Beleaguered state budgets: state budget problems are dominating national headlines and topping legislative agendas.

State finances are closely tied to the health of the national economy, so when the national economy stumbled so did state budgets. As early as FY 2001, lawmakers began seeing budget gaps. And that was just the beginning.

In fact, many states have grappled with budget problems for three consecutive years. With forecasts for FY 2004 looking grim, most states are facing at least another year of difficult budget decisions. For some, the pain is expected to last even longer.

Before states can look too far into the future, however, they have to contend with current problems. In crafting their FY 2003 budgets, states confronted an aggregate gap--lower than expected revenues combined with spending overruns--that exceeded $49 billion. Most lawmakers thought they had done enough to close this gap, and keep it closed, when they enacted their budgets. They tapped reserves, cut spending, delayed projects and even raised taxes, but those actions were not enough. By late November 2002--only a few months after the fiscal year began--states faced a new collective gap of $17 billion. By late January, that gap had grown to nearly $26 billion, a jump of almost 50 percent.

Forty-nine states operate under balanced budget requirements--Vermont is the exception. These requirements mean that states must balance their books by the end of the fiscal year, which is June 30 for 46 states. This poses a distinct challenge, because gaps seem to be growing as the fiscal year nears its end.

Current state fiscal problems are widespread and, in many cases, severe. By late January, 36 states reported budget gaps. Some states reported no gaps because they already had taken action to close them. But for those that still face problems, 15 have holes in excess of 5 percent of the state's budget. In four of these, the gaps exceeded 10 percent.

While this fiscal year is proving to be exceedingly challenging, it appears that the worst is yet to come. At least 36 states are facing gaps for FY 2004, with 33 looking at holes above 5 percent. A staggering 18 states must close gaps larger than 10 percent. Cumulatively, next year's state budget gap is nearly $70 billion and growing.

A handful of states, typically ones that have natural resource-based economies, like New Mexico and Wyoming, have fared better than most during this economic decline. But states reporting solid finances are the exception in this fiscal climate.

HOW DID STATES GET HERE?

There is considerable debate about how states got into their current bind. For the most part, the sluggish national economy, declines in the stock market, contractions in the manufacturing and high-tech sectors, and soaring health care costs combined to undermine the stability of state budgets. Notwithstanding these factors, some argue that the states brought their current fiscal problems on themselves by going on a spending spree in the late 1990s and at the same time cutting taxes too deeply. These contentions merit further examination.

The economic boom of the late 1990s was extraordinary. Revenue collections routinely outpaced forecasts, and, as a result, states began piling up surplus money. State lawmakers took a variety of actions with these unexpected funds.

To begin with, lawmakers stashed record amounts of money into their rainy day funds. By the end of FY 2000, states had accumulated more than $20 billion in these accounts. Combined with unspent funds remaining at the end of the fiscal year, total balances ballooned to nearly $40 billion, or 10 percent of state budgets.

At the same time states were accumulating record reserves, they were shoring up a variety of programs. Elementary-secondary education and higher education received above-average spending boosts. Safety net programs were enhanced. Medicaid programs were made more generous through expanded eligibility, especially for poor children, and the addition of optional coverages. States also used surplus revenues to support capital projects--from schools to roads and bridges--instead of issuing debt.

Despite such changes, states cannot be accused of going on a spending spree, according to Federal Funds Information for States (FFIS). In a recent analysis, FFIS examined state and local spending as a percentage of gross domestic product (GDP). According to the analysis, Medicaid has been a major driver of state and local spending. When it is removed from spending calculations, state and local spending is at levels consistent with patterns over the last 30 years. In fact, non-Medicaid spending declined from 9.1 percent of GDP in FY 1991 to 8.5 percent in fiscal years 1998-1999, before rising to 8.8 percent in FY 2001. Spending defined in this way ranged from 8 percent to 8.8 percent in the 1970s and 1980s, peaking at 8.8 percent of GDP in 1975.

This leaves the criticism that states cut taxes too much in the good years. Looking back, states imposed net tax cuts over seven consecutive years--a trend reversed last year when states raised taxes by some $9 billion. The cumulative tax cut over the seven-year period totaled nearly $35 billion. Measured against the cumulative four-year budget gap--which some tally at almost $200 billion from FY 2001 through FY 2004--the tax cuts seem relatively minor. Moreover, some argue that the cuts had a stimulative effect, and that the current economic downturn would have been even more severe had they not occurred.

Notwithstanding the states' contributions, if any, to their current fiscal plight, budget gaps largely can be traced to problems with tax collections. With the exception of the severance tax states, most others have been concerned about faltering revenues, especially from personal income tax collections. Forty-one states levy broad-based personal income taxes. On average, they account for more than 37 percent of state tax revenues.

With personal income tax collections being an important source of revenue for so many states, officials have kept a close eye on performance. Last year's numbers were dismal, with collections from January through April about 14 percent below the prior year's level. States also paid out a lot more in refunds than expected. Policymakers are concerned about this year's numbers, too. Some are bracing for the worst.

WHEN THE MARKET DROPPED

The decline in the stock market is perhaps the single largest contributor to the falloff in state personal income tax collections. Increasingly throughout the '90s, growing proportions of collections were being derived from taxes levied on capital gains, stock options, bonuses and other forms of unearned income. When the stock market plummeted and the high-tech bubble burst, personal income tax collections fell, too. Capital gains-related taxes grew from 5 percent of state personal income tax collections in 1995 to almost 15 percent by 2000--a threefold increase in just five years, according to the Federal Reserve Board.

State tax collections haven't been the only casualty of the stock market decline. State pension funds, federal tax receipts, private foundations and others also have been pinched.

The bad news has not been limited to personal income tax. Other major taxes have been sluggish, too. Forty-five states levy statewide sales taxes, which generate about a third of state revenues. Shaky consumer confidence--its lowest levels in a decade--has slowed spending, undermining sales tax collections. Corporate income taxes, another important source of revenues, also have seen lackluster performance.

Forty states collected less revenue in FY 2002 than they did the prior year, according to the Rockefeller Institute at the State University of New York. With performance continuing to falter, many states expect this year's collections to be even lower than FY 2002. Going into the current fiscal year, the national projection for state revenue growth was 4.4 percent above last year Considering how revenues are performing, it now seems unlikely.

Notwithstanding assertions that the business cycle was defunct and the United States was operating in a new economy," no one really expected the explosive revenue growth of the late 1990s to last forever. What caught lawmakers and forecasters off guard was the magnitude of the decline.

While current problems mostly are traceable to poor revenue performance, spending overruns also are pressuring state coffers. While states can cover increased spending for short periods, the severity and length of the current fiscal crisis has meant that all programs have been vulnerable to cutbacks. Ironically, just when revenue growth declines in an economic downturn, demand for state services increases--especially for programs that help the poor and other vulnerable populations.

Despite efforts to contain expenditures, 37 states reported in late January that spending was exceeding budgeted levels this fiscal year. Of these, 32 reported overages in Medicaid or other health care programs.

Medicaid is among the top worries for state budget writers. Significant growth in medical costs and a growing number of elderly moving into Medicaid-supported long-term care programs are causing these expenditures to rise rapidly. In fact, Medicaid is once again expected to grow the fastest in FY 2003 budgets. Based on preliminary information, Medicaid is budgeted to grow more than 8 percent--two to three times faster than other major categories of state spending. This rapid increase has squeezed other parts of the budget, and there's no immediate end in sight.

TAX INCREASES ON THE HORIZON?

Despite the obvious pressures imposed by the election last November, five states increased taxes substantially in 2002 as part of larger efforts to close budget holes. Consecutive years of budget cuts are-generating pressure to raise taxes this year, but many policymakers-- particularly governors--promised "no new taxes." While it is too soon to know how this tension ultimately will be resolved, early developments seem to indicate that large-scale tax increases will be rare.

A recent vote in Oregon to temporarily raise the personal income tax was carefully watched around the nation. Measure 28, which failed by a decisive margin, would have allowed lawmakers to restore $310 million in program cuts. Slated cuts included 129 state troopers, assistance for thousands of low-income seniors and the disabled, reductions in community mental health treatment, and $95 million in reduced school funding.

The Oregon vote was yet another signal that citizens are reluctant to pay more taxes. But by late January, at least half the states had tax proposals pending. Like last year, cigarettes and tobacco are again the focus of most proposals to raise taxes. At least 14 states will consider higher cigarette tax levies, while six will ponder higher taxes on alcohol. Some consider these the "low hanging fruit" or those taxes subject to the least resistance from the general taxpayer.

Because excise hikes typically do not raise substantial sums of money, a few states also are looking at one or more of the major taxes. A half dozen states will consider raising the sales tax rate or expanding the base. Kentucky is looking at new taxes on certain services, such as drapery cleaning, flower arranging, termite removal and golf. Kansas is considering service taxes on doctors and hair stylists.

A few states are looking at personal income tax increases. A proposal in Missouri, for instance, would impose an income tax surcharge for high-income earners.

Proposals to generate revenue will not be limited to tax increases. In fact, promises to avoid tax hikes have led many states to consider fee increases or other sources of funds. In Massachusetts, the new governor has proposed raising fees by $60 million. His proposal calls for raising 57 fees and establishing 33 new ones. In New York, Governor George Pataki sought to raise $1.3 billion in fees and fines on everything from marriage licenses to tires.

To the extent they still have money in them, rainy day funds will provide some revenue. States also may continue to tap tobacco settlement money to help fill budget gaps.

Other proposals under consideration include new or expanded gambling revenues. Illinois has increased admission fees on riverboats. Maryland's new governor has proposed adding video lottery terminals at racetracks. Proposals elsewhere are pending. At the same time that gambling appears attractive to some, generating revenues this way is not a sure bet. Lawmakers in Oklahoma still are deciding if a lottery proposal should be sent to the voters for consideration.

IT'S NOT OVER YET

While there have been glimmers of hope that the national economy was starting to recover, they seemed to have been squelched by economic news in February, including reports that 308,000 jobs were lost in that month alone. Until the national economy improves, states are in for tough times.

While no action to realign spending and revenues is easy, it's clear that all of the easiest actions to close budget gaps have been exhausted. This means that the painful decisions confronting state lawmakers-- from further budget cuts to raising revenues--are far from over.

RELATED ARTICLE: MOVING INTO SURVIVAL MODE

A side from tapping reserves, nearly every state has pared spending to help close budget gaps. Some have cut their budgets dramatically. In Michigan, the FY 2004 budget recommendation is equal to the FY 1997 budget, and nearly 12 percent below the level in FY 2001. Maine's budget for the next biennium could be lower than the current biennial budget by 10 percent to 16 percent.

Not surprisingly, virtually every state program has been affected. Even elementary-secondary (K-12) education, an area that tends to be spared as much as possible, has been hit. As an indicator of the seriousness of the fiscal problems, 17 states cut K-12 education in FY 2002, and 14 reported cuts going into FY 2003. Some states even cut K-12 education in both years. As states struggle to craft balanced budgets for next year, K-12 education is likely to be affected yet again.

But K-12 education is far from being alone. The list of programs and groups being affected by budget cuts is growing daily. Examples of reductions, reported by the states or through media accounts, reflect how widespread these cuts have been. For instance, a growing number of states, including Missouri and Oklahoma, have reduced services for Medicaid patients. Homeless families in Massachusetts are being turned away from overflowing shelters. Oregon plans to close three care centers for mentally ill residents.

In California, cuts in adoption services mean that children will spend more time in foster care. New jersey working poor are expected to lose access to state-funded health care. Fewer hospital beds are expected to be available for low-income adults in Louisiana.

Attempts to save scarce funds have taken other forms, too. Kentucky is among the states releasing nonviolent offenders earlier than scheduled. Connecticut has laid off state workers. Ohio will close three state unemployment offices.

In the current fiscal climate, no cost-cutting action seems too small or insignificant. The Missouri governor has ordered every third light bulb unscrewed, office supply closets locked and heavier reliance on Web sites to save paper costs. In the Michigan Legislature, color printers have been unplugged to save money.

The list of cost containment measures seems endless. And while the cutbacks have been especially significant for vulnerable populations, they have affected citizens all across the economic spectrum.

It's fair to say that many of the efforts that states made to broaden state programs--from Medicaid expansions to social services improvements to providing more services to vulnerable populations--have been reversed. With the fiscal outlook grim and in the absence of tax increases, the likelihood of continued cuts in these and most other state programs remains high.

Corina Eckl heads NCSL's fiscal affairs program.