A budget deal reached late last month by Michigan Governor Jennifer M. Granholm and the state’s legislative leaders temporarily spared public school students from spending cuts for the rest of this fiscal year.

But the money lawmakers saved in public school education was largely taken from the budgets of the state’s 15 four-year public colleges and universities, which are facing a $166 million reduction in state grants this year. A $13 million payment to two-year community colleges won’t come until next year, if at all. University students are bracing for steep tuition hikes, including a $1,000 increase already set by the regents of the University of Michigan, in Ann Arbor.

The shuffling of taxpayer money and priorities to temporarily close gaping deficits more than underscores the tightening grip of Michigan’s fiscal and economic crisis. It also reveals how far state political leaders are from reaching a consensus on a strategic, long term solution, say a number of observers. The deficit next fiscal year, which begins in October, is anticipated to reach $1.8 billion.

Meanwhile, legislators in economic powerhouse states—Utah, California, Tennessee, Washington State, and North Carolina, among others—are not talking much about what seems to be the main conversation in Lansing—cutting taxes. Instead, lawmakers in those states are collaborating to invest in education, new rapid transit lines, farmland conservation, environmental protection, and urban redevelopment. These public officials, reaching across parochial and political party lines, are supporting public priorities that attract and retain the young entrepreneurs who are developing the knowledge-based economy of the 21^st century.

Ideology Not Ideas in Michigan
Michigan is doing just the opposite. It is allowing partisanship to trump collaboration and enabling elected leaders of both parties to stubbornly protect old turf and old economic development programs that are yielding less income and fewer jobs.

The result is that lawmakers are cutting budgets for institutions that are essential for ensuring Michigan’s competitiveness. Between 2001 and 2005, for example, Michigan cut state support for higher education by 11 percent. Tuition hikes largely made up the shortfall, according to university budget officers, making it more difficult for students to earn a college degree.

"It looks like the dire situation in Michigan is going to be dealt with by chewing gum and baling wire," Phil Power, the founder and president of The Center for Michigan, told a group of civic leaders at a community forum at the University of Michigan in Dearborn in April. "What’s needed is fundamental reform."

Look no farther for evidence of Michigan’s political and economic futility than the deal reached by the governor and lawmakers on May 25. The pact ostensibly closed an $800 million shortfall by cobbling together revenue from a national tobacco industry settlement with program cuts in higher education, the courts, and health care.

But the usefulness of the agreement, which took over five rancorous months to negotiate, will last just four months. That’s because the deficit opens anew in October. The difference in what Michigan will earn in revenue and what it spends next fiscal year will result in a $1.8 billion deficit, according to state budget specialists.

There is no way to fix this, say economists at the Michigan State University and the University of Michigan, without the sort of basic restructuring in Michigan’s economy and taxes that state leaders have begun to understand but so far have been completely unwilling to accept.

Obsolete Economy and Tax System
A number of public and private study groups, including a commission chaired by Democratic Lieutenant Governor John Cherry, have reached remarkably consistent conclusions about what’s wrong with Michigan’s system of raising revenue.

The short course: It’s obsolete.

Michigan’s sales tax covers goods, like clothes, cars, homes, and boats. That made sense through most of the 20th century, when 60 percent of the state’s economic activity was based on making and buying things, according to the Michigan Department of the Treasury. But those numbers had essentially reversed themselves by 1997, when services accounted for more than 63 percent of the gross state production, and have only grown since then.

The sale of goods is not only less than half of Michigan’s current economic activity, it also is growing so slowly that taxes from the sales of goods is not even keeping up with the rate of inflation, said state Treasurer Robert Kleine.

In other words, revenue from taxing the sale of goods is growing more slowly than the overall economy, much of which is based on services, which are growing and are not subject to a sales tax.

"The basic problem is there is a growing disconnect between the economy and the tax structure," said Earl Ryan, the president of the Citizens Research Council, a respected research organization in Livonia. "As the economy has shifted from goods to services, we’re taxing the economy of 1970, not the economy of 2007."

Another cause of the state budget deficit, say authorities, was the tax-cutting spree undertaken in the 1990s by former Republican Governor John Engler and the Republican-led state House and Senate. The cuts significantly diminished the state’s income tax and lowered Michigan’s business tax to well under the national average. Revenues have fallen 15 percent since 2000—a loss of more than $1 billion in revenue a year, according to the Citizens Research Council—and the size of state government has shrunk dramatically.

The State of Michigan now has fewer employees than in 1973. Late last year, before the state House switched to Democratic leadership, Republicans passed legislation that eliminated the state’s primary business tax and the $1.9 billion in revenue it provided annually. Though Republicans and Democrats agree that the Single Business Tax must be replaced, the governor and the Senate have not yet agreed on a replacement business tax.

Governor Granholm, a Democrat, proposed earlier this year to restructure the revenue side of the ledger by instituting a new, 2 percent sales tax on services, with exemptions for education and health care. Republican leaders immediately opposed the measure, arguing that it would discourage people and business executives from settling in Michigan.

Mr. Ryan and The Center for Michigan say the governor’s proposal makes sense, though Mr. Ryan believes that business to business services should not be taxed.

"We’ve always said that business to business services should probably be exempt because it places businesses that purchase services like accounting and legal services at a competitive disadvantage with places that are doing it in house," said Mr. Ryan.

Needed: A New Development Strategy
The often angry and petulant debate between Lansing lawmakers about how to close the state budget deficit is a reflection of how utterly baffled state leaders are about how to improve Michigan’s economy. Republicans are convinced that lowering taxes is essential to compete with neighboring states to attract new employers. Democrats seek more revenue for education, health care, and social programs that serve favored constituencies.

Leaders of neither party seem to recognize that Michigan’s success in the 21st century depends on building its economy from within and ensuring that the state supports the innovative homegrown companies, institutions, and people that drive the engine of new prosperity, according to Bruce Katz, director of the Brooking Institution’s Metropolitan Policy Program.

During a presentation in Lansing in May, Mr. Katz explained that taxes are low on the list of priorities when companies decide where to locate. Much higher is whether there is an abundance of highly skilled people and whether the communities they choose to settle in can attract and retain similarly bright, talented, and well-educated people.

Michigan, he said, is not doing nearly as well as other states in leveraging its universities, arts and cultural institutions, parks, and cities to recruit and retain entrepreneurs, their employees, and their families. "States have a huge role in supporting the assets that attract top talent," he said. "But Michigan and other states in the Midwest are not getting the best return on their investment."

Governor, Senate Tussle; House Fumbles
The struggle over school funding is emblematic of the problem. In order to finance public schools, Governor Granholm proposed replacing most of the $1.9 billion state business tax, which accounts for 22 percent of revenue to the state general fund, with a new business tax. She also proposed a 2 percent sales tax on services, with exceptions for education and healthcare. Finally, she proposed to close some corporate tax loopholes and reinstate the tax on estates. These steps, said treasury aides, would increase net tax revenues by $1.518 billion and ease the annual struggle that has developed in Lansing over how to fix the deficit.

So far, neither the Democratic-controlled House nor the Republican-controlled Senate has agreed to the governor’s plan. The House has passed a handful of budget-related bills, but no comprehensive budget. Lawmakers also are pondering a shift from Michigan’s flat income tax to a progressive tax that would require wealthier individuals to pay a greater share of their income than poorer individuals—which would require amending the state Constitution. Though they support the general idea of increasing revenues and investing in education, Democrats haven’t moved the governor’s proposal forward.

Senate Republicans insist that government reform should be pursued before raising revenues is even discussed. The fiscal year 2008 budget that the Senate passed earlier this month relies primarily on spending cuts to solve the deficit. That budget proposed cutting funding for community colleges, universities, and $290 million from the 21st-century Jobs Fund, the core of the Granholm administration’s economic development program.

Neither of the competing proposals solves the state’s structural deficit, though experts from The Center for Michigan and the Citizens Research Council say the governor’s proposal is a modest step in the right direction. The Citizens Research Council and the Upjohn Institute, an economic think tank in Kalamazoo, project that if no significant changes are made in taxes or spending over the next 10 years state revenues will fall short of expenditures by $1 billion annually. It could be much worse if lawmakers fail to reach agreement on a plan to replace the Single Business Tax.

"The Senate’s proposal really just puts off the problem until 2008 and probably makes it worse," said Mr. Ryan.