The final item needed for this valuation method is the expected capitalization rate. The capitalization rate is determined by understanding how much of a return investors can expect to realize in a particular market. The rate will vary in different parts of the country, in different parts of a city, even in buildings within a few blocks of each other.

Additionally, residential, commercial, and industrial properties also have varying capitalization rates. Remember, because the capitalization rate measures the profitability of an investment, certain types of properties involve other risks and thus dissimilar profit possibilities.

There are other ways to deal with the problems shown by these projections. Three major policies are involved.

First, about 38% of the structural deficit projection for Tennessee is federally related. That is, by planning to cut its spending on “discretionary” grants the federal government is planning to shift the burden of paying for its share of increased spending for inflation and workload changes to state and local governments. For example, the federal government now pays 8-9% of Tennessee school costs. If it covered its 8-9% share of the costs of serving more students and inflation-driven increases in teacher pay and other costs, it would still cover about 8-9% of costs in FY 2000, FY 2005, and beyond. If it follows its budget plan, it won’t cover its share of these costs, so Tennessee will have to do so while watching the federal share drop to something like 7-8% and even lower as the years go by.

If federal officials can be convinced to pick up additional costs or at a minimum maintain the current federal share, the outlook for all states and local governments gets better. However, to achieve this federal officials would have to abandon their balanced budget targets or make huge cuts in defense and other federal spending.

Second, the Tennessee government can raise money without raising taxes. At a minimum, governments can raise existing charges to match inflation, charging more for everything from getting a copy of a birth certificate to attending a state university. Charges could be raised considerably more than inflation would suggest — making, for example, the cost of attending the University of Tennessee more like those of going to private universities. Charges could be levied for things that are now free, such as for textbooks or extra-curricular activities for public school students and for admission to all state parks.

The alternative to raising taxes to cover the cost of maintaining current services is to cut services to correspond to what current taxes will raise. This is not quite as horrible as the word “cut” implies because the projections have spending increases built into them that Tennessee doesn’t have to make. For example, increasing enrollments could be handled by increasing class sizes and increasing compensation costs for state and local workers could be held to inflation alone, denying these workers the real (inflation-adjusted) increases in living standards that private sector workers will enjoy. The state could attempt a similar squeeze on compensation of workers the state pays indirectly, such as workers in hospitals, nursing homes, and child care agencies.

Obviously, state policy could combine tax increases and spending cuts. For example, maintaining a moratorium on tax cuts and expanded programs, raising taxes about 1% a year, and squeezing current service budgets by about 1% a year would work — mathematically at least.

The projected Tennessee structural deficit is the mathematical result of projecting spending and revenues, comparing the two, and finding a budget gap or structural deficit equal to the excess of projected spending over projected revenues. Because Tennessee shows a bigger gap than any other major state, there must be something in its spending, its revenues, or some in each that explains the difference from the average state.

To make a long story short, the answer isn’t spending. By the standard national projections used in the study, the demographic factors driving spending such as population and school enrollment in Tennessee will grow somewhat faster than the national average. But Tennessee’s economy and thus tax bases will grow a little faster too. In these characteristics, Tennessee is similar to neighboring states which don’t show the same large structural deficits. The Tennessee structural deficit problem comes from its revenues, not its spending pressures. In sweeping terms, Tennessee’s spending for maintaining current services will grow about as fast as Tennessee personal income grows. So if revenues also grew about as fast as personal income, state and local taxes would remain about the same percentage of personal income they are today. (Economists use the term elasticity to describe the relationship between tax revenue growth and personal income growth. For example, if revenue growth from a particular tax were exactly equal to personal income growth, that revenue source would be said to have an elasticity of one.)

All projections of current service budgets depend on predictions of (assumptions about) factors affecting spending and revenues such as: (1) economic growth, (2) inflation in general, (3) inflation in particular kinds of prices such as health care, and (4) numbers of people likely to be receiving government services.

Projecting revenues for long periods uses the same methods used to project revenues for short terms, such as for the next year’s budget. Projecting spending depends on forecasting workloads and prices. Put another way, it involves predicting the number of service-units to be delivered and the unit costs of delivering that service. For example, school spending projections are based on forecasting the number of students and cost per pupil.

Projected spending takes what governments now do as predictors of what they will do, assuming implicitly that all arguments for change are rejected. So no spending is shown to do things many people think should be done like paying public employees more relative to private employees, expanding park systems, reducing class sizes, or providing free community college education to all students who maintain good grades.

Nor are any savings shown to make corrections many people think should be made such as paying public employees less or reducing their pensions, cutting someone’s definition of low priority programs or waste, or getting governments out of some activities they now pursue.

Structural deficits are mismatches of spending and revenues built into a government’s tax system and spending patterns. Structural deficits and structural surpluses, their opposite number, are calculated by
projecting a government’s spending and revenue and comparing the two. These projections are called current service or baseline projections. Not all states make such projections. Not all states having such projections make them public. And not all projections use the same methodology.

Having a structural deficit means a government cannot continue its current spending patterns without raising taxes. The shortfall is often called a budget gap. Conversely, a structural surplus means that current taxes will generate enough revenue to pay for current services with some money left over, sometimes called a fiscal dividend. This money could be used to add new spending, or cut tax rates, or some combination of the two.

Structural deficits and surpluses differ from cyclical deficits and surpluses. The effects of strong economic growth are so positive for most governments that they will show a temporary cyclical surplus in a year of economic boom even if they have a structural deficit. Likewise the impacts of recession are so negative that even states with a structural surplus over the long term may show a deficit in a recession year. Federal and state long-term budget projections do not include predictions of recessions and booms on the theory that they average out in the longrun and their exact timing is impossible to predict.