). The balance -- $67 million -- would remain in the General Fund. In essence, the State is overtaxing hospitals (which, in turn, pass the costs onto their insured patients) to pay for a variety of General Fund expenses.

The reduction or elimination of this "overtaxation" and the corresponding loss of the General Fund revenues will likely be an issue confronting the legislature in 1996. In a recent report, the Lieutenant Governor recommended simplifying the hospital tax and phasing out the revenue/expenditure disparity over a four year period.

Welfare Reform Cost Shift: The state is required to provide child care and transportation assistance to AFDC recipients who are participating in the Job Connection program. The budget for this biennium provides $81 million for this account; however, significant caseload increases are already occurring in this program area. It is likely that demands will exceed budgeted resources over the biennium in this account. The Comptroller's office will monitor the overall budgetary impact of the welfare reform initiatives. As AFDC benefits are reduced, additional costs may develop in other areas of the budget, as is illustrated by the activity in this account.

Federal Fund Cuts: It is difficult to develop an accurate picture of the fiscal condition of the state in the absence of a federal budget for Federal Fiscal Year 1996 (which began October 1, 1995). Approximately 16% of total state revenues comes from federal funds. Proposals under debate in Washington seek to cut growth or to cap federal expenditures for basic support programs that have traditionally been the shared responsibility of the state and federal governments. In order to appease the states, the federal government is offering greater "flexibility" in the administration of these programs. However, what this really means is that states will be given the flexibility to reduce basic levels of support that are currently in place.

While the magnitude of federal cuts is under negotiation as of this writing, the direction for the state budget is clear: Connecticut will experience major federal expenditure reductions in basic health care and child support programs. In Medicaid funding alone, the state stands to lose approximately $1.8 billion over the next seven years (the state's Medicaid spending is presently reimbursed at a 50% rate by the federal government in most categories of expenditure). It is important to recognize that 82% of Connecticut's Medicaid expenditures--which are approaching $2 billion annually--go to care for the elderly and the disabled. The impact of these cuts will begin to be felt in FY 1996-97, and will increase in severity in future fiscal years. The Governor and the Legislature will be confronted with the choice of either cutting services or supplementing lost federal funds with state dollars.

The state should be working now with municipal officials and local direct service providers to redesign our system of service delivery in an effort to minimize the impact of federal funding cuts.

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