The coming year will be excruciating for state budget-makers not just because revenues continue to decline and new rounds of budget cutting are necessary, but because the realization has started to dawn -- and not just in the hardest-hit places -- that fundamental assumptions about how state government operates need rewiring.

"It's beginning to percolate now that things have changed dramatically," says Ray Scheppach, executive director of the National Governors Association. "This is not a normal recession cycle that will put us on our old path in three or four years." Or as Republican Governor Mitch Daniels of Indiana wrote in the Wall Street Journal last September, "What the radar tells me is that we ain't seen nothin' yet. What we are being hit by isn't a tropical storm that will come and go, with sunshine soon to follow. It's much more likely that we're facing a near-permanent reduction in state tax revenues that will require us to reduce the size and scope of our state governments."

As governors and legislators try to come to grips with what this means for their states in 2010, the kinds of fiscal stresses that made California the butt of glib one-liners in 2009 are spreading. Last year, the Golden State was forced to issue IOUs, furlough state workers, and approach the federal government for a bailout. An editorialist for the St. Petersburg Times in Florida reassured readers that things weren't so bad there. "We could be California, the General Motors of state government," he wrote. The comment came before Florida wound up on the Pew Center on the States' list of the nine states most in danger of following California down the road to fiscal perdition.

California, however, may be doing better than its peers in at least one respect: Its political and civic leaders are in the midst of a far-reaching discussion about reforming how state government works, so that the state does not remain hamstrung by the welter of cross-cutting constitutional provisions, legislative procedures and citizen initiatives that have made addressing its problems so difficult.

Governors in a few other states have broached the notion of radical change, most notably Michigan Democrat Jennifer Granholm. Last February, she called for reducing the number of state departments from 18 to eight, and in November she warned that the state budget may need to shrink by another 20 percent on top of last year's 10-percent cut. Calls for a constitutional convention to remake state government are increasing in Pennsylvania and New York. In Illinois, an effort to begin reforming the state's tax structure that passed the state Senate last year will almost certainly resurface. And in Ohio, a Republican-led effort to restructure and downsize state government is getting a more serious hearing than it has in the past.

Still, for the most part, state policy makers seem more consumed with getting through the short term than with taking a hard look at longer-term fixes such as rebalancing their tax structures, rethinking the role and scope of state government, trying to jettison constitutional provisions or voter initiatives that constrain their ability to react to hard times, and reforming legislative processes and procedures. "There haven't been many places that have looked at the fundamental business of state government yet," says Bill Pound, executive director of the National Conference of State Legislatures. "They certainly have the capacity to do it, but it's unclear they have the will." As legislative sessions gear up, the question is whether 2010 -- a big election year, no less -- will be the year they discover they have no choice but to find the will.

This is in part because the little budget tricks that states have tended to rely on in order to keep the electorate happy have mostly run their course. "They've done the gimmicky things like moving a pay day across the fiscal-year date," says Scott Pattison, executive director of the National Association of State Budget Officers. "They've drained the reserves from several funds. So if revenue doesn't pick up, the tools in the toolbox are pretty limited."

Yet there is no sign that the revenue picture will be meaningfully brighter this year than last. As the bottom dropped out of the retail sector and personal and corporate incomes contracted sharply, state revenues in the second quarter of 2009 plunged by 16.6 percent--their biggest year-over-year decline since the early 1960s, according to the Nelson A. Rockefeller Institute of Government. (The comparison only reaches back five decades because reliable records didn't exist before that time.) The toll in several states was striking. Alaska's revenues dropped 37 percent from the spring of 2008 to spring a year later. Florida was down 28 percent from its revenue peak in 2006. Arizona, South Carolina and Georgia were down 20 percent, and a dozen other states were down 13 percent or more. "This is outside the bounds of historical experience," says Donald Boyd, senior fellow at the Institute.

Revenues continued to fall in the third quarter of 2009, although not quite as precipitously, with overall collections dropping 10.7 percent compared with a year earlier. As Boyd sees it, revenue declines are unlikely to be as severe this year, and some states may even have a few revenue sources turn around. But there's scant comfort to be gained. "They're down so far, even with a little growth they're still largely where they were," he says. Indeed, they may even be worse off, given that the federal stimulus money that most states relied on to see them through 2009 is scheduled to end after this year, and that their Medicaid and other social service rolls are expanding. In late October, the Center on Budget and Policy Priorities estimated that overall, states will face a combined budget gap of $350 billion in 2010 and 2011.

In past recessions, state revenues typically have lagged economic recovery by several years, as continued high unemployment dragged down personal income tax receipts and weak consumer spending kept sales tax receipts low. This time, though, there's the additional worry that the sources most states rely on to fund their activities -- the exceptions, of course, being resource-rich states such as Wyoming, North Dakota and Montana -- will either take an unusually long time to recover or may never do so.

That's the argument that has fueled Governor Daniels' warnings of a "coming reset" for state government. Revenue-trimming developments such as growth in the national savings rate, more frugal spending habits and tighter consumer credit, says Chris Ruhl, Indiana's budget director, don't appear to be temporary. "Even if we get to where folks are feeling more stable about the economic situation and their incomes are back growing," he says, "we think they're likely to be restricting spending over time." That, in turn, means sales tax receipts may never come back with the same strength they once had.

Similarly, Indiana has seen roughly three times as much of a drop in tax revenues from non-wage income, capital gains and real estate taxes as in the economic downturn of 2001. "It took us five years last recession to climb back and it's much worse this time, so presumably it will be longer this time until we get this revenue back," Ruhl says. And finally, with the national economic recovery expected to be slow -- and even slower in manufacturing-dependent states such as Indiana -- the state expects taxes on wages and salaries, which bring in about a quarter of all tax revenues, to take years to recover. In all, the state projects its revenues in 2011 will remain below 2007 levels. And Indiana -- where Daniels refused to dip into the state's rainy-day fund -- is in better fiscal shape than many other states.

All of this feeds a conviction that state government is in for a shakeout, says Daniels, a fiscal conservative who since the 2005 fiscal year has cut real per capita state government spending in every year but one. "Sure, I think Americans are better served by limited government," he says, "but this is not philosophy, it's arithmetic. There will not be close to enough money to support everything that's been built up over time. That's just a fact to be faced." Or as a senior New York State agency official puts it, "The truth is, government can't afford government anymore. We've become too expensive."

Seen in this light, the political turmoil that beset states from Arizona to New York last year could be viewed as a first, tentative step in coming to terms with a new reality. In the five stages of grief, states seem to be somewhere between "Denial" and "Bargaining," with a sojourn at "Anger" along the way and "Acceptance" still some distance off. This is hardly surprising, argues the Rockefeller Institute's Don Boyd. "Institutions do not support structural solutions," he says. "Basic structural solutions, like, 'We're going to rejigger the tax structure' or 'Let's fundamentally redo the spending side because we know we can't afford this in the long term' -- the benefits of those strategies come in the future, and political institutions provide no reward for actions that benefit the future. They're focused on actions in the next 12 months."

Still, there are a few states that have begun to look farther out. California, which was first to encounter truly desperate fiscal times, is not especially far along in addressing its long-term problems, but a good slice of its leadership believes that before the state can make long-lasting changes, it first needs to change the way government operates. In essence, says Mark Paul, a senior scholar at the New America Foundation, California has finally buckled under the pressure of three contradictory political systems. There's the regular, majority-rule, two-party system designed at its founding. There are the initiative-and-referendum reforms, which were instituted a century ago by Progressives to overcome the power of the railroads and other business interests, but which have more recently created policy incoherence and strengthened moneyed players who want to make an end run around the legislature. And finally, there's the system of super-majorities, introduced in the 1930s but magnified in 1978 by Proposition 13, "which basically said that we don't trust the legislature to operate in our interests and so we want it to operate by consensus, with a two-thirds majority on fiscal matters," Paul says. Anything of consequence in California, from budget bills to tax increases to changes in school funding, now requires either a legislative or a popular supermajority.

There are three wide-ranging efforts to reform the way California governs itself. One is a move by a foundation-sponsored group called California Forward to put a package of reform initiatives to a popular vote this year. Another is a business-backed push to create a limited constitutional convention to reform the budget process, elections and initiatives, state and local relations and government effectiveness; it would not be able to consider tax increases or social issues. Then there are joint legislative committees in both the Assembly and Senate that are looking at everything from budget reform to finding ways of helping the legislature better set priorities and strengthen its oversight of state government, to overhauling the initiative process. Mike Feuer, a Democrat from Los Angeles who chairs the new Assembly Select Committee on Improving State Government, says he's hopeful that a major change in the structure of government can happen by the end of this year.

Constitutional change is surfacing in Pennsylvania, too. It was the last state to pass a budget in 2009, missing a July 1 deadline by 101 days as Democratic Governor Ed Rendell and leaders from the Democratic-controlled House and the Republican-controlled Senate tangled over closing the state's $3.2 billion deficit. In doing so, they stoked a growing public perception that Harrisburg is incapable of functioning properly. "I think there's a growing realization that it's structural and not just the current crisis," Democratic state Representative Kathy Manderino says. "Our government structures and policies are deficient for a modern world."

Manderino co-chaired a study group of the state bar association that recommended calling for a state constitutional convention last fall, only to see its suggestion defeated at a statewide meeting in October over fears that an open convention might turn against the legal profession. Nonetheless, says Clifford Haines, a lawyer from Philadelphia who is the bar association's president and the moving force behind its reform push, "it is widely viewed that the legislature as it's structured is not functioning well, and that's being as polite as I can be. I think the ball of reform has been teetering and needed someone to push. Whether we've pushed hard enough to get the ball rolling, time will tell."

At the moment, the ball is in the hands of a coalition of four organizations that have been pushing for a convention. The groups include the state branches of Common Cause and the League of Women Voters, a conservative think tank called the Commonwealth Foundation and a grassroots reform outfit called Democracy Rising Pennsylvania. "It's conspicuous," says Tim Potts, Democracy Rising's director, "that the legislature can't reform itself."

While the ingredients might be falling into place for a far-reaching reappraisal of how Pennsylvania government runs, says Chris Borick, a political scientist who heads the Institute of Public Opinion at Muhlenberg College, they haven't yet produced the same momentum as in California. "It's not on the front of the public's mind," he says. And the upcoming election to replace Governor Rendell, who is term-limited out of office after this year, probably won't do much to lay groundwork for more intense reform pressure in the future. "There's nothing that makes me think there will be a more systematic and comprehensive look at state policy," says Borick. "It'll be duct tape rather than a redesign. It's very Pennsylvania."

It's also very United States. In part, says Don Boyd, that's because the policy choices of the moment don't favor long-term retrenchment on the part of state government. "I see politicians making statements about drastically reconsidering the role of government," he says. "But in general, the winds are in the other direction. Look at health care reform: When we're done, states will be doing more, not less, in health care for the needy. And right now, state governments spend more than 90 percent of the money for infrastructure. So unless they're going to get out of health care and education and infrastructure and public safety, the fundamental reworking of what state government does is unlikely."

That hasn't stopped some governors from starting to point their states in that direction. In Indiana, for instance, Daniels argues that the budget-scrubbing he instituted upon taking over five years ago means that all of "the little fruit," as he puts it, has already been picked. Given the state's continuing budget stress, he insists, this suggests that it's time to start looking at bigger matters. "With half of our budget in K-12 education and another 13 percent in higher education, you cannot hold those harmless forever," he says. "And K-12 dollars are as poorly spent in Indiana as they are in most states." In addition, he argues, it's time for the state to encourage consolidation of school districts and local governments -- beginning with an initiative he pushed unsuccessfully in the last legislative session to rid the state of its townships; he has vowed to bring it back this year.

Granholm's belief that Michigan needs to shed state departments comes against one of the grimmest economic shifts in the country. Michigan has lost 19 percent of the jobs it had in 2000 as the automotive industry has been retrenching. Even if the state were suddenly to enjoy the kind of boom it experienced in the 1990s, when unemployment stood at a mere 3 percent, "it would be 2025 before we had the same kind of employment we had in 2000," says Mitchell Bean, who directs the nonpartisan House Fiscal Agency. That is unlikely to happen, he adds. "We've gone from being a rich state to being a poor state, and we really do have to rethink the level of services we're providing, as well as building a broad-based tax structure with a low rate." Yet it seems unlikely that Michigan will be taking up these challenges anytime soon. The governor, attorney general and secretary of state all are term-limited out of office after this year, as are 30 of the Senate's 38 members. So House members are running for Senate, senators are running for statewide office -- and no one expects any substantive work on addressing the state's core fiscal problems to get done.

The same situation prevails in Illinois, where the February primary for governor and legislative seats has put all progress on hold. This is despite the fact that the state will have to close a roughly $12 billion budget hole -- in a budget of $26 billion that actually is spending less on public services than a few years ago. "No one is unaware of the fact that we are in a very dire situation, some would even say nearing a crisis," says Jim Muschinske, revenue manager for the legislature's Commission on Government Forecasting and Accountability.

The problem is that the deficit was engendered not just by falling revenues but also by a set of policy decisions that stretch back years. As part of a 1995 effort to tackle a massive unfunded pension liability that backloaded the truly onerous burdens, Illinois must make contributions in the billions over the next few years. It also must pay debt service on more than $3 billion in pension obligation notes it sold to fund operating expenses. "The recession is going to get a lot of the blame, but all the recession really did is exacerbate existing problems," says Ralph Martire, director of the Chicago-based Center for Tax and Budget Accountability. "At the end of the day, the recession will go away and the fiscal problems will remain."

There is some indication that Illinois citizens understand how deep-seated the problems are. In a poll that found public faith in state government at abysmally low levels -- hardly surprising, given the scandals that have beset the last two governors -- there was one astonishing statistic: "If you look at the value people think they get for services, they think they're getting better value from the federal government than from the state government," says David Yepsen, director of the Paul Simon Institute at Southern Illinois University, which conducted the poll. "I've never seen that before. To me, it just jumps out as evidence that people understand how miserable things are."

Whether that translates into fundamental change, on the other hand, is another matter. As in Pennsylvania and even in California -- where polls show that voters are desperately unhappy with Sacramento, but don't want to repeal the supermajority rule or institute other proposed fiscal changes -- it's uncertain that voters in Illinois are ready to press for doing things differently. "What is the awareness of the general public and members of the legislature as to whether or not we muddle through and end up with the same state government when we get out of this recession?" asks Christine Radogno, the Republican leader in the state Senate. "My hope is this is a time when government in general really does a sort of reset. But I'm not sure we're there yet."

New York may be the best example of just how difficult a process it will be. There, Democratic Governor David Paterson spent most of November wrangling with legislators of his own party -- especially in the Senate -- who refused to believe that the state's estimated $3.2 billion deficit was as severe as Paterson made it out to be, and who persisted in opposing his bid to make cuts in the two arenas that eat up the bulk of the state's budget: education and health care. In the end, the legislature passed a $2.7 billion "deficit reduction plan" that made heavy use of federal stimulus money and one-shot shifts from separate state funds and authorities. Legislators admitted that as soon as they reconvene, they'll have to start all over again.

It is entirely possible that when they do, both in New York and elsewhere, legislators and governors will spend this year as they have so many others when times are tight: looking willy-nilly for programs to cut, new sources of revenue to tap, and creative manipulations to get them through the year. If so, says NASBO's Scott Pattison, they will have wasted a cardinal opportunity. "My hope is that people will start to think about all this more strategically," he says. "Frankly, why do you want to be there at a senior level if you don't have some impact? And when you have scarce resources, the way to have an impact is not just to cut, it's to direct those cuts in a way that you have some kind of prioritization and you leave a legacy."