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September 9, 2001

State Responses to Tight Fiscal Conditions

Short-Term Fixes May Backfire if the Economy Does Not Soon Recover;

Cyclical Downturn Masks Structural Problems in Some States

by Kevin Carey,
Liz McNichol and Iris J. Lav


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This year many states faced the tightest fiscal conditions they have seen in a decade. A slowing economy has resulted in reduced revenue growth as expenditures in areas such as health and education continue to increase. While not all states have experienced problems, a review of state experiences in fiscal year 2001 and projections for fiscal year 2002 show that the signs of fiscal distress are widespread.

In two-thirds of the states, revenues are below original projections. A recent survey conducted by the Rockefeller Institute of Government found that by the middle of FY 2001, the inflation-adjusted growth rate of state revenues had fallen to its lowest level in five years. In addition, spending is exceeding projections in many states. A March report by the National Conference of State Legislatures found that 31 states had expenditures above projections for FY 2001.

Federal actions will increase the fiscal problems states are experiencing. The recently enacted federal tax cuts will result in state income and estate tax revenue reductions in most states, beginning in most cases in FY 2002 or 2003. The squeeze on federal domestic discretionary spending that likely will be necessary to finance the federal tax cuts may also result in reduced grants to states over time.

If decisions about revenue and spending are not made in a thoughtful way, the consequences can be especially severe for low-income and other vulnerable populations who are often the hardest-hit by a slowing economy.

While the current downturn is mild compared to the early 1980s and 1990s, the potential exists for the decline to continue or deepen. In that context, it is useful to examine the actions states have taken to date to cope with this slowdown, and consider how the states might fare if the slowdown is prolonged or worsens. In addition, analysis of the strategies used and decisions made in the states that are feeling the effects first may yield lessons for states that have not yet been affected by tighter fiscal times.

When revenue growth declines, state policymakers are forced to make tough choices about how to balance their budgets. They can reduce spending, raise taxes, spend down reserves, or rely on short-term fixes. Each of these choices has implications for the public who rely on government programs. If decisions about revenue and spending are not made in a thoughtful way, the consequences can be especially severe for low-income and other vulnerable populations who are often the hardest-hit by a slowing economy.

A number of states are using short-term strategies and temporary expedients to close fiscal gaps. For example,

  • California, Indiana, Kentucky, Michigan, Mississippi, Ohio, and Washington have begun to tap the rainy day funds that have been put away for such a purpose and other reserves to balance their budget.
  • Similarly, Tennessee and Wisconsin are using one-time, non-recurring revenues to fund ongoing expenditures.
  • States such as Texas and Indiana are using what might be termed "accounting gimmicks", such as moving expenditures that normally would be made in one fiscal year to the subsequent year. This means that revenues must be found in the subsequent year to cover both the deferred expenditure and normal, ongoing expenditures.
  • Perhaps the ultimate "gimmick" was used by New Hampshire and Virginia in enacting their new budgets; these states simply increased revenue estimates to justify tax and budget decisions.

Use of these budget balancing measures can be a double-edged sword. To the extent that a state's fiscal problems are simply the result of a short-term economic slowdown, use of fund balances or other budget adjustments can be a prudent method of maintaining vital services until revenue growth rebounds. When an economic decline and resulting fiscal deficit are prolonged beyond a single year, however, such tactics can make the second or third year of a downturn more difficult to manage when one-time funds are no longer available and the costs of delayed expenditures come due.

Moreover, in some states the fiscal imbalance has causes that go beyond temporary economic circumstances. If a state's fiscal problems are a function of more serious problems, such as a long-term imbalance between the growth rate of revenue and the growth in the cost of basic programs, short-term budget fixes often delay the realization that difficult choices must be made.

States sometimes respond to tight fiscal circumstances by raising taxes, either temporarily or permanently. In 2001, state tax activity was mixed. Some states have raised or are proposing to raise new taxes. Seven states have enacted legislation that will increase revenues by more than one percent of their operating budgets. They are: Arizona, Indiana, Maine, Nevada, New Hampshire, West Virginia, and New Jersey. At the same time, other states enacted permanent tax cuts or one-time tax rebates that reduced state revenues by more than one percent, including tax reductions in Idaho, Pennsylvania, Oregon, and Minnesota. It remains to be seen if these tax reductions will prove affordable if the economy continues to stagnate or declines.

If a state's fiscal problems are a function of more serious problems, such as a long-term imbalance between the growth rate of revenue and the growth in the cost of basic programs, short-term budget fixes often delay the realization that difficult choices must be made.

In general, the economic slowdown appears to have elevated the level of debate regarding taxation. A few states with tax structures that are less responsive to economic growth have debated fundamental changes to their system of raising revenues. In Tennessee, for example, there was both substantial support and opposition for augmenting the state's traditional sales and property taxes with an income tax that is somewhat more progressive and more likely to mirror the overall growth in the economy. Budget shortfalls in North Carolina have prompted policymakers to consider proposals to close corporate income tax loopholes, add an additional income tax bracket for wealthy taxpayers, create a state lottery, and implement a state sales tax coupled with an earned-income tax credit to offset its regressive effects.

A number of states implemented spending cuts this year, either to balance their FY 2001 budgets or to close projected budget gaps in FY 2002 and 2003.In some cases cuts were targeted at "counter-cyclical" programs such as Medicaid, which tend to increase in cost as economic growth declines. Indiana and Kentucky both enacted budgets with Medicaid appropriations that were less than the estimated cost of providing services, forcing those states to consider cost-cutting measures for their Medicaid programs. Other states, including Ohio, Mississippi, and South Carolina, enacted broad, across-the-board spending cuts by applying a uniform percentage reduction to a variety of budget line items. Both these strategies run the risk of reducing vital services to vulnerable populations at the same time that economic circumstances make those services most needed.

Unforeseen revenue and budget shortfalls highlighted the need in a number of states for better budget information. While the weakening economy was a primary culprit in budget shortfalls, some states may have inadvertently over-reached in cutting taxes and increasing spending during the economic expansion of the 1990's, in part because they lacked long-range budget forecasts and revenue analysis that would have better revealed the ultimate cost of those policies to the state's bottom line. The creation and dissemination of more comprehensive, accurate budget information can contribute to a more informed public debate and allow for more prudent long-range tax and budget policy.



The tenor of state government finance has changed over the past year. Many states that experienced vigorous, sustained increases in tax revenue during the 1990s are now facing declining or even negative rates of revenue growth. As state fiscal climates change, so too do the strategies necessary for managing state budgets. While the focus of state fiscal policy in the mid-to-late 1990s may have been on balancing the need for investments and new programs with the desire to cut taxes and build state reserves, the weakening economy brings a new set of issues. State budgetmakers are challenged to maintain service levels for existing populations in an environment where expectations outweigh resources by a significant degree.

This paper provides an overview of state fiscal conditions and budget decisions in 2001, a more in-depth examination of how four states reacted to those conditions, and a discussion of some of the issues that state policymakers will face as they work to ensure that their states continue to meet their obligations to all citizens, including the most vulnerable, in leaner fiscal times.


Current Status of State Fiscal Conditions

Many states experienced contentious budget deliberations in 2001, in some cases forcing legislatures into special sessions. Negotiations were hampered by fiscal pressures stemming from slowing revenue growth and unanticipated expenditures. Of the 48 states that considered budget legislation in 2001, seven were unable to pass FY 2002 budgets prior to the beginning of that fiscal year.(1)


The general trend among states has been a decline in the rate of revenue growth. At least 27 states revised their FY 2001 revenue estimates downward or did not meet expected revenue targets, while 21 states have lowered their initial revenue forecasts for FY 2002. Revenue forecast downgrades have been as small as $58 million (Arkansas) and as large as $4.6 billion (California) over a two-year period.

A recent report from the Rockefeller Institute of Government indicated that overall inflation-adjusted state revenue growth rates in the second and third quarters of FY 2001 were at the lowest levels in five years. Sales tax revenues grew at the lowest level since the last recession. In six states — Alabama, Maine, Michigan, North Carolina, Ohio, and Wisconsin — revenues during the first three quarters of FY 2001 actually declined from the same time period in FY 2000.(2)

A few states bucked the trend. Fast-growing states like Colorado and New Mexico, whose economies are less dependent on manufacturing, continue to experience strong revenue growth, while rising energy prices have increased revenues for resource-rich states including Alaska and Texas.

Indiana Fails to Address a Structural Budget Deficit

At the end of FY 1999, Indiana had a year-end balance of over $2 billion. Equaling 23 percent of revenues, it was at that time one of the largest surpluses of any state. Since then, a combination of structural budget deficits, stagnant economic growth, and a lack of remedial action by policymakers has dramatically changed Indiana's fiscal outlook. The state's net fund balances will be virtually depleted by the end of FY 2003, with an ongoing deficit between revenues and expenditures of almost $600 million a year. The circumstances and decisions that led Indiana to this point are representative of the issues faced by many states in 2001.

The first signs of Indiana's current fiscal problems can be found in the budget passed for FY 2000 - 2001. That budget, combined with significant tax cuts, produced an imbalance between revenues and expenditures of $400 million per year. This was followed by a national economic slowdown that was particularly hard on the industrial Midwest. In December 2000, forecasters in Indiana cut their state revenue estimate for FY 2001, which in turn reduced expected revenues for FY 2002 and 2003. As a result, budget writers in the 2001 General Assembly were faced with the task of satisfying constituencies accustomed to the strong revenue growth of the 1990s in light of declining revenue growth and shrinking fund balances. An April update to the revenue forecast that further cut the estimate of FY 2001 - 2003 revenues made the situation more difficult. Governor Frank O'Bannon proposed an increase in cigarette taxes to close the budget gap, but the proposal received little legislative support.

The final budget compromise included no new revenue sources or significant spending cuts. Instead, it combined a series of fund balance transfers and payment delays with a Medicaid appropriation that fell short of projected expenditure needs to keep the state financially solvent through the end of FY 2003. The State Budget Agency's projection of revenues and expenditures for FY 2002 - 2003 shows a variety of one-time funds being depleted to shore up the general fund: $375 million from lottery and gambling revenues, $104 million from the state's Medicaid reserve, $175 million from a school funding reserve, and $53 million from the rainy day fund. Indiana also plans to delay $556 million in FY 2002 - 2003 payments to schools, universities, and local units of government until after the end of the biennium. Meanwhile, the Medicaid appropriation was set $140 million below the projected cost of providing services. Policymakers were, however, able to find room in the budget for $70 million in local pet projects for individual legislators.

Indiana is projected to end FY 2003 with a cash balance of $616 million and a delayed payment liability of $556 million - a net balance of $60 million. The next state budget cycle will begin with a deficit between ongoing revenues and ongoing expenditures of almost ten times that amount — $594 million. Citing the state's fiscal problems, the governor let the 2001 budget bill become law without his signature, and announced a seven percent across-the-board cut for many agency budgets in FY 2002.

The unwillingness of Indiana policymakers to address a yawning budget gap in 2001 may have serious long-term consequences for the state. Court-ordered restructuring of the property assessment system and mandated increases in Medicaid costs will add to the state's fiscal pressures. Other than delaying and adjusting a previous tax cut that had ballooned in cost, the 2001 General Assembly took no actions to remedy the state's long-range fiscal problems. Rather than use the fund balances accumulated during good times to facilitate the transition to long-term budget stability, policymakers pushed those decisions into future years where, absent a miraculous turnaround in revenue growth, the circumstances will be more dire. If a budget is a fiscal roadmap, Indiana appears to have charted a course directly toward a financial crisis.

The problem of slowing revenue growth has caused dissension among policymakers in some states with regard to the level of anticipated revenues. For example, while the New Jersey State Treasurer estimated that revenue collections for FY 2001 and FY 2002 would be $948 million below previous projections, the New Jersey Office of Legislative Services predicted a shortfall of $1.6 billion. No reconciliation was made between those estimates. In compliance with state law, the legislature used the treasurer's estimates for its FY 2002 - 2003 budget. If revenue collections turn out to be closer to the Office of Legislative Services projection, a mid-year correction may be in the offing.

In addition to revenue problems caused by the slowing economy, most states will lose revenue due to the recent tax cuts passed by the federal government. The federal tax cut includes a phased-out repeal of the estate tax, costing states approximately $6.5 billion per year once the impact is fully felt in 2005. Most states will begin to lose revenues as a result of this change in FY 2002 or 2003. Because most states rely on federal definitions of income as the starting point for their state income tax, the federal income tax cuts will also result in future state revenue reductions. In addition, the squeeze on federal domestic discretionary spending that may be necessary to finance the tax cuts may result in reduced grants to states over time.



In addition to revenue problems caused by the slowing economy, most states will lose revenue due to the recent tax cuts passed by the federal government.

At the same time that state revenue growth is slowing, many states are experiencing expenditure growth that is higher than projections. A recent National Conference of State Legislatures report indicated that 31 states had expenditures above projections in FY 2001.(3) Medicaid cost overruns were reported in 23 states, while other states cited increased costs for K-12 education and corrections. A survey conducted by the National Association of State Budget officers reported an average growth rate in Medicaid expenditures of 9.8 percent in FY 2001.(4) A subsequent NCSL survey of 40 states that passed FY 2002 budgets reported an FY 2001 Medicaid growth rate of 14 percent. These rates are significantly higher than the rates of growth states have experienced in recent years.

As a response to declining revenue growth and rising expenditures, a number of states cut their FY 2001 budgets during the fiscal year. Three of the largest cuts were in North Carolina, Virginia and Alabama — $330 million, $470 million, and $264 million respectively.(5)

Budget Surpluses and Deficits

Some states may be experiencing budget deficits that are both cyclical and structural in nature — the downturn in the economy is exacerbating a pre-existing, underlying revenue shortfall.

For many states, the basic problem driving budget discussions in 2001 was an imbalance between revenues and expenditures. More money was going out of state coffers than was coming in, reducing the amount of future funds available for appropriations and driving down the level of current fund balances and reserves. A recent report indicated that 33 states saw their fund balances decline from FY 2001 to FY 2002. Aggregate state balances, including both general funds and rainy day funds, declined by 22 percent, while balances as a percent of spending fell from 11.4 percent to 8.2 percent.(6)

In these circumstances, it is often difficult to discern the nature of the problem that must be solved. Deficits may be temporary imbalances between revenues and expenditures caused by fluctuations in the business cycle, or permanent imbalances caused by a long-term gap between the projected increase in revenues and the projected cost of government services. Temporary imbalances related to the ups and downs of the economy are generally referred to as cyclical deficits. Permanent imbalances caused by tax systems that don't raise enough money over the long run to support expenditures are called structural deficits. Fiscal policies that might be appropriate for addressing cyclical deficits will not necessarily improve structural deficits.

Cyclical deficits or surpluses change from year to year, as the business cycle moves from expansion to stagnation or recession and back again. Structural deficits, on the other hand, have a number of possible causes, including:

  • Revenue structures that are overly reliant on types of taxes with growth patterns that tend to lag behind the overall growth in the economy.
  • Rapid growth in spending areas, often driven by population increases.
  • Previous tax reductions or expenditure increases that were phased in over time, so that their true cost was not realized until years after passage.
  • Unnoticed rapid growth in "tax expenditures" — tax breaks for specific groups that erode the revenue base and usually are not listed as state expenses along with budget line items.

The challenge states faced in writing budgets in 2001 was to evaluate whether the gap between revenues and expenditures was the result of a cyclical downturn or the result of an underlying structural deficit. Some states may be experiencing budget deficits that are both cyclical and structural in nature — the downturn in the economy is exacerbating a pre-existing, underlying revenue shortfall.

This distinction has broad implications for prudent fiscal policy. To the extent that states are simply experiencing short-term, cyclical budget deficits, the wisest course of action may be the implementation of temporary budget-balancing measures designed to bridge the gap between the current downturn and an anticipated recovery. On the other hand, if some or all of a state's budget deficit is structural in nature, its policymakers may have a more difficult set of choices to evaluate in moving the state to a position of long-term fiscal stability. While it is extremely difficult to quantify the degree to which a fiscal deficit in any given state is cyclical or structural, states that share some of the structural problems listed above are likely to have at least some structural component to their deficits. The probability that many states have some structural aspects to their deficits is useful to keep in mind as the actions states have taken to close their budget gaps are discussed in some detail in the next sections.(7)


2001 State Tax and Budget Actions

As noted, the fiscal landscape for state fiscal actions in 2001 was characterized by declining revenue growth and increasing expenditure needs. The economic slowdown was more severe in some parts of the country than in others, and not all states were forced to implement measures to address budget shortfalls. For those that did experience problems, budget actions fell into three categories: short-term budget balancing measures, tax increases, and spending cuts.

Use of Rainy Day Funds,Accounting Gimmicks, and Other Short-Term Measures

Politicians are generally reluctant to fix gaps between tax revenues and program expenditures by increasing taxes or cutting programs. As signs of fiscal stress first appear, they often turn instead to short-term measures to balance state budgets. To the extent that budget deficits are cyclical and relatively short-lived, these strategies can be an important component of stabilizing budgets and maintaining important public services. If the economic slowdown is prolonged or if the deficits are structural, however, short-term solutions can lead to long-term problems.

Virginia : Phantom Revenues Allow Expensive Tax Cut to Occur

The 2001 legislative session in Virginia was marked by efforts to revise the FY 2001 - 2002 budget in light of declining revenue growth and increasing expenditure needs. The difficulties of budget reform were exacerbated by political pressure to continue implementing an expensive reduction in car taxes, and the state was ultimately unable to enact mid-biennium adjustments to the budget.

A legislative analysis released prior to the 2001 session showed revenue growth falling below projections while the need for expenditures in Medicaid and other areas exceeded appropriations. These problems combined to create a budget gap that would ultimately amount to $690 million. Virginia is also currently in the process of implementing a $1.2 billion phased-in reduction of its car tax. The reduction includes a "trigger" provision that was designed to delay implementation if revenues grow slower than estimates. The report of slower revenue growth meant that the car tax cut might have to be delayed. In light of these issues, Governor James Gilmore released a revised FY 2001 - 2002 budget in December 2000.

In order to balance the budget, continue the car tax cut,