The Fiscal Crisis in State Government – And What Should be Done About It

While the federal deficit captures the news headlines, there is a deep and pervasive fiscal crisis in state finance. This crisis is largely a result of the Great Recession, which has caused the steepest decline in state tax receipts on record. It is also a structural issue, resulting from unfunded retirement plans that are beginning to come due. With state spending accounting for one eighth of US GDP, this crisis has serious implications for economic recovery, for jobs and for the credit markets, where states and municipalities have borrowed nearly $3 trillion. This paper reviews the origins and the scale of the state fiscal crisis. It considers its impact on economic growth and fiscal stability. And it lays out some recommended policy actions that are needed in order to address these issues and help put state finances on a sounder, more sustainable footing.

The origins of the immediate crisis lie in the severe recession that began in late 2007 and steadily gathered momentum during 2008 as the financial system imploded. The problems states face are not born of excessive spending - overall, state spending increases since the last recession in 2001 have (in aggregate) been modest. The difficulties are overwhelmingly a result of falling revenues. In fiscal 2009 (the twelve months ended June 2009) collections from state sales tax fell by 7% compared to the budget, from personal income tax by 9% and from corporate income taxes by 15%. Between them, these three taxes account for 80% of state revenues. And even though budgeted revenues were adjusted the following year, actual collections again undershot expectations, by 4.5%.

On the other side of the ledger, growing unemployment has pushed up state spending. The deterioration in the jobs market has been the worst for more than sixty years. The unemployment rate rose from 4.4% pre-recession to 10.1% by October 2009 - dwarfing the rise in joblessness seen in the two previous recessions of 1990 and 2001, when in each case unemployment rose by some 2.5 percentage points. For the states, the swelling ranks of unemployed mean growing demand for state services – and in particular for Medicaid – as the unemployed lose their income and their health insurance. Total Medicaid spending rose by 6.6% in fiscal 2009 and is estimated to increase by 10.5% in fiscal 2010.

The combination of this bleak fiscal picture with the balanced budget laws that outlaw deficits in every state save Vermont resulted in multiple rounds of spending cuts as state governors struggled to balance the books. Across-the-board cuts and targeted reductions in individual programs resulted in a 6.8% fall in overall state spending in Fiscal 2010. This followed a 4.3% cut the previous year. Many of the cuts hit the most vulnerable members of society hardest. For example, at least 30 states restricted low-income families’ eligibility for health insurance or reduced their access to health care. A similar number cut aid to K-12 schools and over 40 states reduced assistance to public colleges and universities. Tuition fees at the University of California are increasing by 32 percent.[i]Programs for the elderly, the disabled and for those with serious mental problems have been cut back or eliminated altogether. In total, state and local governments have eliminated 212,000 jobs since the recession began, with other state workers suffering pay cuts, furloughs and reduced benefits (see Chart 1).

States also raised taxes. Collections from state income taxes, sales taxes and user fees rose by a total of $24 billion in fiscal year 2010, the largest jump in more than 40 years. Increases in “sin” taxes (on cigarettes, alcohol and tobacco) were particularly popular. Treasurers in many states raided their so-called “rainy day” funds. At the start of the recession these reserves were at an all-time high, equivalent to 11% of annual spending. By June 2010 they had nearly halved, with reserves in 14 states down to less than 1% of annual spending (see Table 1).

These cuts severely blunted the economic impact of the American Recovery and Reinvestment Act (ARRA), the $787 billion federal stimulus package enacted by Congress in February 2009. True, the states benefited from ARRA to the tune of $140 billion which was made available over a two-and-a-half year period to help fund state programs, including education and healthcare. This money plugged an estimated 30 to 40 per cent of the state budget shortfalls in 2009 and 2010; without it spending cuts (and job losses) would certainly have been much more severe. Even so, the cuts in state spending and state tax increases acted as a significant economic counterweight to the federal stimulus package. Paul Krugman famously compared the states to “50 Herbert Hoovers”[ii]. As a recent NBER paper[iii] showed, after adjusting for the declining expenditure in the 50 states, the aggregate fiscal expenditure stimulus in the US was close to zero for 2009. In other words the federal stimulus simply compensated for the states’ negative stimulus that resulted from collapsing state spending.

Now that the economy is undergoing a fragile recovery, with positive growth in GDP recorded since the third quarter of 2009, the question is: will state finances heal themselves and, if so, how quickly? The short answer is that the states will remain in precarious financial health for some time. Federal stimulus money is running out, unemployment will remain high, and states must figure out a way to fund the huge overhang of unfunded state retirement programs at a time when they can least afford to do so. The conclusion is that without additional fiscal relief state finances will continue to struggle and will impose a drag on the economy that will delay or jeopardize the recovery effort.

Even in a “normal” recession, state fiscal recovery typically lags behind overall economic activity. For example, in the recessions of 1990-91 and 2001, states experienced large deficits and were obliged to make budget cuts or raise taxes well after the recessions had ended. The primary reason for this lag is that unemployment responds to economic activity after a delay. In a recovery firms are reluctant to resume hiring until they are convinced that the upturn in demand is well established. Thus in the last two recessions, the unemployment rate continued climbing for 15 to 19 months after the recession ended and then remained high for a considerable period (see Table 2). At the state level, unemployment is a key driver of both revenues and spending.

A second reason for the lag in state recovery is that some of the strategies states use to plug holes in their budgets are temporary. For example, drawing down reserves is an option that will help for a limited period, after which reserves must be replenished. Similarly, some of the tax rises or increases in user charges and fees tend to be temporary or one-time.

There are particular reasons to expect that this pattern of delayed recovery will be particularly pronounced in the current recession. The first is that federal assistance from the ARRA will largely be exhausted by the end of calendar 2010. ARRA provided a temporary increase in the share of Medicaid program paid by the federal government, to be paid over nine calendar quarters (October 1st 2008 to December 31st 2010). ARRA also includes a $48.3 billion ‘State Fiscal Stabilization Fund’ for education and other key services. By end of June 2010 more than 80% of this money will have been used. The net result is that federal assistance to the states is rapidly drying up. While some states have factored this into their budgets for fiscal 2011, others assumed that Congress would extend Medicaid assistance another six months through the end of the fiscal year. Unless Congress acts, those states which have been over-optimistic will need to make additional spending cuts, or increase taxes still further, to bring their budgets into balance (see Table 3).

The second reason is the pattern of unemployment, which is very different in this recession. Although it has declined in recent months, the overall unemployment rate remains historically high at 9.7%. This is high not just by US but by international standards. Moreover, the numbers show a startling rise in long-term unemployment. Figures for May show the number of Americans looking for work for more than six months rose to 6.8 million, nearly half of all those unemployed. Such a high proportion is unprecedented; in previous recessions the long-term share has reached no more than one-quarter. As a recent study for the Brookings Institution[iv] shows, this is largely because unemployment in this recession is much more heavily weighted to layoffs than to people quitting their jobs. Combine this with the crash in the housing market, making it hard for unemployed workers to move, and the outlook is for a long, slow fall in the unemployment rate. This spells bad news for state finances.

The final reason is less related to the current financial crisis and more a legacy of past mismanagement by state governments. Many of them have granted generous pensions and other retirement benefits (notably health care) to their employees without considering the long-term price tag. A recent analysis by the Pew Center of the States[v] found a $1 trillion gap as of June 2008 between the $2.35 trillion that states and local governments had set aside to pay for employees’ retirement benefits and the $3.35 trillion that these promises would actually cost. This figure is certainly understated because the financial crisis in the past two years significantly impaired the value of pension fund assets. It also led to continued under-funding by cash-strapped states. In addition, most states still assume an optimistic annual return of 8% (in some cases even more) on their pension fund investments. This number is significantly higher than assumptions used by their counterparts in the private sector.

Once a state promises a retirement benefit it is extremely difficult to take it away. Pension benefits already earned have strict constitutional or contractual protection. In some states retiree health benefits are also protected. States can curb benefit costs by avoiding early retirement programs, cost-of-living adjustments, double dipping (where retirees immediately come back to work), and spiking final salaries (a key element of the pension formula). They can also reduce retirement benefits (including raising the retirement age) for new employees and many are doing this. But fundamentally there is no escaping the need to fund the obligations already incurred.

The underfunding problem is not uniformly distributed across states. The Pew report classified 16 states as “solid performers” with a funding ratio in their state pension systems of more than 80%. But 19 states merited “serious concern”. Forty states fell into the same category for retiree benefits. States with the dubious distinction of flunking in both categories include Connecticut, Hawaii, Illinois, Indiana, Kansas, Louisiana, Maryland, Massachusetts, Missouri, Nevada, New Hampshire, New Jersey, Oklahoma, Rhode Island, South Carolina and West Virginia.

All of this imposes an additional burden on already-fragile state finances. So far, these looming risks and uncertainties do not appear to unduly concern the bond markets, where states and municipalities regularly raise funds to finance a wide variety of capital projects. Because interest payments on municipal bonds - or “munis”- are exempt from personal income taxes, munis have long been a favorite with private investors. In addition, the ARRA introduced a new type of municipal bond known as Build America Bonds. These bonds are taxable (and therefore appeal to tax-exempt institutional investors). However the federal government offers an interest subsidy to the states that issue them so that borrowing costs end up no higher than in the tax-exempt market. The idea of the program was to ensure states and municipalities could continue to tap the bond markets even during worst of the financial crisis of and, indeed, Build America Bonds proved hugely popular. The program ends in December 2010, but this year the bonds are likely to account for as much as one-third of all new muni issuance. As a result, after a 9% drop in 2008, this year the muni market may well surpass the record $430 billion issued in 2007.

Given all the fiscal troubles of the states, are investors being too sanguine? Some clearly think so. Legendary investor Warren Buffet recently warned that the bond rating agencies are failing to take into consideration the long-term risks to state finances. “If you are looking now at something where you could look back later on and say, ‘These ratings were crazy,’ that would be the area” he told a Senate panel investigating the causes of the financial crisis.”I don’t think Moody’s or Standard & Poor’s or I can come up with anything terribly insightful about the question of the state of municipal finance in five or ten years from now, except for the fact there will be a terrible problem and then the question becomes will the federal government [bail them out]?”

Rating agency analysts take comfort from the states’ ability to raise additional taxes to cover debts, and from the fact that state governments can’t technically declare bankruptcy, since states are not covered by the federal bankruptcy code. Many municipal bonds are “ring-fenced”, meaning that revenues from the projects they finance are dedicated to paying interest and principal before they can legally be used for any other purpose. And historical default rates are tiny – even in the Great Depression, municipal bond investors lost a mere 0.5% of their money.

Despite this soothing-seeming logic, there are real worries. Alarmists who believe that “California is the next Greece” are almost certainly wrong – California’s economy is larger and its debts and deficits are puny compared with Greece. Nonetheless, if state finances are not fixed the risks are real. The financial crisis in the mortgage market shows how seemingly-safe investments can quickly turn sour. Even the remote risk of a large-scale municipal bailout by the federal government must be avoided.

For all these reasons, state finances cannot simply be left to fix themselves. The process will take too long and the negative impact on jobs and the overall economy is too big. After two consecutive years of declining state spending, fiscal year 2011 is likely to see another round of cuts, especially once the need to plug the gap caused by the disappearance of federal assistance is recognized. Budgets for fiscal 2011 are already below fiscal 2008 in 39 states. This retrenchment is likely to take nearly a full percentage point off growth in U.S. GDP. Based on the rule of thumb employed by the President’s Council of Economic Advisers that each percentage point of GDP translates into 1 million jobs, this in turn could produce some 900,000 fewer jobs in 2011. Mark Zandi, Chief Economist of Moody’s Analytics, recently warned that these state budgetary actions “will be a serious drag on the economy at just the wrong time.[vi]”

Job growth is already uneven. In the first five months of this year the economy added an average of 99,000 private-sector jobs per month; in May the number was just 41,000. If the economy has to rely on private job growth of, say, 116,000 a month (the typical rate between 2003 and 2007) then it could take another four years for the unemployment rate to drop to a more “normal” 6 per cent. The return of discouraged job-seekers to the labor force would slow the process further. In this fragile situation it is vitally important to prevent another round of job losses at the state and municipal level.

Against this background the case for a further round of assistance to the states is compelling. A recent CBO study[vii] concluded that every $1 million of assistance to the states for non-infrastructure spending would add between 3 and 7 full-time jobs in 2010 and 2011 for every million dollars spent. The impact on growth would be to raise GDP in 2010-15 by between $0.40 and $1.10 for each dollar spent. However these numbers understate the magnitude of the benefit. The future of our economy rests in part on the quality of education and healthcare that we provide. Once teachers and nurses have been fired, more is lost than just the value of their jobs. The loss of these workers erodes our investment in human capital and impairs our future ability to grow and compete in the global economy. Moreover these jobs and services, once lost, are not easily rebuilt.

The design of this new round of assistance should be carefully considered. Firstly, it should be temporary, so that it addresses the concerns of the ”deficit hawks” concerned about further permanent increases in federal spending. Second, it should be targeted (like the ARRA funding) primarily at Medicaid (because of its significance in state budgets) and at education (because of its economic importance and the highly job-intensive nature of school spending). Third, eligibility for federal assistance should be conditioned on the states and municipalities putting in place plans to address their long-term structural pension deficits. These would start by quantifying the magnitude of their funding gap using realistic assumptions about future return on their pension fund investments. They would include a long-term plan (say over the next 10 years) to return these funds to health, meaning that they are at least 80% funded. By crystallizing the problem and obliging the states to put in place a plan to address it, a future financial train-wreck could be averted.

Longer term, we need to consider whether it is logical for the states to finance such large portions of such vital programs as Medicaid and K-12 education, leaving them vulnerable to cyclical swings in the economy. But for now, the urgent need is to provide well-designed assistance to the states to protect vital services, help solve the unemployment problem and begin the process of repairing the yawning hole in state balance sheets.