Budget Shocks

States have been feasting on the bounty of a booming economy for half a decade. Now what?
by | July 2001

Since the mid-1990s, spring has been the budget officers' favorite time of year. When year-end tax filings arrived in state treasuries, virtually every state with a personal income tax found itself with the delight of an "April Surprise"--year-end revenues that greatly exceeded state forecasts.

"For the past four to five years, actual revenues beat the estimates and beat them handily," says Sam Nemer, Ohio's chief economist. "You kind of get euphoric and think this is here to stay."

It seemed like it was. Until this year. For most states, this was the spring that the April Surprise vanished. But it's more than the pots of money--and the robust economy that produced them--that have gone aglimmering. So have some of the basics on figuring out what revenues will be, from which taxpayer and from what tax.

Under the old verities, state financial officials shared a common set of assumptions about how revenues would behave if the economy headed south: Sales tax receipts, which now account for 33 percent of state tax takes, would be the first to fall. Corporate income tax receipts, which account for approximately 6 percent of state tax revenues overall, would vacillate wildly. And personal income tax revenues, which now account for another 34.5 percent of state-raised revenue, would play their usual role--old reliable: Unless the economy plummeted sharply and personal incomes contracted severely, personal income tax revenues would stay steady. And even if the economy did plunge into a deep recession, there would still be a lag of several months before personal income tax revenues fell, too.

In uncertain economic times, these assumptions have always been reassuring. The trouble is, they may no longer be right.

The revenue figures behind the April Surprise suggest that states' economic prosperity may now be built on a much narrower base than many policy makers realize. Over the course of the 1990s, capital gains and stock options,--which are extremely volatile--grew to be a larger part of personal income than ever before. At the same time, personal income taxes started to rival sales taxes as the single most important source of state revenue. As a result, among many of the states with personal income taxes, the most important and steady source of revenue is more volatile than ever before.

Thus far, most states have experienced only the upside of this volatility--the April Surprise. And this revenue fallout from the booming economy has brought unprecedented opportunity to state politicians. They have had the enviable task of spending more money while cutting taxes and putting more cash in the state savings account. According to the economic forecasting firm Economy.com, since the mid-1990s, state and local government spending has increased by some $175 billion. At the same time, states have trimmed their taxes by $33 billion over the past seven years, a reduction that more than erased the roughly $15 billion in new taxes that states enacted during the economic recession of 1991-92. And all through the spending and cutting, states were able to build up their reserve funds to the most robust they've been in 20 years.

All of this, of course, was made possible by six years of unusually strong revenue growth. Between 1994 and 2000, state revenues grew 6 to 10 percent a year, considerably higher than the 5 percent growth states typically experience during an economic expansion. And the fastest-growing component of state revenues came from personal income taxes. Between 1994 and 2000, personal income tax receipts grew 61 percent, far faster than the 46 percent growth rate of sales tax revenues or the 37 percent growth rate of corporate income tax revenues.

What were the economic engines that helped produce all this incoming money? For starters, more people were working. Some 21 million new jobs were created in the 1990s. In addition, there was a marked increase in the number of people earning more than $500,000 a year. Between 1994 and 1997 (the last year for which numbers are available), the number of high-income earners increased by approximately 20 percent a year.

Behind the growing number of wealthy people, of course, was a surging stock market. According to a recent study conducted by the Nelson A. Rockefeller Institute of Government at SUNY-Albany, wages accounted for 35 percent of the income of taxpayers earning $500,000 a year or more in 1997. Capital gains accounted for almost as much--33 percent. Income from partnerships, stock options and S-corporations accounted for most of the rest.

At the same time that there was an increase in the number of rich people who were dependent on capital gains and stock options, states were becoming more dependent on the rich. "The other interesting thing driven by capital gains is that the top 5 percent of taxpayers now pay approximately 50 percent of taxes," says John Layman, Virginia's chief economist. In 1994, by contrast, they were paying 35 percent. In fiscal year 2000, the year the Nasdaq hit 5,000, Virginia experienced one month where less than 1 percent of earners contributed more than 10 percent of the state's total withholding revenues.

States such as California, Massachusetts, New York and Virginia benefited the most from the emergence of the capital gains factor. However, all 43 states with personal income taxes also profited from the stock-market boom. In Ohio, for instance, there is a revenue category that includes capital gains, and the state has been seeing growth rates of 15 percent in that category. Nemer, the state's chief economist, believes that, for the most part, the rise in that category was driven by capital gains.

What goes up, must come down. Benefiting from a boom also means weathering a bust. Many experts believe that personal income tax receipts are more volatile now than they've ever been--and potentially far less reliable than some state budget officers believe. A June 2000 study by Donald Boyd, director of the Rockefeller Institute's Fiscal Studies Program, attempted to rank states by their vulnerability to a stock market decline. The results were surprising. Predictably, states such as Connecticut, Massachusetts and Virginia were in the top 10, but so were Colorado, Idaho, Minnesota and North Carolina.

The current wisdom is that the capital gains and stock options income has had its last hurrah, that tax year 2000 was a capital year for capital tax realizations. "People sold stock they'd been sitting on for 20 years," says Mike Kiltie, state economist for North Carolina. "You can only do that once."

At the same time, Kiltie also notes that "unlike the old days, where capital gains was kind of a residual payment, now there are big bucks involved." The bucks are not only big, they're also volatile. "They could go away in a heartbeat," he says.

In North Carolina, they already have. As the state headed into its budgeting season, it was facing an $850 million revenue shortfall.

Already there are signs that stock-market dependent states such as California, Massachusetts and Virginia may be in for a nasty surprise in fiscal year 2002. According to California state economist Ted Gibson, in fiscal year 2001 capital gains and stock options generated 23 percent of California's revenues, roughly $18 billion. Gibson expects that number to decline by 31 percent next year, a decrease that would erase more than $5.6 billion from California's ledger sheet. Virginia, home to high-tech giants such as America Online and Nextel, saw overall corporate income tax revenues fall by roughly 40 percent in fiscal year 2001--a rate of decline more than twice what the state had originally forecast.

Ominous signs of weakness are already appearing in several states. A year ago, New Jersey was trying to digest a tax revenue windfall that allowed state officials to draft a budget with a 10 percent spending increase and a record $870 million surplus. This year, as May turned to June, New Jersey was estimating its budget deficit at $1.6 billion.

Yet despite indications of slowing growth and rising costs, forecasters in some states remain optimistic about the future. While corporate tax receipts in Virginia have fallen and stock-options income seems to be disappearing, Virginia is predicting revenue growth of about 6.8 percent in fiscal year 2002. Economists there note that the state's employment is at a record high, unemployment is 2.1 percent, sales tax growth is still running at about 5 percent, and withholding is looking fairly strong.

Indeed, as of this spring, 15 governors were moving forward with tax- cut proposals. In Florida, even as revenue growth has slowed and Medicaid spending has risen, Governor Jeb Bush has pushed ahead with a $300 million tax cut in fiscal year 2002--while asking the legislature to reduce spending by 5 percent. Virginia is looking at big spending cuts, too.

Capital gains is not the only revenue problem. The manufacturing economy is clearly struggling and has been for a while, affecting the tax take in manufacturing-reliant states from Alabama to Wisconsin. While the service economy has remained fairly strong, states that rely heavily on sales tax revenues--states such as Florida, Mississippi, South Carolina and Tennessee--have had to contend with sharp revenue shortfalls.

For Midwestern and Southeastern states that depend on the manufacturing sector, revenues started to shrink last fall. In fact, the manufacturing slowdown has caused far more pain than the stock market's retrenchment. In recent months, manufacturing-sector states such as Indiana, Iowa, Michigan and Oregon have had to take an ax to their budgets, freezing hiring and purchasing or even imposing across- the-board spending cuts. In many cases, these shortfalls have been exacerbated by previously enacted tax cuts that are only now starting to go into effect.

Iowa, a state whose dependence on manufacturing belies its agricultural image, is one of the states that's suffering most from the manufacturing downturn. A meeting of the Revenue Estimating Council in December projected current revenue would grow 3.5 percent over the previous year. Then, says Cynthia Eisenhauer, the director of Iowa's Department of Management, "we experienced a precipitous drop in revenue that was the most precipitous drop in 20 years." As a result, Iowa lowered projections for revenue growth from 3.5 percent to 0.7 percent. Governor Tom Vilsack has responded to the shortfall by cutting state operating budgets by 6 percent, announcing plans for a complete review of all state government programs and operations and, more controversially, dipping into Iowa's rainy day fund in order to preserve a $40 million increased pay package for state teachers.

After years of strong revenue growth, Indiana experienced flat revenue growth between July 2000 and May 2001. The state's economy is more diversified than it has been in the past, but roughly a quarter of employment and a third of wages are in manufacturing, according to Bob Lain, assistant director of the Tax and Revenue Division in Indiana's state budget agency. Indiana's revenue slowdown also reflects the state's decision to cut taxes, first in 1997 and then again in 1999. In fiscal year 2000, the first year the tax cut went into effect, personal income tax revenues rose only 1.5 percent. In the absence of a tax cut, the budget agency estimates that personal income tax revenues would have grown by around 4 percent.

States that went for rebates rather than permanent tax cuts are in slightly better shape but still have their problems. In Oregon, for instance, if actual revenues exceed projected revenues by more than 2 percent, the state must return the extra money to taxpayers. So Oregon is currently returning money to taxpayers because of larger-than- expected revenues in the past--even though current revenues are falling off. "At the same time we're slowing, we're going to have to send out a $350 million refund," says Cora Parker, a revenue economist in Oregon's Office of Economic Analysis. However, the falloff in revenues will eventually catch up with the mandated rebates.

As to states that rely disproportionately on sales tax revenues, there are revenue problems aplenty. In Tennessee, a state with no personal income tax, the sales tax provides 59 percent of state general fund revenues. As a result, when retail sales start sniffling, Tennessee's budget catches pneumonia. Budget analysts expect fiscal year 2001 revenues to fall short by at least $150 million.

Other Southeastern states are also very vulnerable to slowing sales tax revenues. According to the National Conference of State Legislatures, sales tax receipts provide 40 percent of South Carolina's revenues. Mississippi relies on sales tax receipts for 48 percent of its revenues. Florida's sales tax provides 53 percent of its revenue. Not surprisingly, all of these states are experiencing sharp revenue declines.

When assessing the overall budgetary pressures in the states, Stacey Mazer, acting executive director of the National Association of State Budget Officers, puts it this way: "It's a real mixed bag right now, underscoring the level of uncertainty out there."