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Recession Continues to Batter State Budgets; State Responses Could Slow Recovery

The worst recession since the 1930s has caused the steepest decline in state tax receipts on record. As a result, even after making very deep cuts, states continue to face large budget gaps. New shortfalls have opened up in the budgets of over half the states for the current fiscal year (FY 2010, which began July 1 in most states). In addition, initial indications are that states will face shortfalls as big as or bigger than they faced this year in the upcoming 2011 fiscal year. States will continue to struggle to find the revenue needed to support critical public services for a number of years.

• New gaps in 2010 budgets. An increasing number of states are struggling to keep their 2010 budgets in balance as the mid-point of the fiscal year approaches. Because revenues have fallen short of projections, mid-year shortfalls have opened up in 26 states — some of which have already addressed them — totaling $16 billion or 4 percent of these budgets.
  
  These new shortfalls are in addition to the gaps states closed when adopting their fiscal year 2010 budgets earlier this year. Counting both initial and mid-year shortfalls, 48 states have addressed or still face such shortfalls in their budgets for fiscal year 2010, totaling $178 billion or 26 percent of state budgets — the largest gaps on record.
• Additional large gaps for 2011. States’ fiscal problems will continue into the next fiscal year and likely beyond. Fiscal year 2011 gaps – both those still open and those already addressed — total $80 billion or 14 percent of budgets for the 35 states that have estimated the size of these gaps. These totals are likely to grow as revenues continue to deteriorate, and may well exceed $180 billion.
• Combined Gaps of $350 billion for 2010 and 2011. These numbers suggest that when all is said and done, states will have dealt with a total budget shortfall of at least $350 billion for 2010 and 2011. (This includes both gaps already closed and gaps projected for the future.)
• Role of Federal Assistance. The federal assistance to states provided in the American Recovery and Reinvestment Act is lessening the extent to which states need to reduce services or raise taxes. But it now appears likely the federal assistance will end before state budget gaps have abated. The federal government could avert state actions such as deep additional budget cuts that would further harm the economy by phasing out assistance more gradually over the period during which state fiscal distress is expected to continue.

State Budget Shortfalls in 2010 and 2011

States already have faced and addressed extraordinarily large shortfalls as they developed and implemented spending plans for fiscal year 2009 (which has now ended) and fiscal year 2010 (which is underway). Shortfalls are the extent to which states’ revenues, hit hard by the recession, fall short of the cost of providing services. Every state save Vermont has some sort of balanced-budget law. So the shortfalls for 2009 and most of the shortfalls for 2010 have already been closed through a combination of spending cuts, withdrawals from reserves, revenue increases, and use of federal stimulus dollars.

But in over half the states, new gaps have recently emerged for 2010, as revenues have fallen short of the projections on which the 2010 budgets were based (even though the projections themselves seemed pessimistic at the time). Already, 26 states have identified mid-year gaps — some but not all of which have already been addressed through spending cuts or other measures — totaling $16 billion or 4 percent of these budgets. Table 1 lists the states facing mid-year budget shortfalls.

These new shortfalls are in addition to the gaps states closed when adopting their fiscal year 2010 budgets earlier this year. Table 2 combines these new gaps with previously reported gaps for 2010 — the gaps that were addressed when states wrote their budgets for this year. In total, 48 states have addressed or still face shortfalls in their budgets for fiscal year 2010, totaling $178 billion or 26 percent of state budgets — the largest gaps on record. (Table 4 of this paper shows the 2009 budget gaps that were addressed, and Table 5 lists the sources of these shortfall estimates for each state.)

As we look ahead to 2011 and beyond, even as the economy appears to be moving in the direction of economic recovery, states’ fiscal prospects remain extremely weak. Indeed, historical experience and current economic projections suggest 2011 will be worse than 2010. Figure 2 compares the size and duration of the shortfalls that occurred in the recession of the first part of this decade to shortfalls this time. In the early 2000s, as in the early 1990s and early 1980s, state fiscal problems lasted for several years after the recession ended. The same will undoubtedly be the case this time, since the current recession is more severe — deeper and longer — than the last one, and state fiscal problems have proven to be worse and are likely to remain so. Unemployment, which peaked after the last recession at 6.3 percent, has already hit 9.8 percent, and many economists expect it to rise higher and remain at high levels throughout 2010 and beyond. Continued high unemployment will keep state income tax receipts at low levels and increase demand for Medicaid and other essential services that states provide. High unemployment and economic uncertainty, combined with households’ diminished wealth due to fallen property tax values, will continue to depress consumption, thus sales tax receipts also will remain low. These factors suggest that state budget gaps will continue to be significantly larger than in the last recession, and last longer.

Taking all these factors into account, it is reasonable to expect that for 2011, shortfalls are likely to hit $180 billion. [1] Once employment is growing again, state budget problems will diminish but it is likely that states will face shortfalls of at least $120 billion in fiscal 2012. This means that after taking into account the federal Recovery Act dollars that are likely to remain available for fiscal year 2011 (approximately $40 billion), states will still have to close shortfalls of some $260 billion for fiscal years 2011 and 2012 combined.

Initial projections from the states, although incomplete, are consistent with this outlook. Table 3 lists the shortfalls that many states are already projecting for 2011. A total of 39 states face or have already addressed shortfalls for fiscal year 2011. This total includes at least 28 of the states that prepare budgets annually that have already looked ahead and anticipate deficits for fiscal year 2011. In addition, eleven states that operate on a two-year budget cycle (known as a biennial budget) have already adopted budgets for 2011 that addressed shortfalls totaling at least $22 billion. In total, fiscal year 2011 gaps – both those still open and those already addressed — total $80 billion or 14 percent of budgets for the 35 states that have estimated the size of these gaps. This figure is based in many states on revenue projections that are months old, and it is reasonable to expect that it will grow.

Of course, a faster-than-expected recovery could reduce the size of those shortfalls.  But several factors could make it particularly difficult for states to recover from the current fiscal situation.  Housing markets might be slow to fully recover; their decline already has depressed consumption and sales tax revenue as people refrain from buying furniture, appliances, construction materials, and the like.  This also would depress property tax revenues, increasing the likelihood that local governments will look to states to help address the squeeze on local and education budgets.  And as the employment situation continues to be weak, income tax revenues will continue to lag and there will be further downward pressure on sales tax revenues as consumers are reluctant or unable to spend.

Some states have not been affected by the economic downturn, but the number is dwindling. Mineral-rich states — such as New Mexico, Alaska, and Montana — saw revenue growth in the beginning of the recession as a result of high oil prices. More recently, however, the decline in oil prices has affected revenues in these states. The economies of a handful of other states have so far been less affected by the national economic problems. Only two states, Montana and North Dakota, have not reported budget shortfalls, but the recession has dampened those states’ surpluses, which were largely mineral-driven as well.

The Consequences of Shortfalls

In states facing budget gaps, the consequences are severe in many cases — for residents as well as the economy. As the 2009 fiscal year ended and states planned for 2010, budget difficulties have led at least 41states to reduce services to their residents, including some of their most vulnerable families and individuals.[2] Over 30 states have raised taxes to at least some degree, in some cases quite significantly.

If revenue declines persist as expected in many states, additional spending and service cuts are likely. Budget cuts often are more severe later in a state fiscal crisis, after largely depleted reserves are no longer an option for closing deficits.

Expenditure cuts are problematic policies during an economic downturn because they reduce overall demand and can make the downturn deeper. When states cut spending, they lay off employees, cancel contracts with vendors, eliminate or lower payments to businesses and nonprofit organizations that provide direct services, and cut benefit payments to individuals. In all of these circumstances, the companies and organizations that would have received government payments have less money to spend on salaries and supplies, and individuals who would have received salaries or benefits have less money for consumption. This directly removes demand from the economy.

Tax increases also remove demand from the economy by reducing the amount of money people have to spend — though to the extent these increases are on upper-income residents that effect is minimized because much of the money comes from savings and so does not diminish economic activity. At the state level, a balanced approach to closing deficits – raising taxes along with enacting budget cuts – is needed to close state budget gaps in order to maintain important services while minimizing harmful effects on the economy.

The Role of Federal Assistance

Federal assistance is lessening the extent to which states need to take pro-cyclical actions that further harm the economy. The American Recovery and Reinvestment Act enacted in February includes substantial assistance for states. The amount in ARRA to help states maintain current activities is about $135 billion to $140 billion over a roughly 2 ½-year period — or between 30 percent and 40 percent of projected state shortfalls. Most of this money is in the form of increased Medicaid funding and a “State Fiscal Stabilization Fund.” (There are also other streams of funding in the economic recovery act flowing through states to local governments or individuals, but these will not address state budget shortfalls.) This money has reduced the extent of state spending cuts and state tax and fee increases.

But it now appears likely the federal assistance will end before state budget gaps have abated. The Medicaid funds are scheduled to expire in December 2010, which is just halfway through the 2011 fiscal year in most states.[3] States will have drawn down most of their State Fiscal Stabilization Fund allocations by then as well. So even though the 2011 budget gaps may well be larger than those for 2010, there will be less federal money available to close them. States are likely to respond with spending cuts and tax increases even larger than those that have already been enacted. Such measures in most states will take effect with the 2011 fiscal year — that is, in July 2010, thereby reducing aggregate demand and weakening the economy at a critical moment in its recovery.

A possibility would be for the federal government to reduce state budget gaps – and hence avert some spending cuts and/or tax increases — by phasing-out the Medicaid funds over the period during which state fiscal conditions are expected to still be problematic, rather than cutting them off in December 2010. The federal government could also provide additional assistance to states for education through the State Fiscal Stabilization Fund. Ideally, such action would be taken relatively soon, so that it can be factored into states’ budget decisions for fiscal year 2011.

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