Roller coaster budgets: the astonishing revenue boom of the late 1990s gave lawmakers an exhilarating ride. The recent bust now has policymakers seeing red.

State lawmakers have been mired in budget misery for nearly a year now. The fiscal boom of the late 1990s that started sputtering in early 2001 came to a screeching halt by the end of the year. National economic woes, exacerbated by the Sept. 11 terrorist attacks, made their way to the state level. As early as FY 2001, budget problems were starting to emerge. But by FY 2002, they threw lawmakers for an unexpected loop.

"No one really knows when you start a recessionary period how deep or how long that cycle will go on. You hope it'll be a minor glitch with mild effects on the state's budget," notes Representative Eldon Mulder, co-chair of Alaska's House Finance Committee. "Often times, as we've seen with this downturn, the effects aren't as minor as we had hoped."

In fact, FY 2002 budget problems were widespread and often severe. In April, 43 states reported budget gaps--lower-than-expected revenues plus spending overruns--with the total reaching $27 billion. By June 30, the end of the fiscal year for 46 states, the figure had jumped to $37 billion. In a dozen states, the gaps exceeded 10 percent of the state's budget.

A handful of states, typically ones with natural resource-based economies like Louisiana, New Mexico and Wyoming, managed to get through the fiscal year without a budget gap. But their reprieve appears to be temporary.

"Anywhere from 40 percent to 70 percent of our revenues comes from the mineral extraction industry--oil, gas, trona, coal--so we're always on a roller coaster in Wyoming," reports Senator Grant Larson, chair of the Appropriations Committee. "When energy prices spiked, our projected $100 million deficit turned into a $700 million surplus. But now we're coming to the down part of the cycle because the price of natural gas has dropped significantly and our oil reserves are diminishing."

With a few exceptions, most states were concerned about faltering revenues, especially from personal income tax collections. Forty-one states levy broad-based personal income taxes which, on average, account for more than a third of state tax revenues.

Since personal income tax collections are such an important source of revenue, officials were holding their collective breath on what the April numbers would show. The final figures were sobering. Total personal income tax collections from January through April were $14.7 billion--about 14 percent--below the prior year. Collections were below target in 39 states, with a dozen below forecast by more than 10 percent.

The bad news wasn't limited to personal income tax collections. Many states reported that sales and corporate income taxes also failed to meet projected levels.

"The revenues generated by the Olympics may have disguised some of the underlying problems that were simmering in our budget," says John Massey, Utah's legislative fiscal analyst. "We had to revise our revenue estimates in May, so a lot of the problems that would have shown up earlier did not show up until then. We ended up with a significant shortfall in our FY 2002 revenues."

For most states, however, shortfalls began appearing early. Many initial actions to address them were used by governors through their authority to keep the budget balanced. But it became increasingly apparent that the gaps were growing and needed the attention of state legislatures. As a result, several convened in special sessions last fall.

All the while, policymakers were keeping a close eye on lackluster revenue performance. Many held emergency meetings to reduce estimates. Before the fiscal year ended, several states had lowered their forecasts numerous times to reflect plummeting revenues.

The result was that nationally, state revenues in FY 2002 were 1.4 percent lower than actual collections in FY 2001. A staggering 29 states reported year-over-year revenue declines, with eight seeing drops bigger than 5 percent.

"Like so many other states, our real revenues in FY 2002 were less than they were the year before," says Senator Penfield Tate, vice chair of Colorado's Joint Budget Committee. "Additionally, projected real revenues for the current fiscal year are going to be even less than they were two years ago."

CLOSING THE GAPS

As legislative sessions began earlier this year, most states were in the difficult position of trying to close FY 2002 budget gaps while crafting or revising--in the case of biennial budget states--their FY 2003 budgets. As states looked ahead, it was painfully clear that they were facing additional shortfalls.

Based on initial estimates, the total gap for FY 2003 was $58 billion--on top of the $37 billion from FY 2002. Although California's astonishing $23.7 billion hole accounted for more than 40 percent of the total, 13 states reported gaps above 10 percent.

Most states pared spending as their first line of attack. "Three things happen in tough times," says Kirk Jonas, deputy director of Virginia's Joint Legislative Audit and Review Commission. "First of all, most 'nice to do' programs are eliminated. Secondly, legislatures are forced to reduce many 'need to do' programs. And finally, they even trim some 'have to do' programs."

This scenario certainly played out for FY 2002 and FY 2003. Virtually every state program has been affected by budget cuts, with higher education among the hardest hit.

History shows that higher education is among the first casualties of economic downturns, but also tends to receive make-up spending when prosperity returns. The recent cuts likely mean that students will be asked to pay higher tuition and fees. Michigan already reports that tuition has increased an average of 8.5 percent. In New Jersey, the state university system has boosted tuition by 9.9 percent.

Although higher education spending is vulnerable during downturns, elementary-secondary (K-12) education tends to be spared. But as an indicator of the magnitude of fiscal tribulations, a dozen states cut K-12 spending in FY 2002, with 11 reporting reductions for FY 2003.

With cuts everywhere, state spending grew just 1.8 percent in FY 2002. In fact, 12 states reported declines from the prior year.

THE CUPBOARD IS BARE

To their credit, lawmakers had taken advantage of robust revenue growth in past years to shore up their rainy day funds. With the current fiscal situation ranging from a drizzle to a hurricane, most states used these funds.

"We created a rainy day fund and made sure that it had plenty of money in it," says Colorado's Senator Tate. "Then we promptly spent it when the need arose."

Colorado was far from alone in this regard. Withdrawals from rainy day funds were often significant. Alaska tapped its fund for $842 million, following last year's withdrawal of $777 million. Ohio tapped its for $427.9 million after using $580.6 million last year, bringing the balance to zero. Connecticut ($594 million withdrawal) and New Jersey ($720 million withdrawal) also depleted their funds. The Pennsylvania legislature could not garner the required two-thirds vote to tap its fund, so lawmakers abolished it with a simple majority vote, transferring the $1 billion balance to the general fund. Legislation with a $300 million appropriation was passed, creating a new account for FY 2003.

Some states avoided dipping into reserves, but at a price. "We had two special sessions late in 2001 to adjust spending downward because of our revenue shortfall," reports Alan Johansen, director of the Florida Senate Finance and Tax Committee. "Although we had more than $1 billion in our reserve fund, there was a political decision not to touch it. The perception in Florida is that it wasn't raining hard enough to justify drawing down the balance. In the 2002 regular session, the reserve fund was left intact, but we have virtually no general revenue left unspent. Traditionally we have left $200 million to $300 million for emergencies and minor revenue fluctuations."

With so many states dipping into their rainy day funds and other reserves, balances have fallen considerably. This doesn't bode well if budget problems persist.

NO STONE UNTURNED

In addition to rainy day funds, states searched hard for other revenue sources. Many targeted unspent balances in various state funds.

Pennsylvania used $90 million from its Capital Facilities Fund to reduce general obligation debt service and withdrew $33 million from its Keystone Recreation Park and Conservation Fund. South Dakota used $36 million from its Property Tax Reduction Fund. Virginia diverted one-half cent of the sales tax from the transportation fund to the general fund for $317 million. Indiana tapped $666 million from state funds, including $200 million from its Build Indiana Fund and $100 million from the Medicaid reserve. New York targeted a variety of funds to garner $1.1 billion.

"Anything that wasn't nailed down or hidden well, we found, including a fund set aside to refurbish our Capitol building," says Jeff Youtz, director of Idaho's Legislative Budget Office. "We unfortunately took back that fund after a beautiful effort to get it off the ground--including everything from school children collecting pennies to a televised groundbreaking ceremony. When we had to take it back, it was awful."

On top of traditional state accounts, a dozen states turned to their tobacco settlement funds to help resolve budget shortfalls. Alabama used $30 million in tobacco money for Medicaid. Missouri used $139.2 million to offset its shortfall. Pennsylvania transferred $198.5 million from its tobacco fund to supplant general fund dollars used for medical assistance long-term care. New Jersey securitized its tobacco settlement money to generate more than $1 billion.

States used an assortment of actions to close their budget gaps, though most followed a similar path. "Like everyone else, we really weren't that creative in resolving our shortfall," says Massey from Utah. "We cut the budget, we used rainy day funds and we tapped cash we had for buildings and roads. But other than the cigarette tax, we did not increase taxes."

TAXES ANYONE?

As a matter of fact, while tax hikes were a rarity in addressing FY 2002 gaps, they became much more popular in FY 2003. In a significant turnaround from the past seven years, states actually raised taxes in 2002. The total increase--$6.9 billion excluding any potential actions in California and North Carolina--is the first time since 1994 that states have imposed a net tax increase. So far, this year's boost represents 1.2 percent of 2001 tax collections.

Although all major categories were increased, cigarette and tobacco taxes were by far the most popular targets. Eighteen states raised them and expect to generate $2.9 billion in FY 2003. The increases ranged from 7 cents per pack in Tennessee to 70 cents in New Jersey.

"Like a lot of the states, we had a tobacco tax increase--a fairly sizeable one as a matter of fact--from 80 cents per pack to $1.50 per pack," reports Alan Kooney, New Jersey's Legislative Budget and Finance Officer. "But the bigger news was that we passed, after a lot of difficulty and on the last day of session, a very comprehensive package of taxes on business."

New Jersey's Business Tax Reform Act was designed to address the gradual deterioration of business tax revenue--a development reported by many states. "We were getting to the point where our corporation business tax was bringing in as little revenue now as it was 17 or 18 years ago," says Kooney.

Although most states steered away from broad based tax increases, a handful targeted sales and personal income taxes. Propelled by rate increases in Indiana, Kansas, Nebraska and Tennessee, sales tax increases are expected to generate $1.1 billion this fiscal year. Hikes in personal income taxes will boost state revenues by $689 million.

On top of tax increases, states expect to augment their budgets by $1.7 billion in nontax revenues. Thirteen states raised fees, mostly around motor vehicles. Some states accelerated tax collection schedules and six approved tax amnesty programs.

Despite the magnitude of state budget gaps going into FY 2003, most states avoided big tax increases--at least so far. The big question now is whether states will increase taxes in the near future. Preliminary discussions already are under way in several states.

"We created a task force to help us determine how we're going to generate more revenue, particularly for school finance," says Delegate Sheila Hixson, chair of Maryland's House Ways and Means Committee. "We will be looking at all forms of taxes."

Nevada also has created a task force to look at ways to raise revenues, possibly through broadening the tax base. Recommendations will be available after the November election.

IT'S NOT OVER YET

By all accounts, passing FY 2003 budgets was no easy task.

"For the first time in our history we passed a budget that was actually lower than the prior year's budget, which we had reduced mid-year by 4 percent," notes Idaho's Youtz. "FY 2003 was pretty rough on the budget side."

Besides Idaho, 14 other states expect to spend less this fiscal year than last. Colorado reports the biggest drop--the FY 2003 budget is 8.5 percent lower than last year's. Nationally, spending is budgeted to grow only 1.6 percent above last year's level.

Despite the painful and potentially unpopular budget decisions they made, lawmakers may not be out of the woods yet. FY 2003 budgets were based on projected revenue growth of 3.7 percent, with some states predicting economic recovery sometime during the fiscal year.

"There's still a bit of optimism for FY 2003, which may be unfounded," says Alaska Representative Mulder. "I think the revenue roller coaster may continue to do a dipsy doodle."

If revenues do under perform--as already appears to be the case in some states--or if spending outpaces budgeted levels, especially for caseload-driven programs like Medicaid, policymakers will be faced with another round of difficult decisions to keep their budgets balanced.

"I am confident that, as we have in the past, we will find a way to make ends meet," says Colorado's Tate. "It will not be pretty. In fact, it will probably be pretty ugly."

Some already have started taking their medicine. Both Montana and Nebraska held special sessions shortly after the current fiscal year began. With additional budget problems threatening, more special sessions are likely.

"Our roller coaster ride started in January when we were told that we had to cut $260 million. Then our forecasters met in February and projected revenues upward by $90 million, so we were all relieved, having only cut or delayed $170 million in spending," says Maine Senator Mary Cathcart who serves on the Appropriations and Financial Affairs Committee. "But a week after we adjourned, the governor announced a shortfall of $90 million for FY 2002 and another $90 million for FY 2003. Through executive order, he has taken care of half the problem, but we're going to have to go into special session later this fall to resolve the rest."

AN UPHILL CLIMB

Although states have been able to put together this year's budgets, next year looms large on the horizon.

"Going into FY 2004, we're in trouble, real trouble," says Hixson. According to Maryland legislative fiscal staff, next year's budget is short by 8.3 percent. The shortage increases to 11.7 percent in FY 2005, although actions to resolve the FY 2004 gap will reduce the outyear amount.

Anecdotal reports around the country echo the Maryland situation. Louisiana reports a potential budget gap of $209 million in FY 2004. North Carolina reports that its budget hole easily could exceed $1 billion, following the more than $2 billion gap this year. In Maine, very preliminary estimates place next year's gap at 12 percent. Many state officials expect revenue shortfalls to continue into FY 2005, as well.

Making matters worse, all the easy solutions to close budget gaps have been used. Any future actions promise to be much more difficult.

"About 9 percent of our revenues are one-time now, propping up our ongoing budget. All of those one-time revenues are gone next year," reports Idaho's Youtz. "That's the table we've set for ourselves, closing a 9 percent gap going into FY 2004."

GETTING BACK ON TRACK

Despite the doom and gloom that abounds in today's fiscal environment, some see the glass as half full and argue that this is a propitious time to make changes in the way government operates.

"An economic downturn provides opportunities to reduce the base of government because programs do grow in flush times," says Kirk Jonas of Virginia. "People accept the reality of cuts and don't fight quite as hard. Reducing the budget base produces opportunities for future initiatives."

At the same time, a crisis can produce clarity in terms of priorities.

"We all have programs in our states that are not meeting the mission they originally were designed to meet. We also have taxation policies which to most seem inconsistent or sometimes just plain crazy," says Alaska's Representative Mulder. "We should take the opportunity during a down economic cycle to try to correct some of the systemic problems that we have within our policies. We should use the downturn to our best advantage. We should use it as an opportunity."

RELATED ARTICLE: STATE BALANCES IN FREEFALL?

State year-end balances, which combine general fund cash on hand with rainy day fund balances, are widely considered a good indicator of state fiscal health. Keep in mind that Wall Street analysts-the folks who rate state bonds--like to see balances around 5 percent of state spending.

The latest decline in state balances began in FY 2001. Although the state year-end balance stood at a healthy 8.7 percent, this was the first time in nine years that the balance failed to reach or exceed the prior year's level. By the end of FY 2002, the news got worse. Here are the numbers:

* Aggregate state balances fell 42 percent from FY 2001 to FY 2002, declining from $32.1 billion to $18.6 billion for the 45 reporting states.

* Balances as a percent of spending dropped 3.8 percentage points. This marks the biggest drop since FY 1980, when balances fell 4.6 points (from 9 percent to 4.4 percent).

* Forty states saw their balances decline from FY 2001 to FY 2002, with some declines sizeable.

* The number of states with balances above 5 percent has fallen. Sixteen states ended the fiscal year with a balance above 5 percent, with four of these above 10 percent. The comparable numbers at the end of FY 2001 were 38 and 14, respectively.

* Connecticut reported that it ended FY 2002 with a deficit. State officials expected to issue revenue anticipation notes to eliminate it.

* State rainy day fund balances have fallen as states have tapped their funds. The aggregate balance dropped from $1 6.7 billion at the end of FY 2001 to $10.9 billion at the end of FY 2002.

* Initial projections for FY 2003 ending balances report more bad news. The aggregate balance is expected to fall even further, to 3.6 percent.

Editor's Note: Information in this article was taken from NCSL's annual budget and tax survey of the National Association of Legislative Fiscal Offices (NALFO). General fund budget information is provided for 45 states; tax information is provided for 48 states.

WHAT STATES WANT FROM THE FEDS

During past economic downturns, some state officials have clamored for financial assistance from the federal government. They have argued that the actions they have to take to balance state budgets--principally, cutting spending and raising taxes--deepen the recession and exacerbate the problem. Financial help from the federal government, which does not have to balance its budget, eases the strain on state budgets and speeds economic recovery.

So far during the current downturn, there has been little discussion of a comprehensive fiscal relief package for the states. Rather, state legislators and governors have advocated modest proposals dispersed among several different funding and program areas. A few call for an infusion of new money. Most simply want to avoid more unfunded mandates and cost shifts, and make up for past costly mandates.

Some of these state efforts have already met with success.

NCSL was a prime force in securing several beneficial changes in the food stamp program, which was renewed in May with passage of the new farm bill. The new law raises funding for food stamps by $6.4 billion over 10 years. It ends a costly, six-year unfunded mandate on states by reinstating food stamp benefits for legal immigrants. And it reforms the old quality control system that was an administrative and financial burden to state food stamp programs.

FY 2003 funding for surface transportation was scheduled for an $8.5 billion cut earlier this year, because of an obscure requirement in the TEA-21 law. NCSL joined several other groups in securing restoration of half this money in the supplemental appropriation bill that passed in July.

The economic stimulus package approved in March extends unemployment insurance payments for an additional 13 weeks--fully funded by the federal government. It also provides up to $8 billion in accelerated Reed Act payments to states, which can use the money to alter benefit levels, fund job training and administration, and modify eligibility criteria.

Congress this year has approved money for two programs related to homeland security. Legislation passed in June establishes $1.1 billion worth of block grants for state and local governments to use to combat bioterrorism. The supplemental appropriations bill provides $100 million to state governments to develop emergency management plans.

Several other possible sources of fiscal relief were on the table as Congress entered the closing weeks of its 2002 session. Renewal of the welfare law, if it occurs, propably will include stable funding for TANF block grants and increases for child care. The Social Services Block Grant may also be in line for an increase, perhaps as high as $1 billion. Full FY 2003 funding for highways, additional money for special education, state high speed rail grants and delay in re-allotment of children's health funds were also in the "possible" category for end-of-the-session negotiations. A proposal that would temporarily reduce state Medicaid matching rates passed the Senate in mid-summer, but was opposed by the administration and had little support in the House.

NCSL will pursue several other avenues for fiscal relief during Congress' 2003 session. Technical corrections to the No Child Left Behind law could delay or eliminate numerous unfunded mandates that will phase-in over the next several years, including requirements for data collection, "highly qualified" teachers and technical assistance for failing schools. The organization will also urge Congress to forgive the penalties some states are facing for failing to meet costly deadlines in several other current laws.

Carl Tubbesing, NCSL

Corina Eckl heads NCSL's Fiscal Affairs program.