State Budgets Remain Very Tight Even as Recovery Begins

States’ fiscal environments continue to feel the devastating effects of the recession, even though many economists have concluded the recession ended last summer. Economic output—gross domestic product—rose during the third quarter of the 2009 calendar year, albeit at a modest 2.2 percent annual rate, and the economy is expected to continue growing. But state tax revenues have not shown evidence of an expansion as revenues are still falling in many states, and it will likely be a number of years before tax revenues recover.

Book of the States, Chapter 7: State Finance

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   Table A: Change in U.S. Employment October / November 2008 vs. October / November 2009: Download in Excel or PDF

  Figure A: State Tax Collections as a Percentage of Personal Income, 1993-2009: Download in Excel or PDF

The Economic Environment

State economies were not impacted evenly by the recession, but every state felt its effects. Impacts of recessions are often regional in nature with more limited fallout to other states, but the recent recession was much more diverse. The private sector in every state experienced employment losses and the overall economy has fallen in nearly every state during the past year (See Table A). Similarly, nearly every industry has seen employment declines, except for health care. The result has been a precipitous rise in unemployment rates, as the U.S. rate rose from 4.4 percent in March 2007 to 10.2 percent in October 2009 before falling back to 10.0 percent in November. Fifteen states have unemployment rates above 10 percent, led by Michigan at 14.7 percent.

The economy began what is likely to be a modest recovery—often termed U-shaped to indicate a slow rebound as opposed to V-shaped, which would indicate a rapid recovery—during the summer as GDP began to grow again. Economic strength is initially coming from some improvement in consumer spending, construction of single family housing (which is growing, though at historically very low levels), exports, businesses rebuilding inventories and the economic stimulus package. Consumer spending, which represents about 70 percent of GDP, is the wild card in the recovery. Consumers have been key to the rebound in each recent recovery and it will be very difficult to sustain a strong economy without consumers getting aggressively involved. Consumers have plenty of reasons to be reticent about spending, including the decline in their balance sheets caused by the fall in housing prices and equity markets, large job losses, significant loss of confidence and tight credit. But consumers have proved their spending to be resilient in other economic environments, so it is the hope that consumer spending will increase at least enough to fuel a slow recovery.

The U.S. economy has lost 7.2 million jobs over the past two years and all signs are that employment will rebound only very slowly as GDP rises. Job losses have slowed but more are expected over the next several months. The job losses were so large because businesses, intent on limiting the recession’s effects on their bottom line, aggressively cut costs. One result is that many employers have learned to produce with fewer workers, and many are not likely to reverse these productivity improvements in coming years. Jobs will be added back slowly and only as demand for output increases sufficiently to justify more hiring. Further, employment in a number of industries, such as light vehicle production, housing construction, and financial services, is unlikely to return to the levels reached in earlier years because production in these industries will stay below the previous peaks.

The job losses have put very heavy pressure on most states’ unemployment insurance systems as the number of weeks of unemployment compensation paid out rose dramatically. As a result, many states were forced to borrow funds from the federal government to pay out benefitsand 35 states have increased their unemployment tax either by raising the rates or by expanding the taxable wage base. As with other aspects of the recession, states will continue to pay out high weeks of benefits for several years and the unemployment trust funds will take years to recover to the levels necessary to finance benefits in another recession.

State Tax Revenue Performance

Experience of the past two recessions suggests that state tax revenue is becoming increasingly volatile. For example, Tennessee did not experience a decline in revenue over the three decades leading up to 2002. In contrast, the 2010 fiscal year will mark the third year of negative growth in the past eight years. Some of this can be attributed to lower inflation rates, but there appears to be greater volatility in the underlying bases as well.

Tax revenue in the states fell by 8.2 percent on average during the 2009 fiscal year1 as only Iowa, Oregon, North Dakota and South Dakota saw revenues rise compared with the previous year. Personal income taxes declined by 13.6 percent, the greatest loss among the major taxes. Corporate income declined by 10.9 percent and sales tax revenue declined by 4.8 percent. Local governments also experienced lower tax revenues, but not to the extent felt by the states. For example, local tax revenue only declined 2.8 percent in the last quarter of fiscal 2009, as the property tax actually increased.

No simple relationship exists between tax revenue performance and the economy. Tax revenues and economic performance are correlated, but the relationship is imprecise when evaluated on a year to year basis, particularly at turning points in the economy. Even as GDP began growing again during the summer, revenue declines during the first quarter of the current fiscal year accelerated relative to the 2009 fiscal year.2 Tax revenues were down 10.7 percent as all of the major taxes were lower again. Tax revenues may lag improvements in the economy for many reasons. Loss carry-forwards in the corporate income tax, failure of construction to grow fast as other parts of the economy rise, which is very important to sales tax revenues, and the time between financial market increases and the due date for personal income tax revenue are some of the reasons. Property tax revenues can respond slowly to economic growth as well because of factors such as property tax growth limits and lags between appraisals and tax payments.

Tax revenues in many states will be growing again by the 2011 fiscal year but revenues will not reach the peaks attained in the 2008 fiscal year until 2012 or 2013, and it will be even longer before tax revenues return to their earlier share of the economy. Figure A illustrates that during the 2001 recession, tax revenues did not reach the 1990s norms relative to the economy until 2005 and 2006. This suggests that it will take at least five years after the recession for taxes to return to pre-recession levels relative to state economies. In some states it will take even more years. Tax revenue growth will coincide with the loss of the federal stimulus money, so state fiscal environments will generally remain very tight for the next four to five years, even without a double dip recession.

Balancing Budgets: Strategies for Financing Revenue Shortfalls Near Term

Every state except Vermont has a balanced budget requirement of some form, though the basis can be statutory, constitutional or judicial. The degree to which balanced budget requirements are binding varies, but they generally do not mandate that recurrent expenditures cannot exceed recurrent revenues. For example, states may be able to bond finance some capital expenditures that would otherwise be financed from recurrent revenues or may spend from reserves. Still, states generally must keep recurrent revenues and expenditures within a reasonably close relationship.

States are using some combination of four strategies for balancing their budgets: expenditure cuts, federal stimulus money, reserves or policy-based revenue increases. The first option is to lower spending, which normally requires cuts in service levels. The other three options are alternative ways for states to maintain expenditures, at least to some extent.

Expenditure Cuts

In general, states have been unable to maintain expenditure levels and expenditure growth trends in the face of substantial revenue declines, and unprecedented expenditure cuts are being used by states at levels not seen in recent history. Normally during recessions, states slowed the pace of spending growth but did not actually reduce spending levels. Actual cuts in nominal expenditures occurred during 2009 and are expected again during 2010 for the first time since very small cuts were enacted in 1983. States enacted expenditure reductions in many different ways, but the result is a reduction in service levels in many states. For example, 30 states reported making targeted expenditure cuts, 20 reduced aid to local governments, 17 laid off employees, and 15 instituted furloughs.3 Many states will need to make additional cuts in the 2011 fiscal year, and it is possible, though not likely, that aggregate state spending levels will be reduced for a third consecutive year.

Federal Stimulus Program

An estimated $560 billion will be spent (including tax cuts) as part of the federal American Recovery and Reinvestment Act of 2009 during 2009 and 2010. More than one-fourth of the funds are transfers to states and an additional one-seventh is infrastructure spending, some of which will also go to states. States benefited from federal transfers during other recessions, but the 2009 Recovery Act is providing much greater countercyclical transfers than occurred during the last recession.

States have varying degrees of flexibility in spending the money, but it has clearly lessened the effects of declining revenues on state budgets. Still, the stimulus money was not sufficient to prevent the need for spending cuts. Most of the transfers to states will have been expended by the end of the 2011 fiscal year, just as state tax revenues are growing again. It may well be that states will have fewer resources in the 2012 fiscal year as the net effect of growing own source revenues and falling transfers.

Reserves

Most states had rainy day funds and other reserves as the recession began, and in total the balances have already been cut in half. Use of reserves to lessen the impact of falling revenues can be good policy if implemented appropriately, and is an important reason why reserves were created. Reserves, however, should be thought of as one-time funds while the fiscal problems associated with the recession will last at least five years. States would have needed reserves of more than 30 percent of the revenues they raise to allow them to maintain expenditure patterns in the face of such significant revenue declines. Most states had much lower reserves.

So reserves cannot be seen as the only solution to significant revenue reductions. In most cases the reserves can only be used to prevent the most extreme cuts or to allow the state’s books to be balanced if revenues fail to reach their estimated levels. Rapid use of reserves at the beginning of a recession only stalls the inevitable need to reduce spending and could leave states in a very difficult position if their revenue estimates fail to materialize once the reserves are expended.

Tax Rate Increases

A number of states have already increased tax rates to lessen the extent of budget cuts. In 2010, tax rate hikes and other policy related revenue increases are expected to cause the largest policy increase in revenues, both in dollar terms and as a percent of revenues, in recent history.4 For example, at least eight states have raised their sales tax rate and nine have boosted their income tax rates. Historically, income tax rate increases have been used less frequently than sales tax hikes to generate additional revenues, so this is a change from past norms. Further, a relatively strong trend decrease in income tax rates took place from the mid-1980s until these recent rate increases. The country had transitioned from 15 states with rates above 10 percent to where no state imposed a rate above 10 percent, until now.

Past experience suggests that more rate increases are coming after the recession in an effort to return taxes to their former share of state economies. Thirty-three states raised sales tax rates in the five years around the recessions in the early 1980s, and 22 raised their sales tax rates in the years around the 1991 recession. Broad-based tax rate increases were less frequent around the 2001 recession. Tobacco tax hikes and other tools were more commonly employed to generate revenue during the 2001 recession.5

Tax structure changes should generally be made based on long-term revenue requirements and not as the result of economic cycles. States, however, often appear to use the tight revenue conditions during a recession as the justification to increase tax rates. When viewed from the longer term perspective, the sales tax rate changes are offsetting narrowing sales tax bases that are declining relative to the economy. This is due to growing remote sales (e-commerce, mail order, etc.), state policy choices to exempt additional transactions, and failure to tax many services as the service-based sector expands rapidly. These relative declines in state tax bases become most apparent during a recession and have led to rate increases. Still, the net result of narrower bases and higher rates has been falling sales tax revenues relative to GDP for more than a decade, even before the recession started. Further, states are left with higher tax rates that are more likely to cause buyers to move away from taxed alternatives through either evasion or avoidance causing a spiraling downward of the taxable bases and potentially upwards in rates. Maintenance of broader sales tax bases is certainly a preferred option.

Budget Balancing Alternatives to Avoid

States should be particularly careful to avoid the use of many types of non-recurrent sources to finance recurrent expenditures. As noted previously, prudent use of reserves is an exception. But other options, such as financing what are essentially recurrent expenditures by issuing debt and underfunding pension accounts, should generally be avoided or used very judiciously. The sale of assets (such as highways or roads) or the sale of a revenue stream (such as lottery revenues), are particularly troublesome options. These strategies are likely to cause taxpayers not to understand the real costs of government and can result in government that is too large. The excessively large government in the short run can require cuts later or can result in higher tax rates. Even if taxpayers understand the costs of government, revenues in many states will only come back slowly from the recession and the states will not have additional revenues to finance these costs in the future once the revenues from assets sales are used up. The better strategy is that recurring revenues and recurring expenditures be kept in balance.

Conclusion

Many states failed to learn lessons from the volatility of tax revenues and resulting fiscal problems that arose from the 2001 recession. There is evidence that states did not adapt: They built reserves that were too small, continued to narrow tax bases (sales tax base exemptions and property tax base limits were frequent examples), and assumed that unusually rapid revenue growth in the middle years of this decade would continue unabated thereby allowing expenditure growth rates to be excessive. Perhaps the starker lessons from this recession will provide a clearer picture of how to design state fiscal structures and cause states to develop more effective strategies. Among the lessons and appropriate policy responses are:

  • The worst case for revenue performance is much worse than previously expected. States had not seen such large revenue declines in their modern history and generally did not expect such a big problem. We have now seen that much larger revenue declines are possible and planning for this possibility must be a factor in the design of fiscal policy.
  • Tax structures should be designed to provide sufficient revenue over the business cycle, and not with a focus on a year-to-year basis. This effectively means that tax revenues should grow fast enough to maintain desired service levels across the business cycle. Revenues will grow much faster during expansions than during recessions, so this requires states to build reserves during the expansion years, not reduce tax rates and narrow tax bases.
  • States must avoid building new programs and growing expenditures rapidly during expansion years, and instead design a size of government that is consistent with the demands for public services and the revenues that will be available over the long-term.
  • It is particularly important to ensure that all costs—including pension funds, debt service and others—are properly funded during expansion years because recessions will occur when financing choices are very difficult.
  • States must build reserves that are much greater than 10 percent of tax revenues, and plans should be in place for efficient/appropriate expenditure from the reserves. Nonetheless, it will probably be politically difficult to build reserves to the level necessary to avoid a slowing of expenditures during recessions.

Notes

1. Lucy Dadayan and Donald J. Boyd, “State Tax Revenues Show Record Drop, for Second Consecutive Quarter,” State Revenue Report No. 77, (Nelson Rockefeller Institute of Government, October 2009).

2. Lucy Dadayan and Donald J. Boyd, “Old News is Bad News: Third Quarter Brings More Decline in Tax Revenues,” State Revenue Flash Report, (Nelson Rockefeller Institute of Government, Nov. 23 2009). The percentage revenue decrease was larger than in fiscal year 2009 but not as great as the last quarter of fiscal 2009.

3. National Governors Association and National Associate of State Budget Officers. The Fiscal Survey of States, (June 2009). Retrieved Dec. 21, 2009, from http://www.nasbo.org/Publications/PDFs/FSSpring2009.pdf

4. Ibid.

5. See http://www.taxadmin.org/fta/rate/cig_inc02.html for a listing of tobacco tax rate increases.


About the Author

Bill Fox is the William B. Stokely Distinguished Professor of Business and the director of the Center for Business and Economic Research at the University of Tennessee. He is a past president and recipient of the Steven D. Gold Award from the National Tax Association and former chairman of the Economics Department at the University of Tennessee. He has held visiting appointments as professor at the University of Hawaii, scholar at the Federal Reserve Bank of Kansas City, and Distinguished Fulbright Chair at the University of Frankfurt, Germany. Fox has served as a consultant in more than 25 countries and 10 U.S. states on a wide range of public policy issues.