Bliss or blues: with state revenue performance improving, states appear to have turned the corner on the latest national recession.

State budgets are healthier than they've been in five years, thanks to improving revenues and careful balancing of priorities. Although the downturn seemed to last forever, the turnaround has occurred quickly. While final numbers for fiscal year 2005 are still coming in, the news is surprisingly positive on several fronts. Revenue figures and year-end balances, in particular, stand out as noteworthy.

Part way into FY 2005, lawmakers learned that tax collections were outpacing projections, in some cases by substantial amounts. By March 2005, half the states reported that collections were exceeding forecasts for every major tax thanks largely to increasing employment and rising corporate profits. The reports were even better after April personal income taxes were tallied.

Although robust revenue collections were a welcome change from the situation of recent years, lawmakers were caught by surprise. When they were developing their FY 2005 budgets, states estimated revenues would grow 2.8 percent above FY 2004 levels. The final figure will be closer to 6 percent. Many states used unexpected revenue growth to support supplemental appropriations while others, either through deliberate action or because their legislative sessions already had concluded, left the funds unspent or deposited them into their rainy day funds.

Nationally, states expected to end FY 2005 with a collective balance of 3.6 percent of general fund spending. Estimates now place that figure at 7 percent--nearly twice as high as expected. Although balances are expected to drop by the end of the current fiscal year, they are still projected to reach 4.7 percent.

How long will this relative prosperity last? No one knows for certain, but budget insiders are wary. "Fiscal people never relax, we anguish over this stuff all the time," says Michael Calvert, director of Nebraska's Legislative Fiscal Office. "But as we look at the long-term trends, there are genuine reasons to be concerned."

Any discussion of state budgets and the pressures on them starts with the biggest cost drivers: elementary-secondary (K-12) education and Medicaid. Together, these programs account for nearly 50 percent of state general fund budgets, up from 42 percent a decade ago.

EDUCATION DEMANDS

State constitutions guarantee public education. And K-12 education also enjoys strong bipartisan and public support. It would be politically difficult, if not impossible, to shrink the K-12 share of the budget.

Various factors are propelling K-12 spending. The requirements of the federally mandated No Child Left Behind law are expensive: Experts estimate that the states are shouldering an extra $10 billion annually to comply with the law.

Other factors are fueling costs, too. For years, states have been struggling to address court rulings that their school funding systems are inadequate. Arkansas is one of the most recent states where the system was declared unconstitutional. Lawmakers responded by imposing a 0.875 percent increase in the sales tax and earmarking it for K-12 education.

Most other states are boosting K-12 funding, too. Even in bad times, education usually is spared the budget axe. And now that revenues are improving, K-12 is benefiting. States are raising teacher salaries, enhancing funding formulas, starting new programs or generally increasing their share of K-12 support.

A recent citizen initiative in Maine requires the state to provide a greater share of K-12 educational costs. The original proposal--which raises the state's share from 43 percent to 55 percent--called for the change to occur in FY 2006, but the Legislature is phasing in funding and will reach the target by FY 2009. Maryland is in the middle of a five-year state initiated plan to significantly increase its support for public education. The state has approved $1.3 billion in additional support, which will boost its share of total funding to 47.5 percent from the 40 percent level when the plan originally was approved. Under the current schedule, state aid will increase $500 million per year in the final two years of the program's phase-in.

New or expanding education programs also are raising costs. Delaware lawmakers appropriated $3 million in FY 2006 to continue pilot funding for full-day kindergarten. If the program is implemented statewide, the estimated annual cost is $20 million. Florida's current budget includes $388 million to phase in universal voluntary pre-kindergarten for four-year-olds, a program approved by voters in November 2002. Another voter mandate reduces public school class size by two students annually until constitutionally imposed targets are met. In Oklahoma, lawmakers are using new education trust fund lottery revenues to fund full-day kindergarten and third grade remediation.

Other recent increases in education spending have been driven in part by teacher pay raises or pension costs (Alaska, Mississippi, Oklahoma, Virginia), special education costs (Hawaii), increases in state base aid per pupil (Kansas, Kentucky, Louisiana, Minnesota, Montana, Nebraska, New York) and higher enrollment (Utah).

MEDICAID CONCERNS

Just as education spending is rising, so are Medicaid costs. And like K-12 education, they are difficult to contain. At their discretion, states may add optional populations and services to those that are mandated. But if they fail to provide the minimum levels, they loose the federal match.

Medicaid costs and other health expenses are in the national spotlight. Medicaid consumes 16 percent of state general fund budgets and is the fastest growing category of state spending. Although the national recession is behind us--which presumably means that caseloads are dropping or stabilizing--Medicaid costs are not leveling off. In fact, they are expected to rise as budgeters look at demographics.

More than 50 million Americans receive health services or long-term care through Medicaid. About three-fourths of them are adults and children who meet the income requirements to receive health care benefits. The remainder are individuals with disabilities and elderly people who depend on Medicaid for health services and long-term care benefits. Although these beneficiaries account for only 25 percent of the Medicaid population, they account for 70 percent of Medicaid expenses. With the graying of America, these costs are expected to skyrocket.

In their 2005 sessions, several state legislatures attempted to restrict the rate of spending growth for Medicaid. Maryland reduced the rate of increase for nursing home and managed care payments and bolstered efforts to reduce fraud and abuse. Mississippi changed its prescription drug policy, implemented some co-pays and modified eligibility consideration to save funds. Missouri made optional services subject to appropriation, eliminated the Medical Assistance for the Working Disabled program and changed certain income guidelines. New Hampshire authorized changes that involve long-term care services, estate recovery and asset transfers, all of which are expected to have an impact in the long run.

Ohio's actions included new cost sharing arrangements for dental and vision care, certain prescription drugs and non-emergency services. Pennsylvania's current budget reflects $350 million in savings from a number of cost containment measures. Tennessee's current Medicaid budget is constructed around the disenrollment of three optional adult categories so that the state can maintain funding for the medically needy (another optional adult category).

Despite these and other cost containment measures, Medicaid is still budgeted to grow 8.1 percent in FY 2006. Similar growth rates are anticipated for the future. At NCSL's Spring Forum last April, Secretary of Health and Human Services Michael Leavitt projected that Medicaid would "grow well north of 7 percent annually over the next 10 years."

State officials are very concerned about this trend. Vermont conducts five-year projections of Medicaid costs and the news is alarming. "We can squeak by until FY 2007, but there is darkness after that," says Stephen Klein, director of Vermont's Joint Fiscal Office.

Medicaid is not unique in experiencing rapid rate increases. Many of the same cost drivers are affecting other health care programs, such as those for state employees, retirees and prisoners. Private employer health plans are feeling the pinch, too, with costs escalating even more rapidly.

OTHER PRESSURES

Although K-12 education and Medicaid attract a lot of attention and get the lion's share of spending, there is the rest of the state budget to consider. As spending for these two programs has expanded, many other programs have shrunk, including higher education. Having weathered years of cuts or flat funding, higher education and most other programs now are exerting their own pressure on the budget.

"We have old obligations and new expectations, and we can't keep up," says Representative Maxine Bell, who chairs Idaho's House Appropriations Committee. "Right now we're even, but that's only for a brief moment."

Several states see the current prosperity as temporary because more and more demands are placed on the budget. Consider Maryland's situation. Although the state ended FY 2005 with a $1.2 billion closing balance, officials project a $1 billion deficit by FY 2008.

THE BEST LAID PLANS

Many unknowns can derail even the most carefully crafted budgets. Although most budgets contain some flexibility to adapt to changing circumstances, that latitude usually is minor. It certainly is insufficient to deal with significant events like natural disasters.

Hurricane Katrina--in addition to causing loss of life and property--is dramatically altering budgets in the Gulf Coast states. Although the federal government and charitable groups will contribute to the recovery, the affected states still will face enormous costs to aid victims and rebuild infrastructure.

With businesses and jobs lost, tax collections will suffer. Mississippi officials estimate the loss of tax revenue from Biloxi casinos alone will cost state coffers at least $500,000--every day. Last year, the coastal casinos contributed approximately $73 million to the general fund. Before Katrina hit, that figure was expected to rise to $84 million for FY 2006.

The losses are expected to be dramatically higher in Louisiana, where officials are in the process of developing new revenue forecasting models to adjust for the hurricane's effect. "A big chunk of our economy got turned off," says Greg Albrecht, chief economist in the Legislative Fiscal Office. "It'll take some time to get an actual assessment of the revenue impact, but it's going to be a lot of money. We've got a big problem here."

Although economists point out that the rebuilding process will be an eventual economic boost, that outlook is little consolation right now. "At some point we'll be adding money, but it will be from a very low trough," adds Albrecht.

Other looming factors can upset budget plans. What if the recovery stalls? David Wyss, chief economist for Standard & Poor's in New York, warns that today's energy prices pose a real risk to economic growth.

"Obviously, high energy prices are going to hurt, both because states have to buy gas and because of increased subsidies for the poor to keep the heat on. Most important, however, could be any revenue drop caused by resulting economic problems," says Wyss.

It's impossible to say how long oil prices will stay high--that depends in part on getting Gulf refineries and oil platforms back in operation. "At this time, I think the impact will be moderate, about 0.5 percent," says Wyss. "But if the outages last longer than a month, we may have to revise the national economic forecast down."

The Gulf states have been hardest hit physically and financially by the hurricane and its aftermath. But other states expect to feel the ripple effects as the economy absorbs the shock. The Creighton University Economic Forecasting Group already is predicting slowdowns in other regions of the country.

Notwithstanding the effects of Hurricane Katrina and high energy prices, most state budgets appear to be stable for the moment. But they face myriad challenges in the short and long term. How long the current prosperity will last is anybody's guess.

Stay tuned.

GASB 45 RAISES CONCERNS

The Governmental Accounting Standards Board (GASB), as its name implies, sets accounting standards for state and local governments. In 2004 it issued a new rule that affects how state and local governments estimate and track health care and other benefit costs for retired employees.

The rule is known as Statement Number 45, Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pension. The statement generally requires governments to estimate the eventual total costs of their health care programs for retired employees and report on their annual progress in funding the costs. A previous GASB standard already imposed similar reporting requirements for pensions.

The statement does not require a government to report its total liability for retiree health care costs. Instead, the requirement is for recognition of the annually accruing cost of future health benefits--the equivalent of the annual added cost of pension benefits that is reported to most legislatures. The government must report whether it has met that cost, and whether any part of its annual obligation is unfunded.

The GASB rule requires disclosure, not funding. In the past, governments rarely have required actuarial studies of the future cost of retiree health benefits. The numbers could be shocking. Standard & Poor's has commented that "The new reporting may reveal cases in which the actuarial funding of post-employment health benefits would seriously strain operations, or may uncover conditions under which employers are unable or unwilling to fulfill these obligations." Standard & Poor's suggests that some governments may choose to reduce or drop health care plans for future retirees, once the costs are known. Some private sector employers followed that course when a similar rule was applied to them in past years.

Governments with revenues of more than $100 million (all state governments and many large counties and cities) are subject to the new rule for fiscal years beginning after Dec. 15, 2005. The rule comes into effect later for smaller governments.

The new rule is beneficial in that policymakers will receive information on costs they have agreed to meet. The costs, however, could throw government budgets out of balance if it's not possible to cover them in any given year. To the many governments already hit with escalating retiree pension costs, the new accounting standard could come as very bad news.

--Ron Snell, NCSL 

ARE STATE BUDGETS SOUND?

Budget experts point to a looming fiscal crisis driven by the persistent mismatch between growth rates in revenues and spending. Among state budget writers the lexicon now routinely includes terms like "antiquated tax systems," "structural deficits" and "unsustainable budgets." They all point to trouble.

States are required--either by statute or constitution--to balance their budgets. In recent years lawmakers closed budget gaps by cutting spending, raising revenues or tapping reserves. Some states even borrowed money. Nearly every state used one-time funds to keep budgets in the black.

Although temporary or one-time actions get the job done, they don't offer a long-term solution and eventually work to undermine budget stability. A structurally sound budget must be built on a revenue base that keeps pace with spending over the long term. If the two become misaligned, lawmakers must cut spending, raise taxes or implement some combination of these.

According to the Center on Budget and Policy Priorities, a state has a structural deficit when "the normal growth of revenues under existing tax policy is chronically inadequate to fund the normal growth of expenditures for current services, even at times of healthy economic growth."

The Center on Budget and Policy Priorities has identified 10 factors that place a state at risk for a structural deficit. Using these factors, the center found that 44 states faced five or more risk factors, with 11 states having nine or 10 risk factors. Most of the risk factors are associated with a state's tax structure.

Much has been written about the inadequacies of current state revenue systems (an excellent source is NCSL's book New Realities in State Finance). The bottom line is this: Without modernizing tax structures to fully capture growth in the economy, state collections will persistently lag behind spending growth. Cutting spending, raising taxes--or both--will become painful realities.

Although some states have attempted to restructure their tax systems, policymakers almost always encounter fierce resistance to change. Citizens are reluctant to accept new taxes even if others are lowered in the process. The old adage, "The devil you know is better than the one you don't," seems to prevail. As a result, most changes have been modest at best. At the same time, well-organized interest groups mobilize to oppose new taxes that might affect them. Louisiana Senator Russell Long's famous quip is apropos: "Don't tax you, don't tax me, tax that fellow behind the tree."

Nevada and Virginia modified their tax systems in recent years. In Nevada, the 2003 Legislature approved tax increases after completion of a study that reviewed and made recommendations to address the state's structural imbalance. In Virginia, the 2004 tax package was considered a key step in addressing the state's structural gap. The intention was to develop sustainable revenue streams that could support budget obligations rather than resorting to budget gimmicks.

Still other states are trying to address structural gaps by focusing on the spending side of the ledger. Several have reformed programs or modified services to slow spending growth. Some states have reformed Medicaid to rein in spending. Others have asked state employees to shoulder a greater share of health care insurance costs. Some states are moving from defined benefit plans to defined contribution plans to save on future pension costs. It is too soon to know if these actions or others ultimately will make a difference in closing structural gaps.

State efforts to realign long-term spending and revenue growth rates have been slow. Over the years, periodic bubbles in tax collections have masked underlying problems in state budgets, delaying the need for serious or immediate attention to structural imbalances. But the day of reckoning may be looming.

"We're living in a fiction," says Vermont's House Speaker Gaye Symington.

TEN RISK FACTORS THAT CONTRIBUTE TO STRUCTURAL BUDGET PROBLEMS

* Lack of services in the sales tax base

* Corporate income tax weakness

* Untaxed e-commerce

* Extensive tax preferences for the elderly

* Limited progressivity of the personal income tax

* Tax policy mix and choices that worsen structural gaps

* The growth of expenditure needs for residents

* Process barriers such as tax and expenditure limitations

* Failure to detach from federal policies that reduce state revenue

* Presence of structural gaps found by other studies

Source: Center on Budget & Policy Priorities, Washington, D.C., August 2005.

NALFO SPEAKS

What are the biggest fiscal issues in the coming legislative session and beyond? Members of the National Association of Legislative Fiscal Offices (NALFO) shared their projections during a roundtable discussion at NCSL's Strong States, Strong Nation meeting in Seattle.

[check] MEDICAID: Medicaid ranks as the fastest growing category of state spending. Despite many states' efforts to rein in costs, it is still budgeted to grow 8.1 percent in FY 2006.

[check] OTHER HEALTH CARE COSTS: Many of the same factors driving Medicaid are affecting other health care spending, too. State officials are seeking ways to manage growing health care costs for state employees and retirees, not to mention aging state prisoners.

[check] K-12 EDUCATION: Either through their own initiative, court order or constitutional mandates imposed by voters, state officials are boosting K-12 education spending.

[check] FEDERAL COST SHIFTS: Costly new programs like No Child Left Behind and REAL ID pose considerable expense for states. Congressional and administration efforts to balance the federal budget could mean even more cost shifts, along with reductions in federal aid to states.

[check] PENSIONS: Referred to as a stealth issue by many, state officials are concerned about unfunded pension obligations. Costs could reach billions of dollars.

[check] PROPERTY TAX RELIEF: The rapid rise of real estate values and the resulting increases in property taxes have generated renewed calls for property tax relief programs.

[check] TAX AND EXPENDITURE LIMITS: Advocates of smaller government are promoting limits modeled after Colorado's Taxpayer Bill of Rights, whose provisions include limiting allowable revenue growth to population growth plus inflation.

[check] HIGH ENERGY PRICES: States that don't benefit from severance taxes might be hit on two fronts: sales tax collections could fall as discretionary spending gets directed toward gasoline purchases and spending could grow to cover heating for state buildings and gasoline for state fleets.

[check] YO-YO TAX POLICY: The recovery of state revenues and the resulting reserves may exert pressure on lawmakers to cut taxes during their 2006 sessions.

[check] GASB 45: This one is too complicated for a brief summary. See the sidebar on page 23 for an explanation.

Corina Eckl heads NCL'S Fiscal Affairs Program.

NUMBER OF FACTORS CONTRIBUTING TO A STRUCTURAL GAP

Most at Risk      10 OR 9
                  Alaska
                  Arkansas
                  Colorado
                  Florida
                  Nevada
                  New Mexico
                  Pennsylvania
                  South Carolina
                  Tennessee
                  Texas
                  Wyoming

                  8
                  Alabama
                  Georgia
                  Kentucky
                  Missouri
                  Rhode Island
                  South Dakota
                  Washington

                  7
                  Arizona
                  California
                  Hawaii
                  Idaho
                  Indiana
                  Michigan
                  Mississippi
                  Oklahoma
                  Virginia

                  6
                  Connecticut
                  Delaware
                  Illinois
                  Iowa
                  Massachusetts
                  Montana
                  New Hampshire
                  North Carolina
                  Ohio
                  Oregon
                  Utah
                  West Virginia

                  5
                  Kansas
                  Louisiana
                  Maine
                  Maryland
                  New York

                  4 OR 3
                  Minnesota
                  Nebraska
                  New Jersey
                  North Dakota
                  Vermont
Least at Risk     Wisconsin

Source: Center on Budget & Policy Priorities, Washington, D.C.,
August 2005. The report, "Faulty Foundations: State Structural
Problems and How to Fix Them," can be found at www.cbpp.org