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States Face Four Big Budget Threats

We rely on states and localities to provide public services like education, health care, and infrastructure that lay the groundwork for a prosperous future.  But as we describe in a new paper, four serious challenges threaten their ability to pay for those programs.

  1. The most severe recession in seven decades blasted holes in state budgets from which they have yet to recover. The recession of 2007-09 sharply reduced state revenues, causing budget shortfalls totaling well over half a trillion dollars.  Revenues have improved lately but remain about 6 percent below where they were five years ago, in inflation-adjusted dollars, even as the number of people needing state services has grown.  In addition, states need to replenish reserve funds that states tapped in the recession.  These factors make it very hard for states to reverse past budget cuts — let alone make cost-effective investments in areas like early education, job training, and new business incubation.
  2. States’ antiquated tax systems are ill-suited to raising adequate revenue in a 21st century economy. States haven’t modernized their tax systems to keep pace with trends such the growth of the service sector and of e-commerce (see chart).  Nearly half of total household purchases go for services[v1] , for example, yet only a few states apply their sales taxes to a broad array of services.
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  4. The federal government, which provides about one-quarter of state and local revenues, is on track to make deep spending cuts that could hit states hard. The 2011 Budget Control Act has already caused cuts in grant programs to states and will push federal funding for a wide range of state and local services — schools, water treatment, law enforcement, and other areas — to its lowest level in four decades as a share of the economy.  Additionally, automatic cuts (“sequestration”) are scheduled to begin in March, causing over $6 billion in additional cuts in aid to states this year.  Those are just the budget cuts that are already scheduled to occur; future deficit-reduction legislation could impose still more cuts, especially if it doesn’t include substantial new revenues that would partially offset the need for more cuts.
  5. Some state policymakers are pushing for large tax cuts that would further undermine state revenues, with potentially dramatic consequences for public services. In five states, governors and/or leading legislators have proposed complete repeal of the state income tax, which typically provides one-third to one-half of all state revenues.  (No state other than oil-rich Alaska in the 1970s has ever repealed its income tax.)  Less radical — but still harmful — tax cuts are on the table in a number of other states, as are rigid limitations on state revenue growth.

Some states likely will rise to these challenges, protecting their schools, transportation networks, and other public services and modernizing their revenue systems for the long term.  Some other states likely won’t meet the challenges, choosing instead to accept depressed revenues and decaying public services as the “new normal.”  The country’s future prosperity depends to a significant degree on the number of states that choose the first, more fruitful path.

Click here to read the full paper.