The Budgetary Abyss

States are pushing a bow wave of operating deficits ahead of them in hopes that fiscal conditions may brighten.
May 2003
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 depth of the state budgetary crisis is increasingly clear. The national recession of 2001 and the sluggish, jobless recovery over the past two years are showing that the deficit is no longer just a cyclical phenomenon. Cycles infer that there is an underlying trend that one can depend on to be sustained over dips and peaks. Through the 1980s and 1990s (about 20 years altogether), an upward trend in the economy was observable and the financial markets reflected the steady self-confidence of the ascending era.

There were a couple of jolts at the dawn of the 1990s decade, but state sales and income taxes recovered after a lag of a year or so and then grew mightily. Starting in 1993, states saw almost every year bring in surplus revenues as they generally underestimated growth. Hal Hovey, an expert on these matters, noted that excess revenue collections could be handled in three ways--spending more, taxing less, and saving--and that states were inclined to do all three in about equal measure.

The more they did of the first two things (spending increases and tax cutting), the worse the problems of the present decline have been. That decline is now large and shows no sign of abating. Despite two years of nipping and tucking, state operating deficits appear stuck at about $50 billion annually.

States faced with budget deficits have a variety of tools that they can employ. The first round involves accounting maneuvers that delay recording spending and push forward recording receipts. Most governments also have a variety of funds that they can raid for money to make up cash deficiencies. They can borrow more or earlier for various purposes, kick charges and fees up a notch and go after easy marks such as hiking taxes on gambling, tobacco and booze. Cosmetic and temporary fixes, however, help only for a year or two at best, and they work only if the fiscal falloff is cyclical. Moving into the third year of stagnant revenues, the choices become harsh as the cyclical dip evolves into a structural deficit where expenditures permanently exceed revenues. Structural deficits call for a structural change. Raising taxes or cutting expenditures by large and sustained amounts are the only remedies.

A popular canard is that most states, having to balance their budgets, cannot run deficits. But of course they can and they are. Most state constitutions are vague on the subject of deficits and the legislatures can pretty much define what a deficit is. Besides, the budget is a plan and, by golly, plans can go awry. States are now pushing a bow wave of operating deficits ahead of them in hopes that circumstances may brighten enough to diminish its size before it becomes unsustainable.

With an eye on delaying drastic measures as long as possible, many states are borrowing to buy time. The state of California, which has run sustained deficits in years gone by, is in the market with huge amounts of deficit-based debt, about $20 billion or so a year. The state of Illinois is contemplating a $10 billion general obligation borrowing to replace the higher-cost debt it already owes its pension system with lower-cost debt that it can raise in the bond markets. While the details remain to be worked out, you can figure that a large chunk of the bond receipts will be used to cover the state's $5 billion deficit. Many states are trying to sell more bonds backed by the tobacco settlement. But they are now running into legal problems, which heighten fiscal woes. While bond proceeds were to be used ultimately for many purposes, the immediate need is to raise cash for operations. It will be up to legislatures next year to figure out just how to reimburse the funds that have been drained by "inter-fund borrowing."

It's not just the states that are in trouble. Even as they cut back on aid to the local level, the sword of Damocles hangs over the despised but productive property tax. In many areas, it alone has continued to soldier on in the face of recession because of the increase in housing prices. Homeowners have been refinancing their mortgages at lower rates and capturing the built-up equity to sustain spending. But they rightfully feel no richer. What they have done in many cases is realize and then spend down their assets to support consumption. No wonder property taxes are increasingly under assault.

Meanwhile, the federal government appears headed for another round of tax cuts that no one is pretending is temporary. With billions needed for the war in Iraq and to rebuild that country, there will be less left for domestic spending including programs that are increasingly shouldered by state and local governments. The costs of national security are mounting, as are the demands on health and social programs, as those on the bottom rungs of the economic ladder slip further down. The harsh reality at all levels of government is that a low-tax, slow-growth nation must also have a low-service, smaller public sector. You really can't have it all.