Seat-Belt Budgeting

There's economic turbulence ahead that state budget and fiscal systems may not weather well.
September 2006
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

The pilot intones the familiar phrase: "Put on your seat belts, we've got bumpy weather ahead." It's a good time for states to be thinking about that admonition. After a few years of smooth flying through the recovery in the national economy, states need to be asking whether their budgets and fiscal systems are prepared for an economic downturn.

The states are currently being kept aloft by revenue systems that have undergone restructuring during the past decade. They are now much more sensitive to changes in personal and corporate income. During good years, substantial corporate profits and capital gains bring in slugs of money. But this is followed by droughts when financial markets, business earnings and incomes turn down. Even the sales tax runs on a much more volatile mixture, with higher tax rates spitting out revenues on an ever-narrowing base. So, when incomes and expenditures change--up or down--the resulting bounce in state revenues is much greater. The shallow but prolonged recessionary conditions of 2001 through 2003 reflected this: State income tax collections in 2003 fell by about $24 billion from their peak in 2000.

State spending is also changing. Increasingly, it is driven by the needs of the very old, the very young and the less affluent. The major cost driver has been the Medicaid program, which has grown explosively and now accounts for one-quarter of state spending. The long-term prognosis is not good: State populations are aging, and the cost of health care continues to rise more rapidly than prices in general. Medicaid costs are projected to go up 8 percent a year over the next decade. In good years, state revenue systems meet that mark but not in bad years.

Furthermore, after a decade of subdued inflation, the prices that governments have to pay are growing. The overall price index for government spending, heavily influenced by the growth in the costs of medical care, is going up faster than the general price index. Thus, states in fiscal year 2006 increased spending by 7.6 percent, which appears pretty healthy until you crank in that the state and local price deflator has been rising by 6 percent recently.

What is happening on the inflation front is of critical importance in anticipating fiscal storms. Concern rotates around the impact of higher oil prices and interest rates on the state government sector. A few states--Alaska, Oklahoma, Wyoming--have benefited from higher prices with higher tax revenues, but most are burdened, both directly as the cost of fuel and energy rises and indirectly as increasing costs erode the buying power of consumers. The extra $10 to $20 per week constituents spend on filling up their car means less money to spend on other things. Since most gasoline is taxed per gallon, the higher prices don't help gas tax revenues; but the fewer dollars spent on other things does reduce state sales tax revenues.

Add to that the leveling off of real estate values. Housing starts are at their lowest levels in 15 years, and home listings are up by a factor of three in many markets. Local government finances, which held up well in the early part of the decade thanks to rising property values, may not do so this time around. The sagging real estate market may, in fact, trigger a downturn.

Adding to the uncertainties is the continuing malaise in pension finances. While better times and improved invest- ment results brought some improvement to pension finances the past couple of years, the overhang of unfunded liabilities is unlikely to be dissolved by booming financial markets. And that doesn't even count in the latest fiscal joker--the unfunded employee retirement health benefits.

Nonetheless, state budgets for fiscal 2007 are calling for modest increases in spending and, after an assortment of tax cuts, a reduction in reserves. According to the National Association of State Budget Officers, state fund balances including rainy day funds, were rebuilt to 8.7 percent of expenditures by the end of 2005. Now, they are slated to drop to about 7.9 percent, with no growth foreseen in dollar reserves. Lest we forget, states ate a hole in their reserves in the recent recession--when those reserves were at 10.4 percent of expenditures. The windfalls from the tobacco settlement and the $20 billion in federal payments that were tied to the tax reduction act of 2003 are unlikely to be repeated. Thus, states approach future uncertainties with dwindling reserves, which is likely to mean quicker and deeper cutbacks as deficits emerge.

A downturn is not yet on the horizon, but a dose of fiscal prudence seems to be in order. Check those seat belts.