Economic Development

Deficit Deluge

It's been a shallow recession, yet states and their budgets are in big trouble.
by | May 2002

The recession is over. Alan Greenspan says so.

But try giving that good news to North Carolina Governor Mike Easley. Facing a budget shortfall approaching $1 billion, he recently announced a fiscal emergency. With the special constitutional powers that such a declaration grants him, Easley slashed $350 million from state agencies' budgets. That was only the beginning: He also drained the rainy day fund, seized cash from several trust funds and withheld more than $200 million in tax sharing and reimbursements that should have gone to localities. It still was barely enough to balance the books for the current fiscal year--and the next one doesn't look all that much better.

Despite the brightening of the overall economic picture, red ink is flooding the states. From California to Massachusetts to Florida, $40 billion worth of it was sloshing around as governors and legislators, on the heels of the recession, headed into the fiscal 2003 budget season. Now, in the midst of the process, the news just keeps getting worse. "What we know of tax collections in recent quarters is that they're horrible--just horrible," says Don Boyd, who follows state revenues for the Rockefeller Institute's Fiscal Studies Program. And taxes aren't the only source of revenue falling far short of expectations. So are annual payments from the tobacco-settlement case, returns on pension investments and almost everything else you can name.

The odd thing is that the national downturn--some economists never even bought into calling it a recession--isn't as deep or as long as the 1990-92 recession. But this one feels worse in gubernatorial offices and legislative chambers, where state officials are stressing over their fiscal future: On the one hand, they are making more optimistic economic forecasts. On the other, they are lowering their revenue estimates. "This is not much of a recession," Boyd notes, "but the states are suffering very badly."

Ray Sheppach, executive director of the National Governors' Association, can put some numbers on the relative degree of suffering. When he compares the early '90s recession to the recent slump, he sees a combined deficit that was $20 billion less at the peak of the previous slowdown than it was this January. As a percentage of general revenue, that shortfall measured 6.8 percent a decade ago, but the current one comes in at 8 percent. The number of states forced to cut budgets last time around was 36; this time, it's 45.

It's a puzzling situation, given that the states just came through eight fat years where the revenues that came pouring into their coffers were managed fairly well. At least that is the view of credit analysts, who see the boom as a period in which the states built up rainy day funds, resisted spending splurges and tax-cutting sprees and shied away from debt. "By and large, behavior was very good," says Claire Cohen, vice chairman of Fitch, the credit-rating agency. In fact, though, toward the end of the '90s, some states weakened and spent a little too much here and cut taxes a little too deeply there. "Prosperity went on too long," Cohen says. "They tried not to do it, but it happens."

However, such straying from strict fiscal discipline hardly explains the tide of red ink that is menacing states now. The big question is, why are the states and their budgets so devastated by a fairly shallow recession? And, of course, when and how will they recover? The answer starts with the nature of the recent recession and the other fiscal pressures that can affect state revenue.

Unlike the early 1990s financial-services recession, the 2001 downturn was a more general recession that hit traditional manufacturing hardest. That means states in the Midwest and South, and to an extent those in the Pacific Northwest, felt the brunt of the decline the most, whereas some of those states barely felt the earlier recession. "For Kentucky, the early '90s downturn was short and rather mild," says Merl Hackbart, a professor of finance at the University of Kentucky. This time around, however, Kentucky, with an economy that is more focused on manufacturing than services, is feeling the impact substantially and extensively. North Carolina, which went into the recession in weakened condition (Hurricane Floyd and the settlement of a lawsuit drained capital), was hit particularly hard because its economy depends heavily on the textile industry.

States with diverse or services-oriented economies aren't off the hook, however. Their fiscal problems are less recession-related and more tied to other factors. For many of them, according to Boyd, "the number one culprit" is the stock market decline. Taxpayers who sold stocks at a profit in 1999 and 2000 didn't have gains in 2001, and those losses have been showing up in dramatically lower quarterly personal income tax returns.

Through the first quarter of 2002, the news couldn't have been much worse, especially for wealthy states such as California, Connecticut, Massachusetts and New York that rely heavily on the personal income tax. "Every year in the good years, a higher and higher portion of their income tax yield came from capital gains, the exercising of stock options or bonuses," Cohen says. "That has fallen very sharply this year." While some states have only experienced a 6 percent drop in income tax revenue, many others are seeing decreases of 25 percent or more.

California's plunge is the worst. Estimated payments for the fourth quarter of 2001, which arrived in January, showed a year-over-year decline of 36 percent--$1 billion worse than was forecast for the quarter. "If you started out the year forecasting that kind of number- -if you had been able to predict it--no one would have believed you," Cohen says.

Things aren't much better on the East Coast. According to Robert Tannenwald, an economist at the Federal Reserve in New England, between fiscal 2001 and 2002, Massachusetts, which has a tax revenue base of between $15 billion and $16 billion, will have lost $1 billion in income tax from the same cause. "A drop of $1 billion on that kind of tax base--that's big," says Tannenwald.

What makes the problem worse for the affected states is the outlook: Even if the recession has ended, the revenue bubble from huge Nasdaq gains, dot-com excitement and big bonuses is unlikely to bounce back. "Everybody knew the party would end," Cohen says. "They didn't know it would end so abruptly or that the drop would be so severe."

For most states, the recession and the stock market's draining effect were further compounded by the tragedy of September 11. For a time, people were shopping and traveling less. That, in turn, reduced the take from the sales tax. In states such as Florida and Nevada, where tourists contribute handsomely to the vibrancy of the sales tax, the impact was huge.

And if income and sales tax troubles weren't enough of a drag on revenues, the federal government took actions that were less than helpful. The phase-out of the estate-tax credit will cost the states $75 billion over 10 years and the stimulus-package tax cuts will drain another $15 billion over three years. "Congress is hurting states big time," says Sheppach. "That's a problem, coming on top of other losses." Some states may resist the stimulus package. Of the 20 or so states that automatically adjust their tax codes according to changes in the federal tax laws, several are moving to undo that link in order to stanch the loss of revenue.

There are also unexpected losses from another big source of state revenue: tobacco-settlement money. The exact amount of payments due from the tobacco companies participating in the settlement is based on the consumption of those companies' cigarettes, which a report from the Council of State Governments says is declining by 1.5 percent a year. Although that may be good news from a health standpoint, it also means that tobacco cash coming to the states is arriving in significantly lower amounts than initially projected. According to the report, the rate of decrease is expected to speed up so that states will receive 20 percent less than originally predicted through 2010.

Unfortunately, lower revenues are only part of the reason states are in such difficulty now. Spending pressures are equally intense--not because of pet projects or pork-barrel investments or because states went crazy creating new programs during the boom times. Rather, it's that old nemesis: health care costs. Medicaid now accounts for 20 percent of state budgets; health care for employees and programs for the elderly eat up another 7 percent. That's more than one-quarter altogether, and health care inflation is growing at about 11 to 12 percent--a significant increase over the 7 to 8 percent growth rates in the 1990s.

Over the past decade, Medicaid costs were tamped down when states put a significant number of Medicaid-eligible patients into managed care. Today, there's no comparable tool to squeeze costs. What's more, Medicaid is a program in which it's very hard to make spending cuts. "In trying to deal with their troubles, states are compelled to wag a mighty big dog with a very small tail," says the Federal Reserve's Tannenwald. Some states, such as Massachusetts, have tried to control overall Medicaid costs by lowering provider-reimbursement rates, but that approach may be "unsustainable if you're going to keep the provider base viable," he adds.

Meanwhile, the number of Medicaid beneficiaries is growing as the population ages and develops more disabilities that qualify them for the program. With prescription drug costs rising at a rate of 18 percent a year, the upward pressure on Medicaid budgets is explosive.

On top of that, add homeland-security expenditures--increased funding for state police and security-related capital projects for state facilities, especially in capitols--and increases in pension contributions now that pension portfolios are no longer producing tremendous earnings. It's no wonder states are swimming in red ink.

Initially, states thought they could easily withstand a low-level recession. Just before the recession got underway, reserves were at an all-time high of 11 percent of revenues. Moreover, the states generally had disciplined themselves, despite pressures to expand programs or return money to constituents.

On the tax-cut front, the National Conference of State Legislatures figures that in a period of eight years during the boom, states passed $35.7 billion in tax cuts--an amount very close to the total shortfall states were facing as they began to balance their budgets this year.

"A lot of people jump to the conclusion that tax cuts were a part of the deficit problem," says Scott Pattison, executive director of the National Association of State Budget Officers. However, NASBO studied the figures and found another way to look at the $35.7 billion: The tax cuts equaled the tax increases of the early 1990s. "It's more of a wash than people think," Pattison says.

As to spending, a lot of the excess money states took in during the boom years was used for capital projects, to reduce debt and to finance other one-time projects. Many of the capital projects were financed on a pay-as-you-go basis.

Those days are in the past now. Wherever you look, governors and legislatures are frantically making budget cuts--either across the board or by focusing on particular programs. One big target is higher education, which Bill Pound, NCSL's executive director, has called "the flywheel of state budgeting." As of mid-March, at least eight states, including California and Florida, had trimmed spending for higher education, and several others, including Massachusetts and Oklahoma, had cut financial aid or sports programs. The cuts, which come on top of already low budget increases to public universities and colleges, are likely to increase tuition at public universities by an average of 7.7 percent. State university officials in North Carolina worry that the cuts will prevent them from handling growing enrollments.

Another victim of the budget ax is aid to localities--a favorite expedient of the previous recession. This time around, Wisconsin, which was facing a $1 billion-plus drop in revenue for its 2001-2003 biennium budget, proposed a total phasing out of revenue sharing to cities and counties through fiscal 2004, which would total about $1 billion a year.

Another way states are trying to cut costs is by looking at pay-as- you-go capital projects and converting them to debt. Connecticut is issuing $63.5 million in bonds to cover several capital projects that already had been funded. The bonding would free up the appropriated money for use by the general fund.

In addition to trimming budgets, states are looking for other funds to use to help make up for disappointing revenues. The budget reserve trust funds--frequently called rainy day funds--are there for just such a purpose and are being drawn down, but not completely. Most states are trying to preserve at least a portion of the money--as a hedge against another bad year or two or just to keep some money in their coffers.

Not that it is easy to withdraw money from reserves even when the rainy days are here. In Missouri, for instance, Governor Bob Holden had to declare that state and national economic conditions were a "disaster of major proportions." Even with that formal declaration, he had to muster a two-thirds vote in the legislature to get approval of a bill to use money from the fund to pay for some state programs.

Rainy day funds aren't the only pots of money being tapped. Any fund that was set up for a specific reason and didn't spend its money is fair game. "You'll find a great investigation of balances in other funds to sweep into the general fund," Cohen says. Oregon, for instance, had an education endowment fund "lend" it the money in its account to the good of the general fund. Colorado is laying hold of funds from transportation and senior programs, in addition to redirecting funds from an unclaimed-property account.

Several states, such as Wisconsin, are folding tobacco-settlement payments into their general funds to offset the shortfall. But some are going even further with tobacco money. New Jersey, for instance, is slated to securitize its tobacco payments--in effect, borrowing against its share of the tobacco-settlement money--to raise cash to close some of its budget gap. The securitization, Cohen notes, "is deficit funding by any other name." It's extraordinary, Cohen adds, "because usually if you had to finance a deficit, you'd use short-term notes or bonds, usually five to 10 years in length. But tobacco bonds would be 20 years and up, which is a long time to pay for bad things in the next couple of years."

The raiding of trust funds and the use of tobacco money--these are the sorts of maneuvers that tend to surface during hard times. So do more egregious measures, such as selling an asset to a newly created agency and then borrowing against that asset.

How rampant are gimmicks this time around? "Not as much as expected," says NASBO's Pattison, although the answer depends in part on definition. There are a lot of one-time ploys or delays of payments. Whether or not they're gimmicks that deserve condemnation is a trickier question. "Sometimes it might not be a prudent measure, but other times it's not a problem," Pattison says of the use of single- shot stratagems. "It depends on what the alternative is. Sometimes a gimmick is probably not what you'd teach in a good-budgeting class. But it's a short-term thing to get you through."

One thing states seem determined not to do is raise taxes. Yes, they're hiking cigarette taxes in a number of places, and some states have put on hold tax cuts that were being phased in. But by and large, with the exception of North Carolina, which did increase its income and sales tax rates, neither governors nor legislators seem to have any stomach for taxing, which was one of the main tools states used to haul themselves out of the 1990-92 recession. In Kansas, for instance, lawmakers recently rejected proposals to raise the state income, sales and property taxes--despite new figures that showed the state deficit increasing from $426 million to $680 million.

"My take on all this is that, unfortunately, there's pain in either cutting budgets or raising revenue by direct tax, fee or tuition," Pattison says. "Eventually, as the economic picture improves, so will the revenue picture for the states."

That prospect, however, isn't just around the corner. Even as the recession winds down and economy heats up, states are likely to experience a 12- to 18-month delay before they feel it in their coffers: People have to get jobs and earn income, and there's a lag before the taxes on that income are due. Even then, the capital gains and bonuses that mushroomed income tax revenues won't be there. Moreover, effective corporate tax rates have declined from 9 percent to about 5 percent, which means the tax is shrinking relative to the base, and the sales tax is increasingly out of sync with economic reality. "There's a deteriorating tax base," says the NGA's Sheppach. "We don't tax services and that's where growth is. We're threatened with sales tax losses from Internet sales, and corporations are more sophisticated about getting around state taxes. A lot of that was covered up the last five years because the economy was growing 50 percent faster than the long-run average and that camouflaged structural problems."

All of which gives economists and financial analysts continued cause for concern. "States are going to have to rethink how they finance their budgets in the future," Cohen says. "Their problems haven't ended."


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