Where does the buck stop when the bucks stop? It's tempting to seek a scapegoat for state budget woes, and critics have been quick to blame lawmakers. But a closer examination of the facts points to causes outside of policymakers' control.

It's been a tough two years for state legislatures. Facing the worst fiscal conditions since the Great Depression, states have struggled through a sea of red ink to balance budgets with woefully inadequate revenues.

The fiscal problems in 2002 were amplified in FY 2003. Lawmakers made painful decisions to close a cumulative $50 billion shortage. But the pain was far from over. Just months into the fiscal year, a new gap of nearly $30 billion opened.

Policymakers explored every possible avenue to close the shortfalls. The wide array of actions included tapping reserves, which continued a three-year plummet from record levels just years earlier. Aggregate reserves--which include year-end balances plus rainy day funds--dropped 48 percent during FY 2003. Thirty-four states saw their balances decline, some significantly. Only a few states reported any improvement.

REVERSAL OF FORTUNES

Anemic revenue performance largely explains the latest round of state fiscal problems. The robust growth that began in the mid-1990s took a nosedive in 2001. The decline has been remarkable.

A staggering 40 states collected less revenue in FY 2002 than they did the year before, according to the Rockefeller Institute of Government in Albany, N.Y. Subsequent data collected by the National Conference of State Legislatures showed a dozen states taking in less in FY 2003 than the year earlier. Nine states fell into both categories, reporting back-to-back years of waning revenues.

Entering the fiscal year, economists projected that revenues would grow 4.4 percent. But by April, it was clear that the target was in serious jeopardy: Revenues lagged projections in 37 states, forcing most to lower their forecasts. When it was all over, revenues grew a meager 0.7 percent.

Looking ahead, aggregate revenue growth is projected at 4.3 percent for FY 2004. At first glance, this appears to be a promising indicator of a revenue upswing. But that may not be the case.

Many legislative fiscal directors report that one-time revenues continue to bolster state coffers. Moreover, tax performance estimates could be too optimistic unless the economy turns around more strongly. Some legislative experts already predict that revenue estimates will be lowered in coming months.

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WHO'S TO BLAME?

Given the strong revenue growth after 1990, did states irresponsibly spend themselves into this crisis? The evidence says no.

The most important factor affecting state finances is the national economy. When it slips into recession, as it did in March 2001, state budgets will feel the brunt. Looking back to the national recessions that occurred in the early 1980s and 1990s, the impact on state budgets is obvious. State reserves--one of the best indicators of state fiscal health--dropped to precipitously low levels both times. State revenue performance, another important indicator, also declined.

The biggest difference this time around was the severity of the revenue drop. According to the Rockefeller Institute, the tax revenue decline was an astonishing 7.4 percent, when the drop in real GDP per capita was 0.7 percent.

"The revenue decline for states was more severe than the overall economic decline," says Nick Jenny, senior policy analyst at the Rockefeller Institute. "This is related to what happened with investment income, the stock market, capital gains and high income taxpayers." In particular, the tax revenue states derived from capital gains dropped significantly.

As the stumbling national economy took its toll, demand for state safety net programs soared. Medicaid spending, for example, which has increased $90 billion or 54 percent during the past five years, grew nearly 13 percent in 2003 alone. It now accounts for 19 percent of state expenses. States also took advantage of matching federal funds to expand Medicaid coverage to an additional 12.8 million poor people, a 51 percent increase in the number of enrollees.

While state lawmakers opted to boost spending to cover more poor people, they also saw expenses grow because of skyrocketing health care costs--a development causing widespread alarm. Some fiscal policy experts now warn that Medicaid spending could overwhelm state budgets in the coming years. In response to recent budget problems, many states scaled back Medicaid programs and eligibility.

Medicaid, other health care programs and education all come with high price tags and together make up 60 percent of state budgets. They also have strong public support. A recent USA Today/CNN/Gallup poll reported that 78 percent of the public do not want any funding cutbacks in health care, and 77 percent do not want cuts in education. Responding to this directive, as well as rising enrollment and the costs of special education programs, states increased funding for education 90 percent over the last decade.

Add to this an $82 billion annual price tag for federal mandates that come with insufficient money attached for special education, No Child Left Behind, election reform and homeland security, as well as voter approved measures that require spending increases and prohibit tax increases. Many legislators find themselves hamstrung.

"States benefited from an impressive growth in the U.S. gross domestic product in the 1990s," says NCSL fiscal expert Ron Snell. "As a result, state governments were able simultaneously to cut taxes, rebuild reserves that had been depleted by the recession of 1990 and expand spending on priority programs."

States cut taxes by $35.7 billion from 1995 to 2001, reversing the tax increases they had enacted earlier in the decade. Legislatures also established record reserve funds, bumping them from about 1 percent of general fund expenditures to 10.4 percent, for a total of $47 billion.

State spending did increase 88 percent from 1991 to 2001, from $628.6 million to $1.2 trillion. But inflation and population growth accounted for about half the average annual growth in spending. Increases for Medicaid, corrections and education costs rounded it out. In fact, the average growth rate for the period was 6.6 percent, ranging from a low of 2.74 percent in 1996 to a high of 11.66 percent in 1992, a year when recession-driven demands for safety net programs and double-digit increases in Medicaid costs squeezed state budgets.

"Medicaid completely accounts for the increase in state and local spending from 1991 to 2001 as a percent of GDP," says Snell. "It represents a significant shift in state spending priorities."

With so many factors outside their control, policymakers have found it very difficult to stem the flow of red ink. "Their efforts at prudent management were overwhelmed by the impact of the economic downturn on state tax collections and spending pressures driven by population growth and uncontrollable expenses," Snell says. "Lawmakers have tried to control spending and limit tax increases, which proportionally have been much smaller than in the last recession. But until economic recovery lifts state fortunes, legislators will face very hard budget decisions."

Editor's note: To read NCSL's analysis of state fiscal actions in the 1990s, go to www.ncsl.org/programs/fiscal/stspend90s.htm

TOTAL TAX AND NONTAX REVENUES

When the economy was booming from
1995 to 2001, states cut taxes and
fees a total of $35.4 billion. In
the past two years, tax and other
revenue were raised $22.1 billion.

         BILLIONS

        Nontax/Tax

'92        $5.2
'93        $4.6
'94        $2.0
'95        $2.7
'96        $4.0
'97        $2.2
'98        $7.2
'99        $7.1
'00        $9.8
'01        $2.4
'02       $11.5
'03 *     $10.6

* 42 states reporting

Source: NCSL

Note: Table made from bar graph.

RAINY DAY FUND BALANCES FALL
(BILLIONS OF DOLLARS)

State rainy day fund balances have plunged
from their record highs in 2000.

FY 2000             $25.9
FY 2001             $20.0
FY 2002             $11.4
FY 2003              $8.5
FY 2004 Projected    $8.0

Source: NCSL

Note: Table made from bar graph.

RELATED ARTICLE: Feds help out.

Relentless fiscal woes became big news in 2003, with virtually every major media outlet publishing or airing stories about the severity of the problem and the effects on state programs. The story made its way to Congress and the administration through the perseverance and political clout of state legislators who led lobbying efforts for the National Conference of State Legislatures.

The cause was picked up by five U.S. senators--Susan Collins and Olympia Snowe (Maine), Ben Nelson (Nebraska), Jay Rockefeller (West Virginia) and Gordon Smith (Oregon)--who successfully pushed for state support. A $20 billion state fiscal assistance package spread over two years became part of the Jobs and Growth Tax Relief Reconciliation Act of 2003. Half the money took the form of flexible grants, with the other half devoted to Medicaid--a shared program between federal and state governments.

The federal grants have been a helpful boost--at least in the short run--to the health of state finances. Because of legislative calendars, however, many had passed their FY 2004 budgets and adjourned by the time the federal relief money arrived in early June.

In many of those states, unspent federal funds temporarily are propping up balances. States that have yet to use the funds might be better positioned financially should mid-year budget gaps open.

RELATED ARTICLE: Rainy day funds run for shelter.

A key component of state reserves is money set aside in rainy day funds (also called budget stabilization funds). Most states strengthened rainy day funds during the 1990s when the economy was booming.

Fund balances have fallen precipitously since then, however, as the current economic decline has wreaked havoc on state budgets. States have seen their accounts shrink from a total of $26 billion in FY 2000 to less than $9 billion in 2003.

Nearly every state has tapped into its fund in recent years, and a number have either made serious dents or depleted them completely. Arizona, Idaho and Oklahoma zeroed out their funds in FY 2003. Texas and Washington expect to exhaust their funds entirely this fiscal year.

All rainy day funds were created for the same purpose, but not all were created in the same way. The majority of states have authorized rainy day funds by way of statute, but a few (Alaska, Delaware, Louisiana, Oklahoma, South Carolina, Texas and Virginia) have constitutional authorization.

Deposit mechanisms also differ from state to state. Most deposits into rainy day funds come via year-end surpluses, through appropriations or a combination of both. Idaho, Nevada, New Jersey, North Dakota, Texas, Utah and West Virginia require deposits when economic or revenue growth exceeds specific levels, while Alaska, Louisiana and Texas have deposits associated with mineral or oil and gas revenues. Arizona, Indiana, Michigan, Virginia and Washington have their deposit amount based on specific formulas. These use either personal income growth or some other measure to decide the amount.

States administer withdrawals in different ways, as well. Most require a revenue shortfall or some form of fiscal emergency before they can tap into their rainy day funds. Only Alaska, Georgia, Ohio, South Dakota and Wyoming allow funds to be withdrawn for any reason lawmakers believe necessary, and thus have no limitations on how the funds can be spent. Sixteen states require a supermajority vote of the legislature for some or all withdrawals from rainy day funds.

In addition, seven states have a repayment provision that requires all withdrawals be replenished over a specific period of time. Florida requires a repayment of all withdrawals from its Budget Stabilization Fund within five years. The majority of states, however, do not have specific repayment provisions.

--Jamil Bilem, NCSL