December 11, 2001

State Deficits Show Need for Congress to Assist, Rather Than Undermine, State Efforts to Balance Budgets
by Nicholas Johnson, Iris J. Lav and Kevin Carey

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As Congress continues to debate federal stimulus legislation, state fiscal conditions across the country are worsening. As recently as a few weeks ago, total state budget deficits were estimated to equal $15 billion. Now state budget officials estimate that state deficits equal or exceed $40 billion, an amount that includes $35 billion in revenue shortfalls and higher-than-expected spending on countercyclical programs such as Medicaid, plus an additional $5 billion in unanticipated spending on homeland security. Because not all states have estimated the size of their budget deficits, and because state economies are expected to worsen, the National Governors Association projects that shortfalls for the current fiscal year could rise to $50 billion.

The projected state shortfall is greater in both absolute and percentage terms than the state shortfalls experienced as a result of the recession of the early 1990s.

This new information increases the importance of Congress providing net fiscal relief to states. If Congress fails to act aggressively to ameliorate state fiscal conditions or — even worse — if the federal government exacerbates state deficits by enacting stimulus legislation that erodes states' tax bases, which causes them to lose tax revenue, federal stimulus efforts will be greatly diminished by the worsening state fiscal crisis.

States are required to balance their budgets, so they must close their deficits by enacting tax increases, spending reductions, or a combination of the two. If the federal governments provides $100 billion in economic stimulus measures in the current fiscal year and states enact $50 billion in spending cuts and revenue increases, fully half of the stimulative effect of the federal package would be offset by state actions. If only $75 million of the federal package provides an immediate stimulus effect in this fiscal year, the state fiscal crisis could wipe out two-thirds of the desired impact.

Two provisions of the federal stimulus package in particular will have great impact on whether the final stimulus package helps or hurts states.

If the temporary increase in the federal share of Medicaid costs provides more revenue to states than they lose from bonus depreciation, then the accelerating decline in state fiscal conditions will be alleviated, states will enact fewer tax increases and spending cuts, and the economy will benefit. If, on the other hand, Congress fails to provide net fiscal relief to states, state budget deficits will be even larger, and the economy will suffer as a result.