Faced with decreased revenues and economic uncertainty, states must make tough budgetary decisions

David Fettig | Managing Editor

Published December 1, 1990  | December 1990 issue

Forty-nine states are required by law to balance their budgets; on the eve of new legislative sessions, 30 of those states are flirting with the law.

With tax revenues at an ebb during the national economic slowdown, and with continuing economic uncertainty over events in the Middle East, many states are scrambling to address current and future shortfalls.

All this comes at a time when voters—in most cases—are growing impatient with calls for higher taxes. Still, many citizens are also demanding more services from government, particularly for education, law enforcement, transportation and health care.

State of the states

The National Governors' Association and the National Association of State Budget Officers (NASBO) recently released their annual survey of state finances, and the report doesn't bode well for most states, according to Marcia Howard, NASBO's research director.

"For the most part, imbalances were created by poor revenue performance," Howard says. "More than half the states reported that revenue collections for fiscal 1990 were lower than the estimates used when the budget was adopted."

Of course, imbalances are also created from the expenditure side. From 1979 to 1991 state spending increased, on average, 8.1 percent. In 1991, however, state fiscal growth is expected to be 6.5 percent (down from 7.7 in 1990), according to NASBO, the second lowest rate since 1983.

"Appropriated budgets for fiscal 1991 total nearly the same amount as governors' recommended budgets," the NASBO survey says. "This is a departure from the past few years, when strong state economies allowed state legislatures to enhance governors' spending proposals."

Other major findings of the NASBO survey include:

  • Twenty-six states increased net revenues during their 1990 legislative sessions. (The personal income tax is the largest source of new revenue.)
  • Corporate income tax revenue was lower than expected in 33 states.
  • Aid to Families with Dependent Children increased in 24 states and the District of Columbia.
  • Medicaid payments rose $660 million above 1990 estimates.
  • Ending balances in fiscal 1991 are estimated at $7.4 billion, or 2.5 percent of expenditures—the lowest level of balances since 1983.

The bottom line: 33 states spent more than they collected in tax revenue in fiscal 1990, and 34 expect to spend more than they collect in fiscal 1991.

All things being equal, the major culprit for this grim assessment is the nation's economy. "The most important thing to states is the national economy," Howard says. The latest economic forecasts from the Minneapolis Fed, which portend continued sluggish growth for the region through 1992, echo that claim.

Steven Gold, director of the Center for the Study of the States at the State University of New York in Albany, says the Center's recent surveys don't put much faith in the national economy. Gold warns that sluggish growth in sales taxes, decreases in corporate income taxes and relatively small increases in personal income taxes reflect an underlying weakness in the economy, and may spell more trouble for states. (Sales, corporate and personal income taxes account for over 70 percent of state tax revenue. Two states in the Ninth Federal Reserve District are exceptions to that general rule: Montana is one of six states without a sales tax and South Dakota is one of five with no personal income tax.)

According to NASBO, the Western states may be the last refuge of the '80s expansion. "While generalizations are difficult, the slowdown in the national economy has been moving from east to west," the NASBO report says, with New England, the Mid-Atlantic and Southeast regions suffering first. "It appears likely that these three regions will feel more strongly the effects of the slowdown in fiscal 1991, as will the Plains. For now, the western United States offers the country's only bright revenue picture."

Government options

State governments really have little choice when it comes to balancing their budgets. Unlike their federal counterpart, which has much more latitude, states must either cut spending, raise taxes or use a combination of both.

But that's not as easy as it seems, according to Howard. She says states usually follow a predictable pattern when they face a budget crunch. First, all travel is stopped, then vacant positions are left unfilled, spending is frozen, programs are cut, early retirement plans emerge and finally—as a last resort—increased taxes and/or forced layoffs are considered.

"States hope that the 2 to 3 percent they save early on in that process will get them through until things get better," Howard says, thereby foregoing the tougher decisions of personnel cuts and tax hikes.

In Minnesota, the Department of Finance instilled state agencies with a new spending ethic this year to cushion the blow of a projected budget deficit. Agencies were told that all new costs—whether from inflation or program expansion—must be absorbed within the existing budget.

The alternative to spending cuts—tax hikes—is often politically as difficult. Faced with a projected budget shortfall and a desire to increase spending for education, the North Dakota State Legislature last year passed a series of tax increases. Voters later rescinded the new taxes in a state- wide referendum; ironically the state now faces the prospect of a substantial budget surplus.

Twenty years ago, states would have looked to the federal government for aid during such trying times. From 1960 to 1978, federal aid to states—as a percent of gross national product (GNP)—increased from 1.4 percent per year in 1964 to 3.6 in 1978. But 1978 proved to be the peak year for federal aid.

"By the end of the [1980s], federal aid declined by 16 percent in real terms from the 1978 peak," reports Brian A. Cromwell, an economist at the Federal Reserve Bank of Cleveland. Cromwell's research, published in the bank's Economic Commentary, showed that federal grants as a share of GNP fell 1.1 percentage points during the last decade, from 3.4 to 2.3 percent.

"To put the decline into perspective, 1.1 percentage points as a share of GNP represented $58 billion in the $5,233 billion 1989 economy," Cromwell says. "This more than accounts for [the states'] current operating deficit."

But that doesn't mean the states are bitter about the decreased federal role. Quite the contrary, according to Howard. "I don't think the states are looking to Washington because they've learned that what Washington gives, Washington takes away."

What the states would like from Washington, NASBO's research director says, is a serious attempt at balancing the federal budget and a moratorium on federally mandated laws that states must help fund.

Medicaid is an example of such a program; the maximum federal match for Medicaid is 65 percent, minimum is 50 percent.

Establishing priorities

Some analysts believe a new dynamic may be developing between taxpayers and government—a pay-as-you-go, prioritized system that is increasingly focused at local government. For example, in California, the state that gave birth to the '80s tax revolt with Proposition 13, voters this summer approved an increase in the gas tax. Funds from the tax were marked for highway construction—a near-and-dear issue for many Californians.

Far from being a rejection of their earlier anti-tax sentiment, as some theorized, the tax hike was hailed by others as an indication that local voters are willing to pay a certain price for services they deem important.

This movement toward local accountability won't result in any sweeping acceptance of higher taxes, however, Howard says. Not only can taxpayers see, first-hand, the benefits of their taxes at a local level, but they can also become more frustrated at what they perceive to be inefficient services. "Taxpayers are more easily frustrated at a local level," she says.

Such frustration was revealed in Wisconsin this November when voters overwhelmingly supported a mandate which informed the state that counties are no longer willing to pay for state-created programs. If the state creates a program, the state—barring local approval—should pay for it, according to the mandate.

Factors such as local accountability and taxpayer anger may, in the end, be the great equalizer to the states' current budget crunch, according to Cromwell. Because of reduced federal aid, he says, "State and local governments now face the true cost of providing public services and must weigh the costs and benefits of public expenditures through politically challenging budget processes.

"A result of this transition is likely to be greater variation in public services that more accurately reflect the preferences of local citizens."