Economic Slowdown: How Bad Is It?; Lawmakers knew that robust economic growth couldn't last forever. But they were caught off guard by the rapid deterioration in state finances.

What a difference a year makes. This time last year, state finances were going strong. Lawmakers were reaping the benefits of the longest economic expansion on record. Unemployment and inflation levels were at notable lows, state revenue growth was robust, and reserve funds were well endowed. For a while, it seemed that the good times would never end. But they have, and the Sept. 11 terrorist attacks on the World Trade center and Pentagon are only making it worse.

The first signs of real trouble emerged last January. As state forecasters analyzed December revenue collections, they realized something was amiss. Sales tax revenue, one of the stalwarts of state revenue growth, was slipping. The timing was critical because holiday sales typically boost December collections. There were also early concerns about personal income tax collections because quarterly estimated payments were lagging projections.

But no one hit the panic button. Instead cautious analysts asked: Were December collection figures just an aberration or a harbinger of things to come? As the last few months of the fiscal year drew to a close, the answer became clear. The economy was changing, and so were state finances. The strong fiscal conditions of a year ago had been replaced by anemic revenue growth and growing budget gaps.

Before FY 2001 had ended, 17 states grappled with budget shortfalls. For the first time in a decade-since the national recession of the early 1990s-a large number of states were cutting budgets, tapping reserves and implementing temporary measures to balance their budgets. And that was just the start. crafting balanced budgets for FY 2002 would be challenging, too. Little did lawmakers know that the task of keeping their budgets balanced would take on new proportions as the fiscal year ensued.

A NEW FISCAL CLIMATE

When legislatures convened their 2001 sessions, policymakers confronted several hard facts: Revenue growth was slowing dramatically, spending-especially for Medicaid-was exceeding budgeted amounts, and a growing number of states faced budget gaps. These facts stirred up distant and unpleasant memories of budgeting under tight fiscal constraints. For the first time in nearly a decade, the economy was forcing lawmakers to make difficult and unpopular budget decisions. For some, the debates led to protracted budget battles. Seven states missed their budget deadlines, the largest number since 1991 when 11 states were late.

The first step for developing FY 2002 budgets was to keep spending in line with projected revenue growth. Although aggregate FY 2001 spending and revenue grew 9.1 percent and 4.5 percent, respectively, the projections for FY 2002 were 2.2 percent and 2.3 percent. These amounts left very little room for school enrollment increases, growing Medicaid caseloads and adjustments for inflation. Lawmakers would have to re-evaluate spending priorities.

MEDICAID MULTIPLIES

For several straight years, education spending outpaced other major categories of state funding. But Medicaid started challenging education for the top spot last year Mid- way through FY 2001, nearly half the states reported that Medicaid was exceeding budgeted levels. In fact by the end of the fiscal year, Medicaid spending had grown by 14 percent over FY 2000. It originally had been budgeted to grow by 6.4 percent. Medicaid is threatening to be a budget buster again, projected to grow 8.8 percent in FY 2002.

With Medicaid spending on the rise and resources tightening, other major categories of spending will feel the pinch. Elementary and secondary education is slated to grow 3.7 percent and higher education 3.6 percent, well below growth levels in recent years.

In the face of sputtering revenues and growing spending demands, many lawmakers searched for new ways to balance their FY 2002 budgets. Many lawmakers opted for belt tightening. Ten states reduced spending, although selected programs often were exempted from the cuts. Arkansas policymakers reduced funding from FY 2001 levels for most state agencies, except for K-12 and higher education, human services and corrections. Iowa lawmakers reduced the FY 2002 budget by $43 million below FY 2001 spending. Actions in Kentucky included a 3 percent across-the-board cut, but K-12 education, higher education and Medicaid were excluded. Michigan lawmakers reduced appropriations by $200 million. South Carolina legislators cut $176.5 million, although public education, colleges and universities were spared. Ohio lawmakers cut appropriations by 1.5 percent but excluded the Department of Education, Board of Regents, Department of Corrections and the Department of Mental Health.

Several states postponed expenditures. Indiana officials delayed a higher education payment of $65.3 million and a tuition support distribution of $202.5 million. Maine lawmakers deferred expenditures by changing the timing of certain reimbursements. Washington policymakers suspended deposits to the Tort Liability Reserve Fund, the state ferries system arid the transportation fund.

THE RAINY DAY HAS COME

Lawmakers also looked to the revenue side of the ledger to balance their FY 2002 budgets. One of the most popular actions, opted for by 10 states, was tapping rainy day funds or other reserves.

Kentucky used $120 million, half of its rainy day fund, to help balance its budget. Indiana took $200 million from its lottery and gaming surplus account, $26.3 million from the rainy day fund and $51.7 million from the tuition reserve fund. Michigan transferred $155 million from the rainy day fund to the general fund. Ohio used $100 million from the family services stabilization fund, among other accounts.

Five states increased taxes or other revenues. Indiana repealed a personal property tax credit and delayed another one to garner $118.9 million. Kansas increased traffic fines to raise about $16 million annually. Both Maine and Rhode Island increased their cigarette taxes. New Jersey closed a corporate income tax loophole hoping to raise $420 million and started a new lottery game to raise about $50 million.

Three states tapped tobacco settlement funds. Maine used $29.4 million from tobacco settlement money, and Michigan used $72 million. Wisconsin sold bonds, backed by its tobacco settlement allocation, and used $450 million of the proceeds to help balance the general fund.

State policymakers also took other actions. For example, Kansas, Maine and Ohio enhanced tax compliance efforts; Kansas shifted from pay-as-you go capital projects to bond finance; and Ohio eliminated the State and Local Government Commission, the Women's Policy and Research Commission, and the Correctional Institutions Inspections Committee to save $1 million.

Taken in combination, and compared with the kinds of fiscal decisions lawmakers had been making in recent years, these actions stand out as extraordinary. But they probably won't be enough.

THE BEST LAID PLANS

Many lawmakers already were concerned about the stability of their budgets as the new fiscal year began for most on July 1. In many states, FY 2002 budgets were developed last spring, before solid information about the magnitude of declining revenue growth could be factored into projections.

Even before the beginning of their fiscal year, which began Oct. 1, Michigan lawmakers knew that revenue projections made in the spring were not going to be met. "Our May forecast assumed that the economy would pick up steam by the fall. That obviously didn't happen," says Gary S. Olson, director of the Senate Fiscal Agency and member of the state's consensus revenue estimating group. For only the second time since 1990, the group convened an emergency meeting to reduce the state's revenue forecast. It met on Oct. 23, and dropped the FY 2002 forecast by about 5 percent. This left lawmakers seeking ways to plug a $500 million hole in the general fund budget and $300 million in the school aid budget. Early proposals to cover the shortfalls ranged from 5 percent budget cuts to further withdrawals from the rainy day fund. Some lawmakers also proposed suspending previously enacted tax cuts.

Michigan wasn't alone. Idaho's governor ordered a temporary 1.5 percent spending holdback for K-12 education and 2 percent for everyone else. Governors in several states, like New Hampshire and Tennessee, asked agencies to develop contingency plans to reduce spending. Florida confronted a $1 billion shortfall. Across the nation, states were reporting fiscal problems. Then came the tragic events of Sept. 11.

THE IMPACT OF SEPT. 11

Almost immediately after the terrorist attacks, economists and state forecasters warned lawmakers to expect the worst. In a Sept. 13 forecast issued by Standard & Poor's, Chief Economist David Wyss reported, "The World Trade Center disaster has changed the near-term economic outlook (although that seems trivial given its other repercussions). The consumer, the last bastion of strength in the economy, is now likely to pull into his shell. Businesses are delaying any decisions on capital spending until the future is less cloudy. The result is likely to be a mild recession."

More evidence of a recession mounted. The U.S. Commerce Department reported in late September that gross domestic product, the output of goods and services produced in the United States, grew a meager 0.3 percent in the April-June quarter--the weakest performance in more than eight years. The outlook for continued economic growth in the third quarter already was dim, and that was before Sept. 11.

By mid-October, the economic impacts of the attacks were just making their way into state revenue figures. For many states, it was difficult to separate the effects of the economic slowdown from the effects of the attacks, "It's too early to make a determination of the direct and indirect effects on the budget," reported Alan Kooney, New Jersey's legislative budget and finance officer, in mid-October. "Much of what we've seen so far in revenue sluggishness predates that event and is due to the general economic slowdown. Obviously, what happened on Sept. 11 didn't help."

It was becoming painfully clear that revenues were slipping precipitously, and policymakers began bracing for the worst.

Many governors, vested with the authority to make limited mid-year spending reductions, announced budget cuts. Illinois Governor George Ryan announced $50 million in cuts on Sept. 25, blaming heightened economic uncertainty stemming from the terrorist attacks. The cuts included a freeze on most state hiring and new equipment purchases, as well as reductions in out-of-state travel. Other governors followed suit.

Although several legislatures already had anticipated the need for special sessions to address growing budget problems, the September attacks underscored the urgency.

Just two weeks into the fiscal year, Nebraska officials began talking about a special session. "When we left our regular session at the end of May, our fiscal house was in good shape," says Nebraska Speaker Douglas A. Kristensen. "But in June we started seeing disturbing revenue declines in all tax sources. While we were unable to detect the immediate effects from the attacks, we knew we had to address our dramatic decline in revenues." In an effort to resolve the growing budget gap, the Legislature convened in special session in late October. Among the options considered was a 3 percent across-the-board budget cut.

The Hawaii Legislature met in an unprecedented third special session in a single year, with the most recent session focused on the economic crisis caused by the terrorist attacks. "Just six days before the terrorist attacks, our council on revenues projected a growth rate increase from 4.1 percent to 5.1 percent," says Speaker Calvin KY. Say. "But the events of Sept. 11 took an immediate and drastic toll on the Hawaiian economy." To address the concerns raised by the crisis, the drop in tourism and concomitant job losses, the governor asked legislators in an October special session to approve $10 million in additional money--to be matched with another $10 million from the private sector--to implement an emergency tourism strategy.

THE CHALLENGES AHEAD

Although a few states were struggling with budget problems when the economic slowdown began, most were in strong fiscal positions and at least had some flexibility to manage the effects of a slowing national economy. But no one could have predicted the terrorist attacks of Sept. 11 and their widespread economic impact. This unexpected and unprecedented development has created significant uncertainty for state budgets, leaving policymakers with problems of unknown size.

Washington's budget director announced in early October that revenues could be down anywhere from $200 million to $800 million, depending on the severity of the economic downturn. The governor announced that budget cuts of as much as $1 billion could be necessary as the state responds to the decline in the airline industry and other economic fallout resulting directly from the terrorist attacks.

Other states also report growing fiscal problems, but don't know the exact magnitude. Oregon faced a general fund shortfall of about $300 million based on the September revenue forecast, with the December forecast expected to show another decline. Arkansas saw a big drop in corporate income taxes and expected budget reductions as a result. New Jersey expects a significant revenue shortfall this year, especially in the personal income tax as income and capital gains flatten for wealthy taxpayers. The list goes on.

Nationally, state revenue growth is expected to slip below the lackluster 2.3 growth rate originally projected. Massive lob layoffs in the airline industry and other sectors of the economy will exacerbate declining personal income tax collections. The decline in the stock market also will affect income tax collections as stockholders realize fewer and smaller capital gains. Corporate income taxes, already a shrinking share of state revenues, are expected to decline further as businesses scale back or go under.

As consumer confidence wanes, so will sales tax revenues. States heavily dependent on tourism, like Florida, Hawaii and Nevada, are especially concerned about sliding consumer confidence and reluctance to travel. "With an economy largely based on tourism, the dramatic drop in air travel effectively cut the flow of Hawaii's lifeblood," says Hawaii's Speaker Say. "When tourists don't fly in, our hotels, restaurants and retail shops are empty."

Although forecasters are still trying to get a handle on the revenue numbers, the news isn't expected to be good. "We're hoping for a national recovery by February or March of next year," says Michigan's Olson. "In the meantime, I expect all states will be revising their forecasts downward."

To their credit, many lawmakers planned for a rainy day by bolstering state reserve funds. These well-endowed funds are providing an important cushion as state finances deteriorate. But they are unlikely to be enough. While rainy day funds can help in the short run, they never were intended to be large enough to help states weather a fiscal crisis.

On top of shrinking revenues and reserve funds, many states are faced with uncertainty on the spending side of the budget. Although lawmakers have appropriated an 8.8 percent increase for Medicaid in this year's budget, will it be enough? How will the economic downturn affect funding needs for other social programs? What about funding for public safety, an area of growing concern across the nation? The list of unknowns seems endless.

State budgeters have gotten through fiscal crises before, and they will get through this one, too. Although there is considerable uncertainly about the magnitude of the current crisis, it is certain that tough times are ahead. "We are preparing for a prolonged recovery," says Hawaii's Speaker Say. "However, I am hopeful that our short-term efforts will stabilize the economic free fall."

Corina Eckl heads NCSL's Fiscal Affairs Program. This article is based on NCSL's annual survey of state budget and tax actions, Information was provided by 46 states; Massachusetts, New York, North Carolina and Tennessee had not passed budgets by the time of the preliminary report. The final report will be available in January.

RAINY DAY FUNDS ARE EVAPORATING

When revenue growth was robust, states found themselves with large
general fund balances at the end of each fiscal year. Combined with
rainy day funds, these amounts gave states healthy reserves. But as
revenue growth sputters, general fund balances are disappearing.
Increasingly, rainy day funds are accounting for the bulk of total state
balances, yet even these amounts are shrinking as states tap them.

          Rainy Day           Cash on hand,   Total
          Funds, in billions  in billions    Balance

FY 2000         $23.51           $20.16      $43.67
FY 2001         $22.65           $11.45      $34.10
FY 2002         $19.21            $7.54      $26.75
estimate

Note: Table made from bar graph

RELATED ARTICLE: BUDGET OUTLOOK IS GLOOMY

Significant attention has focused on the national economic slowdown effect on state finances. Anecdotal reports revealed the beginnings of a troubling picture. A survey conducted by the National Conference of State Legislatures (NCSL) in late October was the first look at the 50-state picture. The news was not good. With only a few exceptions, state fiscal conditions had taken a dramatic downturn. Moreover, as legislative fiscal analysts looked ahead, the budget outlook appeared bleak.

Highlights from the NCSL survey include:

* State revenue growth has slowed dramatically. Forty-four states reported that revenues were below forecasted levels in the opening months of FY 2002.

* Nineteen states reported that spending was exceeding budgeted levels with another seven reporting that overspending in some areas was likely. Medicaid continues to exceed budgeted levels, proving to be an ongoing problem in many states.

* At least 28 states have begun or are considering budget cuts.

* Twenty states may tap reserves to balance their FY 2002 budgets. Most states are eyeing their rainy day funds, although a handful may tap tobacco settlement money.

* Fourteen states have started belt-tightening measures that include hiring freezes, cancellations of capital projects and travel restrictions.

* Seven states have convened or will convene in special sessions to address budget problems. Several others are considering such sessions.

* The budget outlook for the rest of FY 2002 is worrisome for most states because fiscal conditions are expected to get worse before they get better.

* Much of the information currently available does not yet include the economic effects of the Sept. 11 terrorist attacks.

REVENUES FALL SHORT: A SAMPLE OF STATE EXPERIENCES

July and August revenue figures provided early warning signs that collections were falling below even the modest projections built into FY 2002 budgets. Although there is still time for states to reach their estimates before the end of the fiscal year, the prospects are growing increasingly dim.

* Arizona's general fund revenues fell $37.8 million (3.9 percent) short of estimates in the first two months of FY 2002. Sales and use tax collections were $31.7 million (6 percent) less than forecast and grew by only. $2 million (0.4 percent) from July and August of the previous year.

* California's tax collections were $607.8 million (6.6 percent) less than forecasted for July and August. The personal income tax had the largest shortfall-$237.1 million (5.2 percent)-while sales and use tax receipts also came in well short of expectations-$223.6 million (5.9 percent).

* Florida policymakers reduced FY 2002 revenue projections in September by $673 million or 1.3 percent of the $48 billion annual budget. The biggest drop occurred in the sales tax, which fell $412 million below estimate.

* Georgia's revenues declined $1 36,2 million (6.2 percent) in July and August compared with the previous year. Individual income tax declines led at $81.1 million (7.3 percent), while corporate income and sales tai collections dropped $59 million (66.9 percent) and $12.9 million. (1.5 percent), respectively.

* Indiana's revenues for the first two months of FY 2002 were $124 S million short of projections. Collections are 4' percent lower than the previous year.

* Massachusetts policymakers realized that one advantage of missing their July 1 budget deadline was that it allowed them to consider actual revenue data rather than relying only on projections Tax collections were down $73 million in July and August compared with collections over the same period last year.

* Mississippi tax collections were $33.6 million (5.8 percent) below projections for July and August. Governor Ronnie Musgrove asked state agencies to limit spending in the first six months of the fiscal year to 45 percent of the annual budget.

* Pennsylvania's general fund collections came in $30,7 million (1.1 percent) short of projections for July and August. Personal income and sales tax made up 87 percent of the shortfall-$15.3. million (50 percent) and $11.5 million (37 percent), respectively.

* Virginia's revenues grew 2.1 percent in July arid August compared with last year, but that figure was well below the 7.5 percent growth target included in the FY 2002 budget. Sales tax collections were down 0.4 percent, despite a projected growth rate of 7.7 percent. Although personal income tax collections increased 2.9 percent they fell short of the 7.8 percent forecast.

Blake Mockey, NCSL

MEDICAID COULD SOON BE DRIVING STATE BUDGETS

Medicaid spending is way ahead of what state lawmakers originally budgeted for FY 2001. Policymakers thought the growth would be around 6.4 percent, instead it grew more than double that--14 percent over FY 2000 spending. Some factors that contributed to this double-digit growth include:

* Increases in prescription drug prices and use.

* Demands by providers for higher payments.

* Enrollment growth due to expanded eligibility and outreach efforts.

* Growth of the disabled population.

* Limited impact of Medicaid managed care.

* Reliance on home- and community-based services.

Trinity Tomsic