The State Fiscal Crisis: Extent, Causes, And Responses, 4/24/03

While much public attention has been paid in recent weeks to the fiscal crisis confronting states across the nation, reports differ as to the seriousness of the crisis, its causes, and the steps that states are taking to address it. This report briefly summarizes certain facts about the issue.

States are facing budget deficits of approximately $100 billion that must be closed over the next several months — $25 billion in deficits for the current fiscal year[1] and between $70 and $85 billion for the fiscal year that begins in June. These new budget gaps are on top of the $50 billion gap states closed when they enacted their fiscal year 2003 budgets.

The fiscal year 2004 gaps alone, which represent between 14.5 percent and 18 percent of total state spending, are twice as deep as the gaps states faced during the recession of the early 1990s.

Because virtually all states have balanced budget requirements and thus cannot run operating deficits (unlike the federal government), they must close budget gaps for this and future years through some combination of spending cuts and revenue increases.[2]

It has been argued that the current state budget crisis is largely the result of a massive spending increase by states during the 1990s. In fact, the response of the states to the economic growth of the 1990s included a mix of tax cuts, reserve accumulations, and moderate spending increases. Spending growth was concentrated in education, healthcare and corrections – areas where costs were rising, need was growing and/or the voting public was demanding improvements in services. The pace of state spending growth during the 1990s was low by historical standards and state government grew no faster than the private sector during the decade.

Over the course of the 1990s, states increased total reserves to their highest level in twenty years. By the end of fiscal year 2000, states had total year-end balances (which includes both general fund balances and rainy day funds) of almost $50 billion or 10.4 percent of expenditures. Prior to the last recession of the early 1990s, states had total balances of only $12.5 billion or 4.8 percent of expenditures. As a result, states were better prepared for this economic downturn than they were for the recession of the early 90s.[3] (See Figure 1.)

These reserves have served to ameliorate some of the effects of the economic downturn on revenue. However, despite being large by historic standards, state rainy day funds have not been large enough to offset budget gaps in most states.

From roughly 1994 through 2000, state revenue collections grew rapidly as a result of unusually high levels of economic activity, particularly personal consumption and capital gains realizations. Most states used some of the increased revenues that resulted from this economic expansion to cut taxes. From 1994 to 2001, nearly every state cut taxes and most of the tax cuts were substantial. In 43 states net tax cuts exceeded one percent of total state revenues, and most were much larger than one percent. Aggregate net tax reductions from 1994 to 2001 equaled about 8.2 percent of state tax revenues. (See Figure 2.)

Unfortunately, many states used those temporary levels of revenue growth to finance permanent tax cuts. The tax cuts enacted during the 1990s are currently costing states more than $40 billion per year.

Not surprisingly, the states that enacted the biggest tax cuts in the 1990s are in the biggest fiscal trouble now. The ten states that enacted the largest tax cuts in the 1990s faced a median budget gap equal to 13 percent of state spending when they initially considered their fiscal year 2003 budgets. By contrast, the median budget gap in 2003 for the ten states that cut taxes the least was only one percent.

State and local tax revenue is now at its lowest level since the double-dip recession of the early 1980s. By 2002, state and local tax revenue made up a smaller share of personal income than in 1990 and was below the thirty year average. (See Figure 3.) If states merely raised taxes back to the average level, collections would increase more than $30 billion – enough to eliminate over one-third of the budget deficits states now face.

Thus far, the net increase in taxes due to changes in 2001 and 2002 is very small relative to the tax cuts enacted in the 1990s — only 1.7 percent of taxes. Even if all tax increases proposed by governors in 2003 were enacted, total tax increases would amount to well under two-thirds of the total tax cuts enacted during the 1990s.

While state spending grew in real (i.e., inflation-adjusted) terms during the 1990s, it did so at a slower rate than in previous decades.

After adjusting for inflation, the amount that states spent per resident, using funds that states raised from their own sources, increased by an average of 2.0 percent per year between 1989 and 1999. This is well below the 2.9 percent average annual spending growth for the 1949-1999 period and the growth of 2.9 percent seen during the 1980s.

Most of the growth in state spending that did occur during the 1990s was in three areas: education, healthcare and corrections. (See Figure 4.)

The vast majority of new state spending during the 1990s went to education, health care and law enforcement. After adjusting for inflation, nine out of ten dollars of increased state spending was in one of these areas. (See Figure 5.)

Another reason state spending in general rose faster than inflation during the 1990s was that state governments assumed new responsibilities that formerly had been handled by federal and local governments.

Tax and Spending Limits like Colorado's
Do Not Guarantee Fiscal Health

Some have suggested that states should adopt strict tax and expenditure limits as a way to restrain spending and avoid future fiscal crises. The specific model that is often recommended is Colorado's "TABOR" amendment, a package of constitutional provisions that severely limits the state's ability to raise and spend revenue. TABOR is perhaps the nation's most restrictive tax and expenditure limit. Colorado's limit, however, has most certainly not made the state a model of fiscal health. In the 1990s, the Colorado limit forced the state to enact large and (as it turned out) unaffordable tax cuts. As a result, TABOR has worsened the state's fiscal crisis, contributed to damaging spending cuts, forced the state to borrow against its own fiscal future, and lowered the state's bond ratings.

Colorado's fiscal situation is worse than those of many other states. For 2003, the state is struggling to close a $1 billion deficit, equal to about 20 percent of total spending — among the largest deficits in the nation. The outlook for 2004 is no better.

The state's fiscal plight has led bond rating agencies to downgrade the state's bond rating and credit outlook in recent months; analysts specifically blamed TABOR for making the fiscal crisis worse. The bond-rating agencies are not the first outside observers to recognize the havoc TABOR is playing with Colorado's finances. In a pair of studies in 1999 and 2001, Governing magazine ranked Colorado's finances as among the worst-managed in the country, again due to TABOR.

This growth in state spending occurred during a period of great growth in the economy of the United States as a whole. Personal income and the country's private and public output as measured by Gross Domestic Product grew significantly. In times when states are neither expanding nor scaling back their responsibilities, state spending can be expected to grow at about the same rate as the economy, which means that the ratio of total state spending to total personal income (a common measure of the size of state economies) would remain roughly constant. Between 1990 and 2001 state government grew no faster than the rest of the economy. Since 2001 state spending has grown more slowly than the economy. Thus, the size of state government relative to the economy as a whole has declined since 1990. (See Figure 6.)

Since the start of the economic downturn in 2001, state spending has declined significantly. Data from the National Association of State Budget Officers show that state general fund spending – the category of spending that typically is subject to year-to-year appropriations – declined 1.0 percent after adjusting for population and inflation and is projected to decline 2.3 percent in FY03.

Moreover, the projected cut for fiscal year 2003 reported by NASBO is based on state budgets enacted last spring. Large additional budget gaps have opened up since then, and governors have begun making mid-year cuts that will reduce spending below the appropriated levels. The actual decline will be larger when the full extent of the budget-cutting measures used to close gaps that developed after enactment of the 2003 budgets are known.

This same trend is evident in patterns of employment growth. State government employment as a share of total employment actually declined during the last decade. As of January 2003, state employees made up 3.8 percent of total employment, a lower percentage than at the start of the decade in 1990 and equal to the level of thirty years ago. The current fiscal crisis has caused states to cut their payrolls for most state functions. Total state employment in areas other than education declined by 20,000 over the last 12 months.

Current State Fiscal Problems Are The Result Of Unprecedented Revenue Declines

If states did not overspend during the 1990s and built reserves to historic levels, why are they facing such deep fiscal stress now? The major cause of the current state fiscal crisis is a steep drop in revenues. According to data collected from state revenue departments by the Rockefeller Institute of Government, state revenues have declined relative to the same quarter in the prior year for the last six quarters. (See Figure 7.) Revenue in each quarter of FY2002 was well below the same quarter of the previous fiscal year — about 13 percent below in the crucial April-June quarter which is the most important quarter for tax receipts. The recent revenue decline was twice as steep as that seen by the states in the recession of the early 1990s. Thus far, state revenues have not rebounded and begun to grow again in real terms even from the low levels of fiscal year 2002.

This drop in revenues resulted from a number of factors including the effects of the economic downturn and the bursting of the stock market bubble, the continuing effects of the state tax-cutting of the 1990s, the ongoing erosion of state tax bases due to their failure to adapt to the changing U.S. economy and the effect of federal tax policies on state revenues.

One reason that state revenue declines are so large now is that the revenue increases of the late 1990s were so large. The stock market was booming, capital gains realizations were at all-time highs, consumption was soaring as savings rates fell — all of which pushed up revenues. As we now know, that wasn't sustainable. When the stock market fell and the recession began, state revenues fell abruptly.

Unfortunately, as discussed above, many states used those temporary levels of revenue growth in the 1990s to finance permanent tax cuts. The tax cuts enacted during the 1990s are currently costing states more than $40 billion per year, exacerbating the drop-off in revenues due to the economic slowdown.

In addition, states are feeling the effect of long-standing problems with their tax systems. A long-recognized flaw in state revenue systems is that revenues fail to keep pace with economic growth. As the National Governors Association and the National Conference of State Legislatures have reported, the gradual erosion of state revenues relative to growth occurs largely because of the substantial reliance on sales and excise taxes; items subject to those taxes in most states are declining in the long term as a share of total consumption. In addition, state corporate income taxes as a share of corporate profits have steadily declined over several years, partly reflecting corporations' ability to restructure their finances to avoid state taxes. State income taxes do the best job of keeping pace with economic growth over the long term, but they typically are not structured to compensate fully for the gradually declining revenue from other tax sources. As a result, over a period of several years, state tax bases tend to decline as a share of the economy, meaning that states over the long term must raise taxes or ratchet down spending to keep budgets in balance. The unusual economic circumstances that existed in the late 1990s masked these problems, but their impact is now adding to state fiscal woes.

Federal actions also have eroded state tax bases. State revenues have been reduced by federal tax cuts as well as state tax cuts. Because of the linkages between state and federal tax codes, cuts in federal taxes often have the side effect of reducing state revenue. The consequences for states are particularly significant now because large federal tax cuts are being implemented (and further large tax cuts have been proposed) at the same time that the economic downturn has depressed state revenues.

For example, the phaseout of the federal estate tax, contained in the 2001 tax legislation, had the potential to cost states $75 billion through 2013. Also, the 2002 economic stimulus legislation contained a temporary change in business depreciation rules that had the potential to cost states $14 billion over the provision's three-year life. In both cases, some states have protected themselves against these revenue losses by “decoupling” the relevant parts of their tax codes from the effects of the federal tax changes. Other states have not decoupled, however, and are losing revenue on a temporary or (in the case of the estate tax) permanent basis.

Moreover, the Administration's proposed fiscal year 2004 budget contains proposals for additional tax cuts that would cost states another $64 billion over ten years.

All of these factors taken together resulted in the revenue declines that caused the state fiscal crisis.

Vital state services are now at risk as states strive to balance their books. States for the most part have drawn down their reserves. By the end of fiscal year 2003, fund balances including rainy day funds will total less than 3 percent of state budgets and much of those remaining reserves are unlikely to be drawn down because of procedural barriers to their use. State must now rely primarily on spending cuts and tax increases to balance their budgets.

It has been argued that the current state fiscal situation does not constitute a “crisis” because states are responding by merely slowing the growth of spending rather than instituting actual spending cuts. The reality is that state spending has already declined in real terms and is likely to decline further.

Data from the National Association of State Budget Officers show that state general fund spending – the category of spending that typically is subject to year-to-year appropriations – declined 1.0 percent after adjusting for population and inflation and is projected to decline 2.3 percent in FY03.

Moreover, the projected 2.3 percent cut for fiscal year 2003 is based on state budgets enacted last spring. As noted above, large additional budget gaps have opened up since then, and governors have begun making mid-year cuts below the appropriated levels. Thus it is likely that the decline in real general fund spending will be greater when the books are closed on 2003 and greater still in fiscal year 2004.

The claim that states are not cutting spending is based on the fact that the total funds appropriated by all states unadjusted for inflation and population growth continue to rise from year to year. Comparing nominal spending totals does not accurately measure states' ability to continue providing their current level of services. That ability is steadily eroded both by inflation (which increases the number of dollars needed to provide a given service to a given individual) and by population growth. Population growth — especially growth in specific expensive-to-serve populations such as school-age children and the elderly — increases the number of individuals who must be served.

In addition, many state programs are designed to be counter-cyclical: their costs rise during economic downturns as they assist families that have lost jobs or income. States also may be required to take on new costs as the result of federal policies and mandates, which further increases the cost of maintaining current services.

So the appropriate test is not whether states are increasing nominal spending but rather whether they are maintaining or cutting existing programs and services. Cutting is what is now happening across states. Moreover, in a number of individual states — most notably California — the budget gap is so large that the state is cutting spending in nominal terms as well as real terms.

Many state governors are trying to moderate the spending cuts that would be required to close their budget gaps by also proposing tax and other revenue raising measures. Of the 48 budgets that have been submitted so far this year, four out of five include revenue-raising measures. Half of the nation's governors have proposed tax increases.

These increases, which cover income taxes, sales taxes, corporate taxes, and/or excise taxes and include both raising rates and broadening tax bases, have been proposed by governors of both parties and in all regions of the country. (One sign of the seriousness of the current situation is that several of the governors who have proposed tax increases built their public identities in part on lowering taxes.)

Nevertheless, even if all the proposed tax increases were approved, the combined tax increases passed during the current downturn would raise state revenues by just over $20 billion per year, about half of the more than $40 billion states are losing each year from the tax cuts they passed during the 1990s.

Nor are the tax increase proposals large enough to close states' budget gaps. The tax increases California's governor is proposing would close only one-quarter to one-third of the state's budget gap; proposed tax increases in New York and Ohio would close less than one-sixth and about one-half of those states' gaps, respectively.

What Impact Will State Actions Have on the Economy?

In order to balance their budgets in the current fiscal crisis, with most of their reserves depleted, states face a choice: They can cut services or they can protect public services by raising taxes.

Opponents of tax increases often argue that increasing taxes will reduce economic growth. The effect of taxes on economic growth is an area where misperceptions and misinformation abound. It is important to remember that taxes exist to fund government services such as education, transportation, and law enforcement, and these services have a large impact on economic performance. Economic research into the long-term tradeoff between taxes and public expenditures suggests that public expenditures can contribute as much, if not more, to economic growth as low taxes.

There is a large body of literature that has carefully studied the impact of taxes on economic growth using a variety of measures with controls for characteristics of states other than tax levels. These well-designed studies of the effect of taxes on economic growth find that the impact of taxes on economic growth is very small and exists only if you hold everything else — including the level of government services — equal. In addition, business executives, in hundreds of surveys, have placed taxes lower on the list of important location factors than such factors as labor availability, costs and training; access to markets; access to raw materials; transportation costs; public services; and quality of life.

Careful studies of the relationships between taxes, spending, and job growth show that undermining a state’s educational system, its infrastructure, or other services vital to businesses and workers over the long run can do more damage than maintaining or increasing taxes.[1]

In addition, state budget-cutting could have a short-term impact on the economy’s ability to recover from the current downturn. Although the economic perils of tax increases are often touted by their opponents, spending cuts could actually be more damaging to the nation’s economy than tax increases.

As Nobel Prize-winning economist Joseph Stiglitz and Peter Orszag of the Brookings Institution have pointed out, a $1 reduction in state public-sector spending typically results in a $1 reduction in a state’s economic activity. A $1 increase in taxes, by contrast, is likely to result in a smaller reduction in a state’s economic activity, because to some extent the tax increase would be financed out of reduced savings, or from reduced out-of-state consumption. This is particularly true of tax increases on higher-income individuals, because such individuals are most likely to have access to savings.

Stiglitz and Orszag conclude: If anything, tax increases on higher-income families are the least damaging mechanism for closing state fiscal deficits in the short run. Reductions in government spending on goods and services, or reductions in transfer payments to lower-income families, are likely to be more damaging to the economy in the short run than tax increases focused on higher-income families. In any case, in terms of how counter-productive they are, there is no automatic preference for spending reductions rather than tax increases.

1 See, for example, Michael Wasylenko, “Taxation and Economic Development: The State of the Economic Literature,” New England Economic Review, March-April 1997, reprinted in State Tax Notes, June 23, 1997, pp. 1883-95; Robert G. Lynch, Do State and Local Tax Incentives Work?, Economic Policy Institute, Washington, D.C., 1996; Timothy Bartik, Who Benefits From State and Local Economic Development Policies?, W.E. Upjohn Institute for Employment Research, Kalamazoo, Michigan, 1991.

States face the largest budget gaps they have seen in decades. Closing these gaps will be difficult for a number of reasons: the national economy remains sluggish, states already have used up their least-painful measures to balance their budgets in fiscal years 2002 and 2003, and federal tax cuts are threatening to reduce state revenues still further.

The fact that the fiscal crisis is not the result of massive overspending by states during the 1990s also complicates their task. Generally speaking, states did not undertake large, unwise, and unaffordable spending initiatives that now can be scaled back or eliminated to restore budget balance.

States would be well-served to take a balanced approach to addressing the budget gaps they face. As many governors have recognized, the only way to avoid devastating spending cuts is to include revenue-raising as part of the solution to the current fiscal crisis.

There are many revenue-raising options available to states. States that did undertake large, unaffordable tax cuts during the 1990s may want to reassess and reverse those tax cuts. Temporary tax increases such as a temporary income tax surcharge can raise substantial revenue to allow preservation of important services while the economy temporarily depresses state revenues.

Revenue-raisers such as corporate or sales tax base-broadening can both provide additional resources during the current revenue shortfall and serve to strengthen state tax bases for the future by addressing long-standing structural problems.

In addition, states can protect themselves against revenue losses due to federal actions such as the estate tax repeal by “decoupling” the relevant parts of their tax codes from the effects of the federal tax changes.

The Center's State Fiscal Project has prepared a number of reports that provide additional detail on the topics discussed in this paper. These papers which can be found on the section of the Center's website: www.cbpp.org include the following:

[1] National Conference of State Legislatures, State Budget Update, February, 2003.
[2] All states except Vermont are required by statute or constitution to adopt a balanced budget. State laws differ over how long a budget can remain out of balance if revenue or spending estimates change once a budget has been adopted.
[3] National Association of State Budget Officers (NASBO), Fiscal Survey of the States, November 2002.