Budgets on the rebound? Revenues are showing signs of recovery, but will that be enough to keep state budgets solvent?

By now it's old news: State budgets suffered historic deterioration during the last national recession. That's what makes the recent news so welcome. Revenues are recovering. So logic argues that the worst is behind us. But unfortunately, it's not that simple. Yes, the revenue dilemma may be easing, but spending pressures show no signs of diminishing.

"Revenues are performing better than expected," says Michael Calvert, director of Nebraska's Legislative Fiscal Office. "But the improved revenue estimate is offset by revised cost estimates."

Nebraska's experience is echoed across the country.

BUDGETS UNRAVEL

Fiscal doldrums began about four years ago. Mid-year budget problems in a few states spread like wildfire, encompassing nearly all of them within a year. Not only was the problem pervasive, it was severe. Lawmakers faced billion dollar budget gaps. As gaps mounted, state year-end balances shrank--a whopping 50 percent drop from FY 2001 to FY 2002.

NCSL's data show that states have closed a cumulative budget gap surpassing $235 billion since FY 2002. How did these gaps develop?

State budgets are built from two sets of data: revenue forecasts and expenditure projections. Lower-than-expected revenues and higher-than-expected expenses lead to budget gaps. It's impossible to predict future revenues and expenditures precisely, but the task is even more difficult when the economy is changing rapidly, as it did at the beginning of the decade.

State finances took a dramatic turn for the worse when the national economy stumbled. Most states saw revenue performance fall below projections--in some cases dramatically below. Many states even reported year-over-year drops in actual revenue collections--a development not seen since the Korean War, World War 11 or the Great Depression. On the expenditure side, a variety of social and safety-net programs outstripped their budgeted levels. The biggest problems occurred in Medicaid and other health care programs. In combination, these factors led to yawning budget gaps.

BRIDGING THE GAPS

The $235 billion gap that states closed since FY 2002 required difficult and unpopular actions. Lawmakers used the easiest solutions--like tapping rainy day funds, deferring spending and delaying capital projects--at the beginning of the downturn. The harder choices followed.

Legislators mostly cut spending to balance their budgets. According to the Center on Budget and Policy Priorities (CBPP), cuts accounted for 42 percent of the actions to close gaps between FY 2002 and FY 2004. In FY 2004 alone, 42 states used targeted or broad spending cuts to bring spending in line with revenues.

One-time revenues also played a crucial role. Nearly half the states used non-general funds to shore up their budgets this year, either by transferring agency fund balances into the general fund or shifting costs to other state funds.

* Iowa shifted $207 million for Medicaid spending to other accounts and funded about $160 million in property tax credits from the rainy day fund.

* Indiana used $190 million in FY 2004 and FY 200S from its Pension Stabilization Fund to pay for teacher pensions.

* Alabama tapped the Securities Commission Fund, the Insurance Department Fund and the Public Service Commission Fund.

* Kansas used $4.3 million in ending balances of selected special revenue funded agencies.

Because rainy day funds have dwindled in recent years, fewer states had this option available. But nearly a dozen still tapped their funds this year, including Massachusetts with a $340 million withdrawal.

Alaska had planned to use $372 million from its fund, but escalating oil prices enhanced the state's fiscal fortune. Now, officials think they'll have surplus money to deposit into the rainy day fund, possibly boosting the balance by several hundred million dollars. Unlike Alaska, however, most states have not been able to replenish their accounts. This raises a red flag.

"Many states still have minimal budget stabilization funds," says Robin Prunty, director of Public Finance at Standard & Poor's. "We see that as a risk to fiscal stability because it provides little flexibility for most states to react to mid-year budget imbalances."

THE TAX TABOO 

Despite the magnitude of budget gaps, states did not turn significantly to tax increases to shore up their budgets. According to CBPP, tax and fee increases accounted for only about one-seventh of gap-closing measures.

Tax increases are very unpopular and hold little political reward for legislators and governors who seek re-election every two or four years. Some lawmakers also are hamstrung by voter-imposed measures that limit revenue growth. In Colorado, revenue growth is limited to the change in population plus inflation, and any tax increase must be approved by the voters. While other states don't face limits as stringent as Colorado's, many have their own set of tax or spending limits.

A few, like Arkansas, New Jersey and Virginia, bit the tax bullet recently, but major tax increases have been the exception, not the rule during the past downturn. Contrast this to the recession a decade ago when nearly every state raised taxes to sustain their budgets.

In 1991, a non-election year for most states, lawmakers raised taxes by 5.4 percent of prior year collections. This is a significant increase by any measure. Had states raised taxes by a similar magnitude in 2003 (again, a non-election year for most), the national increase would have been nearly $30 billion. Instead, states raised taxes by $8.8 billion, or 1.6 percent of prior year collections.

While some of the increases affected broad taxes--the personal income or sales tax--many were targeted to specific products, like cigarettes, or earmarked for particular purposes, like health care or education. And some of the increases were temporary, like Idaho's 1 percent sales tax increase that will end July 1,200S.

Some lawmakers rejected tax increases because of their concern that new levies could stall economic recovery. Others felt they could hold out until revenue growth recovered on its own.

BUDGETS IMPROVE

Recovery began creeping into state budgets last year and helps explain why gaps are shrinking. Some of the credit goes to the federal government for giving states a helping hand.

Fiscal assistance from the federal Jobs and Growth Tax Relief Reconciliation Act of 2003 was a critical injection to ailing state budgets. It was intended to help states protect essential programs and cover rapid growth in Medicaid expenses at a time when revenues were faltering. And it worked. It helped minimize program cuts and reduce the use of reserves and other one-time revenues. Without the additional federal money, balances--already at shaky levels--surely would have dropped.

There's also evidence that state revenue performance began to improve. According to preliminary information from the Nelson A. Rockefeller Institute of Government in Albany, N.Y., state tax revenue increased 7.9 percent in FY 2004. After adjusting for tax increases, processing changes and inflation, revenue grew 3.4 percent--the first real growth after two years of decline.

Recent data on FY 200S collections suggest that revenues are continuing to recover. Personal income taxes are beating forecasts, sales taxes are largely on target and corporate taxes are dramatically above estimates in most states. They also show strong year-over-year gains.

In Iowa, total revenue for the first three months of the fiscal year is 9.5 percent over the same period in FY 2004. "It's recovery from a year ago," says Dennis Prouty, director of Iowa's Legislative Services Agency. "Whether it sustains itself or not, that's something else, because we've had several false starts in the past."

Indeed, skittish state officials and forecasters are reluctant to get too excited about recent revenue news. Although the numbers look good, they are being viewed with some caution.

Between FY 2002 and FY 2004 revenues fell sharply in many states, so strong year-over-year gains reflect in part the low base on which the increases are occurring. Additionally, many forecasts were conservative. News about collections exceeding estimates are partly explained by these conservative starting points.

Questions about the strength of the economic recovery also have some officials guarded. While personal income tax collections were ahead of target in Idaho, withholding taxes--a key indicator of the economy's underlying strength--slipped for the second time in eight months. "There are fluctuations that occur in the monthly data, and until you see evidence of a trend setting in, it's difficult to draw any meaningful conclusions," says Michael Ferguson, chief economist for Governor Dirk Kempthorne.

IS REVENUE RECOVERY ENOUGH?

2Despite recovery news, lawmakers are concerned about the future of their budgets--and with good reason. Reserves have dwindled, leaving a very thin cushion. Lawmakers also need to find revenues to replace the onetime federal funds that helped balance previous year budgets.

Multiple years of budget cuts and depressed spending also are exerting intense pressure on lawmakers to boost funding for state programs.

"Although the states are much stronger from a revenue recovery standpoint, we still see spending pressure as a challenge," says S&P's Prunty.

Even with stronger revenue performance, spending is expected to outpace revenues. If this trend holds, new budget gaps may open and year-end balances will continue to fall.

But this revenue-spending imbalance is more than just an immediate problem. It is likely to continue into FY 2006 and beyond.

Louisiana projects a gap anywhere between $582 million and $844 million in FY 2006, depending on budget increases related to merit pay, personnel benefits and inflation. Maine is looking at a structural gap of $785 million for the next biennium. New Jersey could face a gap as large as $4.1 billion next year, after closing multi-billion gaps recently. California sees a $6 billion gap looming for FY 2006, with an $8 billion gap possible in FY 2007.

THE BUDGET SQUEEZE

An immediate and long-term pressure point is Medicaid. Costs for this state-federal program are being driven up by spending for long-term care, prescription drugs and expanding caseloads. For the past four years, Medicaid has been the fastest growing program in state budgets. Budgeted to grow nearly 13 percent in FY 2005, it could easily be more. As Medicaid demands grow faster than revenues, many other programs are squeezed.

Nearly a decade ago, Medicaid represented 12 percent of state general fund budgets. Today, it accounts for 16.3 percent. Elementary-secondary education, which benefits from strong bi-partisan support, adjustments for enrollment growth and mandated spending levels in some states, also has increased its share, from 29.9 percent to 33.6 percent today. These two programs, which 10 years ago represented 42 percent of general fund spending, now constitute half.

Other programs have seen their shares shrink as a result. Higher education has dipped to 11 percent of the budget; it has represented more than 12 percent in the past. The big piece of the pie identified as "other'--parks and recreation, state police, information technology, environment, economic development and arts programs, among others--has fallen from 41 percent of the budget a decade ago to one-third today. Even within this "other" category, some programs are growing rapidly, like state employee health benefits and pensions, so the rest of the programs in this slice of the pie are getting hit even harder.

Antiquated state tax systems pose one of the biggest challenges to future revenue growth. In his recent book, New Realities in State Finance, Ronald Snell carefully describes the limitations on current tax structures and their dependence on a manufacturing-based economy, not the service-based one we live in today. Slow erosion also threatens personal and corporate income tax bases and, over time, collections.

If these challenges weren't enough, Donald Boyd at the Rockefeller Institute cautions that the personal income tax is unlikely to see the astounding growth it experienced in the latter part of last decade. He says that revenue had been propped up by unsustainable forces, particularly unprecedented growth in capital gains, which we're not likely to experience any time soon.

The challenges facing state tax systems probably mean that the only way revenues will rise enough to meet growing spending needs will be if taxes are increased. As recent experience shows, however, new taxes are a long shot. Even though lawmakers will do their best to reprioritize spending within available revenues, tight budgets appear inevitable.

"Vermont, like most other states, has made hard choices to get spending down, but our budget is being squeezed by these underlying pressures," says Stephen Klein, director of Vermont's Joint Fiscal Office. "We're by no means in a position of smooth sailing."

WHERE GENERAL FUND MONEY GOES

10 YEARS AGO

K-12 Education        30%
Medicaid              12%
Corrections          5.3%
Higher Education    11.7%
Other               41.1%

TODAY

K-12 Education      33.6%
Medicaid            16.3%
Corrections          5.9%
Higher Education      11%
Other               33.2%

Note: Table made from pie chart.

Source: NCL

CLOSING THE BUDGET GAPS
(IN BILLION OF DOLLARS)

               Before Enactment    After Enactment
                 of the Budget      of the Budget

FY 2001
(43 states)
FY 2002
(43 states)                             $37.2
FY 2003
(43 states)         $49.1               $29.9
FY 2004
(43 states)         $79                 $83.7
FY 2005
(43 states)         $36.3

Note: Table made from bar graph.

Source: NCL

Corina Eckl heads NCSL's fiscal program.