FRBSF Economic Letter
2003-23; August 15, 2003
Understanding State Budget Troubles
Fiscal 2004 started on July 1 this year, and it brought little
solace to many lawmakers struggling to bring state and local spending
back in
line with revenues. On the heels of a difficult fiscal 2002 and a worse
fiscal 2003, state budget leaders were forced to augment programs of
temporary fixes—including deferrals, fund shifts, tapping reserves,
and borrowing—with more permanent adjustments, such as slower spending
growth and increased taxes and fees. That being said, most states maintained
or increased nominal spending levels in fiscal 2004. The current outcome
is not unusual. State and local government spending generally flattens
out during economic downturns but rarely declines, as budgetmakers spread
the pain of difficult adjustments over several years. The gradual process
of working through budget problems typically restrains state and local
governments well after the national economy recovers. This Economic
Letter reviews the magnitude and genesis of states' current fiscal problems,
examines the adjustments states made in fiscal 2004, and discusses the
likely impact of state budgets on the national and regional economies.
Revenues, spending, and fiscal health
Throughout much of the 1990s state
and local revenue growth outpaced expectations, allowing governments
to expand spending, provide tax relief
to citizens, and accumulate sizeable reserves. According to the National
Conference of State Legislatures (NCSL 2003), even with rapid spending
growth—46% between 1993 and 2000—and sizeable tax cuts—$35 billion
between 1995 and 2000—state and local governments ran yearly surpluses
for much of the 1990s expansion. States used these surpluses to build
reserve funds (year-end balances plus rainy day funds) close to 11% of
general fund spending.
In late 2000 the picture began to change, with
many states facing spending commitments in excess of revenue flows. In
2001, state and local governments
ran a deficit of more than $30 billion. State and local finances deteriorated
further in 2002 and the first half of 2003. The inability to fund budgeted
spending through yearly revenue flows forced states to dip into reserves,
which began to decline rapidly in 2001. NCSL data show state reserves
amounting to only 3.1% of general fund spending at the close of fiscal
2003.
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Figure 1 illustrates these developments and provides some historical
context by displaying the calendar year differences in actual state and
local revenues and expenditures, typically referred to as current surpluses
(positive values) or deficits (negative values) over the last 20 years;
the data are from the Bureau of Economic Analysis, National Income and
Product Accounts (NIPA). Measuring the relative size of state and local
fiscal problems by the size of the annual NIPA deficits relative to the
size of total spending, the present state and local fiscal problem is
far more severe now than in the early 1990s recession. For example, during
the early 1990s recession, states faced an average annual deficit of
about $6.3 billion (average of 1991 and 1992), amounting to about 0.8%
of 1992 state and local expenditures. This time around, state and local
governments so far have recorded an average current deficit of $41.6
billion, representing about 3.1% of 2002 expenditures. NIPA data for
the first half of 2003 point to little improvement, suggesting that both
the magnitude and the duration of states' present fiscal difficulties
will be greater than in the early 1990s.
Looking at state reserves data
from the NCSL indicates a much larger swing in the size of the state
cushions this time than during the previous
recession in the early 1990s. During the 1990s recession, state reserve
funds fell from about 5% of general fund spending to about 1% of general
fund spending, a 4 percentage point decline. As indicated earlier, in
the recent downturn, state reserve funds fell from a peak of nearly 11%
of general fund spending to about 3.1%, a 7.9 percentage point drop.
Recent data from the NCSL show that, through the first half of 2003,
about 40 states had reserves less than 5% of general fund spending.
Roots
of the problem
Reasons cited for states' most recent fiscal difficulties
include deep dives in revenues, cost overruns on federally mandated programs,
and
rapid spending growth more generally. In terms of revenues, the collapse
of the stock market and the generally slow economy have kept tax receipts
well below expectations in most states. The largest errors in forecasts
have been for corporate and personal income taxes, which account for
a little over half of all state tax revenue. Sales tax revenues have
performed much better, coming in at or only slightly below expectations.
On average, total state tax collections have run about 10% below forecast
over the past three years, with nearly every state experiencing some
shortfall.
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Although state forecasts for revenues proved too optimistic,
they were not out of line with experiences in past economic downturns.
Consistent
with the revenue growth pattern during the early 1990s recession, most
states planned for revenue growth to slow modestly for a short period
as the economy weakened and then to pick up as the economy recovered
(Figure 2; note that the subsequent decelerations in revenue growth from
1992 through 1996 were associated with ongoing economic weakness in California
and with state and local tax relief outside of California).
At the same time states were "over-forecasting" revenues,
they also were underestimating the costs of several programs under federal
and state mandates. Nearly every state with a reported budget shortfall
noted cost overruns on some budgeted item. Overruns were largest and
most common in the Medicaid program, where provider fees and prescription
drug costs rose much more rapidly than states had predicted. Several
states also struggled with unbudgeted costs in welfare programs and corrections.
Higher than expected welfare expenditures largely were driven by caseload
increases associated with the weakening economy. Spending on corrections
rose for a variety of reasons, including higher salary costs associated
with competition for security personnel after September 11.
While overly
optimistic revenue forecasts and unexpected increases in costs contributed
to state budget problems, longer-term and more fundamental
spending decisions states made during the expansion also helped set the
stage for a budget crisis. During the good times of a booming economy
and surging tax revenues, states increased spending rapidly, funding
expansions in a wide range of programs including education, Medicaid,
welfare, and corrections. In so doing, states departed sharply from standard
spending rules that hold either real per capita state spending or state
spending relative to personal income constant. For example, among all
states, real per capita state and local spending increased 36% between
1989 and 2000. State and local spending as a share of personal income
rose from 13.1% in 1989 to 14.2% in 2000. When the economy and state
revenues began to falter, these increases proved difficult to roll back.
As a result, state spending continued to rise in 2001 and 2002, pushing
both real per capita spending and spending as a share of personal income
to historic highs.
State budgets and economic activity
While budget gaps have garnered considerable
attention and clearly pose significant challenges for state and local
lawmakers now and into the
future, the magnitude of their impact on the national and regional economies
is less clear. One reason involves the measurement of widely cited budget
shortfalls and the budget "cuts" required to resolve them.
Estimated budget shortfalls usually refer to the difference in desired
spending and projected revenue flows; thus they frequently overstate
the adjustments required to keep state and local spending at existing
levels. California's budget numbers provide a good example. California's
governor estimates the state's budget shortfall to be $38 billion, which
represents the difference between current revenue expectations and what
spending might have been if the economy had not weakened. This desired
spending figure includes a significant increase in spending relative
to existing levels. Thus, the state can substantially reduce the $38
billion shortfall without reducing nominal spending in the state. While
such adjustments to expectations can be painful, they arguably have a
less negative impact on current rates of economic growth than do cuts
to actual spending levels.
These measurement differences can be seen
in the outcomes of the fiscal 2004 state budget processes. Reports from
state legislatures indicated
that fiscal 2004 state budgets were balanced with significant cuts in
planned spending (including deferrals), modest use of nonrecurring revenues
and rainy day funds, and some tax and fee increases. Looking carefully
at those states reporting significant "budget cuts," one finds
that most maintained or slightly increased nominal spending in 2004.
For example, in Minnesota, which reported 15% cuts in spending across
most state agencies, nominal spending is budgeted to increase 5.8% from
fiscal 2003 to fiscal 2004. States unable to come up with the funds to
support increases kept nominal spending constant; California and New
York relied heavily on deferrals and nonrecurring revenues to support
fiscal 2004 spending and will enter fiscal 2005 with structural shortfalls.
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This
pattern of maintaining nominal spending during down times is not unusual.
In fact, state and local governments generally try to prevent
declines in real spending levels as well as in state and local employment,
choosing instead to spread the pain of difficult adjustments over several
years. This is illustrated in Figure 3, which shows real state and
local spending growth and state and local employment growth from 1969
through
early 2003. Real state and local spending and employment rarely fall;
the exception is the early 1980s. Typically, state and local spending
and employment growth hold up during recessions, come down sharply
in subsequent years, and recover more slowly than the rest of the economy,
as states work through any shortfalls accumulated during the downturn.
This pattern reflects several constraints on state budgets, including
the slow pace of political dealings and the unpopularity of sharp cuts
in spending or large increases in taxes. Overall, this slow-to-fall
and
slow-to-rise pattern in state and local government spending and taxing
spreads the economic impact of state budget squeezes over several years,
making it less of a factor in any particular period.
The key point
about state budgets and the economy is that the health of the economy
determines the health of states' budgets. Ongoing economic
weakness limits states' abilities to grow their way out of current
problems, making legislative discipline even more important. Sustained
improvement
in the national and regional economies will be critical to improvement
in state fiscal conditions.
Mary Daly
Research Advisor
References
[URLs accessed August 2003.]
Bureau of Economic Analysis, National
Income and Product Accounts, Current
Government Receipts and Expenditures, State and Local Government
http://www.bea.gov/bea/dn/nipaweb/SelectTable.asp?Selected=N
National Conference of State Legislatures. 2003. "Preliminary
Report on Annual Survey of Recent State Budget and Tax Actions."
http://www.ncsl.org/programs/fiscal/presbta03.htm
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