General fund revenues were already running a billion dollars below what they were three years ago when Michigan was hit with more bad news in October: Tax collections for the new fiscal year were coming in $900 million below the already low estimates, and most of that deficit was showing up in school-aid accounts.

With crippling unemployment problems, Michigan's fiscal health does not look like it will improve anytime soon. That leaves policy makers with two choices: Make spending cuts or impose tax increases. After three years of slashing the budget, will legislators finally opt to raise taxes? "Over my dead body," says state Representative Jacob Hoogendyk Jr. "People are saying, 'Our taxes are too high. Make do with what you've got, because that's what we've had to do.'"

Hoogendyk's attitude is typical--in Michigan as elsewhere. Nearly every state has been suffering serious fiscal problems for the past three years. Total budget shortfalls this year topped $75 billion. But state legislators across the country have for the most part resisted raising broad-based taxes on sales or income. They are sticking with the cut-we-must approach, and the result is that state governments are shrinking.

For the first time in 20 years, overall state spending, which in recent decades has averaged a 6 percent annual growth rate, is actually going down. In Michigan, state spending is already below where it was 10 years ago, while the costs of delivering its services have gone up by 27 percent. In the aggregate, state budgets will continue to shrivel before they start growing again. "I would still expect cuts of $25 billion to $30 billion during the current fiscal year we're in," says Ray Scheppach, executive director of the National Governors Association.

No one expects legislatures to solve the budget crunch by heading for big tax hikes in 2004. The trouncing Alabama Governor Bob Riley's $1.2 billion tax package received from voters in September has resonated with policy makers nationwide. "Since it is an election year in almost all the states," says Ron Snell, director of the National Conference of State Legislatures' economic division, "it will be very hard to imagine that legislators who weren't willing to think about tax increases this year will be willing to think about them next year."

CURBING APPETITES

No new tax bills may be good news for taxpayers, but it's going to make it tough for states to balance budgets. There are plenty of states where revenues are starting to increase. Fee hikes have helped, and there have been some slight upticks in monthly tax collections. But there hasn't been a real rebound in revenues yet, and the main reason for the delay is that this recovery has not led to the creation of new jobs. Michigan is a case in point. At this point following every recession since World War II, says state House Fiscal Agency Director Mitchell Bean, the state has created jobs at a faster clip than the national average. That's not the case right now. Michigan, hurt by the loss of manufacturing jobs in general and stung by the poor performance of the domestic automobile industry in particular, lost a net 188,000 jobs in the 18 months following March 2001. Such job losses create a drag on income and sales tax receipts, while placing greater demands on social services.

The particulars may vary in other states, but the economic fallout is the same--as is the prognosis. "The way this recession worked is that it hit the states so hard to begin with--rather hard and rather suddenly--that it's probably going to take them longer to recover than has been the case historically," says Nicholas Jenny, a state fiscal analyst at the Rockefeller Institute of Government. "I think we need another year or so to get back to normal."

Although revenues are flat, expenses are not. Medicaid costs, for instance, aren't climbing as rapidly as they were a year or two ago, but they are still growing at three times the rate of elementary and secondary education spending and four times the rate of corrections. Meanwhile, the spending demands associated with homeland security or meeting federal education testing requirements may be new but they are relentless.

PRESSURE POINTS

It's been rare to hear any formal arguments about what functions state governments should perform when resources are diminished. But there has been a de facto debate, and winners and losers are becoming clear. Most states are still holding K-12 education more or less harmless, refusing to cut payments to schools and in some cases raising appropriations. Not cutting their largest budget item has led, of course, to pressure elsewhere. In Medicaid, every state has taken action to reduce eligibility or limit payments to providers. At least two dozen states have cut the size of their employment rolls. Smaller agencies such as environmental protection are taking disproportionate hits; some arts and historic preservation programs even face elimination. Universities and local governments continue to watch their checks from the state shrink. Lawmakers may not be happy about making cuts in health care for the poor or watching college tuition go up by double-digit percentages, but these are seen as preferable to raising taxes.

There have been some tax increases, of course. An NCSL survey found states overall raised taxes by $11.8 billion for fiscal 2004. That's a bump of slightly more than 2 percent of their general fund revenues. During the 1991 recession, the corresponding figures were $15.4 billion in additional taxes, representing 5.4 percent of revenues. If states were raising taxes at the rate they did in the early 1990s, there would be an additional $25 billion in the till.

Among those that did take tax actions this year, Ohio increased its sales tax by a penny for the coming two years, while Nebraska and North Carolina extended temporary sales tax increases that had been enacted at the start of the recession. Idaho Governor Dirk Kempthorne, a professed lover of tax cuts, pushed through a penny increase in the state sales tax and doubled cigarette taxes rather than cut education spending. Several states also raised billions in fees by, for instance, assessing charges for court filings, raising costs for car registrations and increasing co-payments for health insurance plans.

While a few states have revenues running a little ahead of where they were last year, most other states, particularly large states and ones where manufacturing jobs are being lost, are still falling short. Some economists believe that state officials were overly optimistic about their revenue projections when they crafted the 2004 fiscal year's budget. That means that those states will have to make more cuts as the current budget year drags along.

BAD DEBTS

California and its new governor, Arnold Schwarzenegger, start the budget-writing process for fiscal 2005 knowing they will be at least $8 billion short--the amount of expenses punted over from fiscal 2004. The state also issued and swapped other debt to cover current expenses, which means that Californians will spend a long time and a lot of dollars paying for the government services that they're getting right now.

But before other states laugh too loudly at California's credit-card style of budgeting, they had better total up the number of one-time fixes and accounting gimmicks included in their own budgets. Illinois and several other states issued pension bonds to help balance their current budgets. Other states were even more creative in issuing debt that would, in effect, pay for current spending. "A lot of the states that haven't raised taxes have gone into some long-term debt," says Jeff Youtz, Idaho's legislative budget director. "They can say that they didn't raise taxes, but they have some long-term structural deficits."

Raiding the few capital or other accounts that were still flush proved to be a popular pastime. States did their best to kick payroll dates back a few days to move spending off of this year's books--but onto next year's. Virginia and several other states demanded early collection of sales taxes, moving next year's receipts into this one. Almost three dozen states tapped this year's legal settlement dollars from the tobacco companies for general fund and deficit purposes. Many states also have run quickly through their one-time $20 billion windfall from the federal government, including $10 billion in extra Medicaid payments.

Several states looked to reorganizing efforts to cut expenses--some with more success than others. Washington State ran a budget built by function, rather than by agency, and filled a $2.6 billion hole without raising taxes. In general, though, the idea of trimming expenses through streamlining was much more discussed than realized. Government-wide reorganizations failed to pass legislative muster in Arkansas, Massachusetts and Texas, although the Lone Star State did consolidate its health bureaucracy to achieve a savings of $1.2 billion a year.

That leaves states to face the tough work of making do with less. Consider North Carolina, a state that had to close a $1.5 billion shortfall in 2002. This year it managed to pass a budget with $150 million set aside for its rainy day fund. The state didn't resort to a lot of accounting tricks, although policy makers weren't shy about blowing through their federal windfall. They cracked down on Medicaid expenses and cut most non-education budgets by 10 percent or more. The state withholds 2 percent of each agency's budget every month in case of emergency--money that served it well when Hurricane Isabel stormed through in September. "Things have stabilized quite a bit," says Dan Gerlach, budget adviser to Governor Mike Easley.

North Carolina's budget is now smaller than the one Easley's predecessor handed him when he took office back in 2001. That hasn't left Easley much wiggle room for trying new programs, and that experience turns out to be typical. "We usually say, wait for a recession, because nobody's going to innovate unless they have to," says the Rockefeller Institute's Jenny. But he notes, "we got through this recession without anybody innovating anyway." States are pretty much in a muddle-through mode at this point, and they are likely to remain so until revenues pick up a lot more than they have so far.