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States Continue to Feel Recession’s Impact

As a new fiscal year begins, the latest state budget estimates continue to show that states’ ability to fund services remains hobbled by slow economic growth.  The budget gaps that states have had to close for fiscal year 2013, the fiscal year that begins July 1, 2012, total $55 billion in 31 states.  That amount is smaller than in past years, but still very large by historical standards.   States’ actions to close those gaps, in turn, are further delaying the nation’s economic recovery.

The budget gaps result principally from weak tax collections.  The Great Recession that started in 2007 caused the largest collapse in state revenues on record.  Since bottoming out in 2010, revenues have begun to grow again but are still far from fully recovered.  As of the first quarter of 2012, state revenues remained 5.5 percent below pre-recession levels, and are not growing fast enough to recover fully soon.

Meanwhile, states’ education and health care obligations continue to grow.  States expect to educate 540,000 more K-12 students and 2.5 million more public college and university students in the upcoming school year than in 2007-08.[1] And some 4.8 million more people are projected to be eligible for subsidized health insurance through Medicaid in 2012 than were enrolled in 2008, as employers have cancelled their coverage and people have lost jobs and wages.[2]

Consequently, even though the revenue outlook is trending upward, states have addressed large budget shortfalls by historical standards as they considered budgets for 2013.  The vast majority of these shortfalls have been closed through spending cuts and other measures in order to meet balanced-budget requirements.  As of publication all but five states have enacted their budgets, and those five will do so soon. To the extent these shortfalls are being closed with spending cuts, they are occurring on top of past years’ deep cuts in critical public services like education, health care, and human services.

The additional cuts mean that state budgets will continue to be a drag on the national economy, threatening hundreds of thousands of private- and public-sector jobs, reducing the job creation that otherwise would be expected to occur.  Potential strategies for lessening the impact of deep spending cuts include more use of state reserve funds in states that have reserves, more revenue through tax-law changes, and a greater role for the federal government.

Our survey of state fiscal conditions shows that:

States continue to face a major fiscal challenge.  Thirty-one states projected (and in most cases now have closed) budget gaps totaling $55 billion for fiscal year 2013.  (See Figure 1.)  These shortfalls were all the more daunting because states’ options for addressing them were fewer and more difficult than in recent years.  Temporary aid to states enacted in early 2009 as part of the federal Recovery Act was enormously helpful in allowing states to avert some of the most harmful potential budget cuts in the 2009, 2010 and 2011 fiscal years.  But the federal government allowed that aid to largely expire at the end of fiscal year 2011, leading to some of the deepest cuts to state services since the start of the recession.  Far from providing additional assistance to states, the federal government is now moving ahead with spending cuts that will very likely make states’ fiscal situation even worse.

State finances are recovering, but slowly.   The shortfall totals for fiscal year 2013 are smaller than the totals from the last few years.  But they remain large by historical standards, as the economy remains weak and unemployment is still high. (Note that even if economic improvement accelerates, state fiscal recovery tends to lag recovery in the broader economy.)

The shortfalls that states have projected for fiscal year 2013 are in addition to the more than $540 billion in shortfalls that states have closed over the past four years.

State Budget Shortfalls in 2012 and 2013

States already have addressed extraordinarily large shortfalls as they developed and implemented spending plans for fiscal years 2009, 2010, 2011, and 2012.  Shortfalls are the extent to which states’ revenues fall short of the cost of providing services.  Every state except Vermont has some sort of balanced-budget law.  So the shortfalls for 2009 through 2012 — which totaled more than $540 billion combined — have already been closed through a combination of spending cuts, withdrawals from reserves, revenue increases, and use of federal stimulus dollars.  The substantial shortfalls projected for FY2013 have also been largely closed.

Figure 2 compares the size and duration of the shortfalls that resulted from the recession during the first decade of the 2000s to shortfalls reported to date following the onset of the latest recession.  In the early 2000s, as in the early 1990s and early 1980s, state fiscal problems lasted for several years after the recession ended.  The same has proven to be the case this time. The most recent recession was more severe — deeper and longer — than the previous one. State fiscal problems also have proven to be worse and are likely to remain so for the foreseeable future.

States’ fiscal conditions are improving along with the broader economy.  But states are coming

out of a very deep hole.  Figure 3 illustrates the magnitude of the problem.   State revenues have begun to rebound.  State tax intake grew 8.3 percent in the 12-month period ending in June 2011 — the 2011 fiscal year for most states.  This encouraging growth offers a glimmer of hope that states are beginning to climb out of the fiscal hole caused by the recession.  Unfortunately, that hole was so deep that even if revenues continue to grow at last year’s rate — which is highly unlikely, as explained below — it would take seven years to get them back on a normal track.

In other words, revenues probably won’t come close to what states need to restore the programs that they cut during the recession unless states raise taxes, at least temporarily, or receive additional federal aid while the economy slowly recovers.  As noted below, additional federal aid is unlikely.

Figure 3 shows how much states would be collecting if revenues had not dropped sharply due to the recession but instead had continued to grow at their historical rate of 5 percent.  (The 5 percent rate is based on actual collections between 1980 and 2008, with adjustments for projected inflation and GDP growth.)  It also shows that, at the 2011 rate of 8.3 percent, revenues wouldn’t get back on a normal track until 2019.

State tax collections typically grow faster than normal after a recession as they recover from a reduced base.  But states haven’t seen sustained growth at an 8.3 percent level since the 1960s.  Already, revenue growth for 2012 has slowed compared to 2011.  Preliminary figures show growth of about 4 percent for the most recent quarter.

Beyond simply coming out of a deep hole, states face major obstacles that will slow their fiscal recovery.  One is the shifting role of the federal government.  It allowed emergency aid to states to largely expire at the end of fiscal year 2011, leaving states with fewer options to address their still substantial budget shortfalls in fiscal year 2012 and beyond.  Moreover, the federal government has been moving ahead with spending cuts that will very likely reduce ongoing federal funding for state and local governments and make state fiscal conditions even worse.

Another major obstacle to recovery is sluggish economic growth.  Unemployment remains above 8 percent, and many economists expect it to stay at high levels throughout 2012 and beyond.  Continued slow job growth will restrain the rise in state tax receipts.  This is especially true for the sales tax.  High unemployment and economic uncertainty, combined with households’ diminished wealth due to fallen property values, will continue to depress consumption, keeping sales tax receipts at low levels.  If, as in past recessions, the incomes of the wealthy recover faster than those of low- and middle- income individuals and families, this would mitigate somewhat the effect of a sluggish job market on tax receipts, especially in states with progressive income taxes.  Beyond depressing state revenue collections, the weak economy increases demand for Medicaid and other essential services that states provide.  These factors suggest that state budget gaps will continue to be a problem for states for some time to come.

Estimates from the states, although incomplete, are consistent with this outlook.

Thirty-one states have addressed or are addressing shortfalls totaling $55 billion for FY2013, the fiscal year that begins July 1, 2012 (See Table 1).[3]   These totals may be down somewhat from the daunting budget gaps of the last several years, but they are still very large by historical standards, especially four years after the recession ended.

There are factors that could make it particularly difficult for states to fully recover from the current fiscal situation.  For example, housing markets have been slow to fully recover; their decline has depressed consumption and sales tax revenue as people refrain from buying furniture, appliances, construction materials and the like.  The weakness in the housing market has also depressed property tax revenue, which largely funds schools and local governments.  Property tax collections were 3.5 percent lower in the 12-month period ending in December 2011 than in the previous 12 months.  This places a strain on local governments’ budgets and makes it more likely that they will look to states to help them sustain funding for local services like education and police and fire protection.  Of course, an unexpected acceleration in the economic recovery could speed the pace of state fiscal recovery.

Some states initially were not affected by the economic downturn, but the number has dwindled over time.  Resource-rich states — such as New Mexico, Alaska and Montana — saw revenue growth in the beginning of the recession as a result of high oil prices.  Later, however, the decline in oil prices affected revenues in these states.  The economies of a handful of other states have so far been less affected by the national economic problems.  Only two states, North Dakota and Montana, have not reported budget shortfalls in any of these years.  One other state — Alaska—faced shortfalls in fiscal year 2010 but has not projected gaps for subsequent years.

Table 1:

States That Have Addressed Or Are Addressing FY2013 Gaps

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