Budget-making was smoother in Midwest in 2012, but fiscal future is laced with challenges and uncertainty

Stateline Midwest ~ June 2012    

Interview with NASBO director Scott Pattison on state budget conditions »

The signs of improving fiscal conditions were apparent in most of the Midwestern states where new annual budgets were adopted this year.

In Iowa and Kansas, legislatures adopted increases in general-fund spending, and the headlines from the two state capitols were less about reducing expenditures and more about proposals to cut taxes.

There was a modest increase in South Dakota’s fiscal year 2013 budget as well (2.9 percent), following a year in which every major area of state government had been cut — between 10 percent and 22 percent for most departments.

In Michigan, after years in which revenue growth consistently fell below expectations, the state actually had an additional $300 million to work with in crafting its FY 2013 budget.

“There is no doubt things are getting better, a lot better,” says Kurt Weiss, public information officer for the Michigan Department of Technology, Management & Budget.

“We went through a decade where every time the [state] Revenue Estimating Conference would meet it was, ‘Here is how much less money you have.’ The last three conferences have been good news.”

Illinois faced perhaps the most difficult fiscal challenges of the five Midwestern states where new budgets were passed. (The six other Midwestern states in the region operate on biennial budget cycles.) Though overall spending increased modestly, the budget adopted by Illinois legislators in late May included cuts in state aid to schools and to higher education.

Maybe most significant of all, too, the Illinois General Assembly moved ahead with a major restructuring of its Medicaid program.

“No state has ever taken on the challenge of cutting this much from its Medicaid program in a single year,” Democratic Sen. Heather Steans said upon passage of SB 2840, which cuts $1.6 billion in FY 2013.

On top of those reductions, legislators passed a $1-a-pack increase in the cigarette tax, with the additional revenue going to shore up the Medicaid program’s finances. In all, the mix of cuts and the tax hike added up to $2.7 billion for the next fiscal year.

Democratic Rep. Sara Feigenholtz, who helped lead the legislative effort, described this year’s Medicaid restructuring as both “herculean” and “painful.” But in the end, she says, the measures passed because lawmakers knew the program had reached a tipping point.

“If we didn’t address the crisis this year, our payment cycle [for Medicaid providers] would have gone from about 150 days to 300 days,” she says. “Providers’ doors were already closing. Had we not done what we did, I believe the whole system would have collapsed.

“As a state, we had to get back on track and stop pushing our liabilities into the next year.”

Economic uncertainty clouds improved budget conditions

The hope for leaders across the Midwest is that the worst budget conditions and toughest fiscal choices are behind them. Still, there will likely be much uncertainty in 2013, when all 11 legislatures in the Midwest meet again to craft new annual or biennial state budgets.

“I don’t think we’re going to see the same kind of crisis atmosphere; on the other hand, it is still not an easy time to govern,” says Tracy Gordon, a fellow at The Brookings Institution who tracks state and local finances.

Tax collections have gone up for nine straight quarters of the year, she says, but the increases are slowing. Meanwhile, the unemployment rate remains high, and overall U.S. economic growth is slow. In some states, too, revenues are starting to fall below expectations, and there are continued concerns about the future of the federal budget.

“I think it’s a foregone conclusion that states around the country are not going to be receiving as much from the federal government,” says Jason Dilges, South Dakota’s Bureau of Finance and Management commissioner. “It’s just a question of where those cuts are going to be made and come from.”

Here is a look at the state of fiscal conditions in the five Midwestern states where new budgets were recently passed by the legislatures: Iowa, Kansas, South Dakota, Michigan and Illinois.

Iowa enjoys healthy surplus as debate continues over property taxes

If there is another economic downturn, or if federal funding declines, Iowa Democratic Sen. Joe Bolkcom says his state is well-positioned to handle it: Iowa’s budget surplus, cash reserves and rainy-day funds now total almost $1 billion.

“We’re quite healthy, and it was a bipartisan effort and a number of really good decisions that allowed us to get there,” he says.

Bolkcom notes, for example, that in the middle of the last fiscal crisis, the state went ahead with a mix of spending reductions (an across-the-board cut for state agencies of 10 percent, for example) and government-efficiency initiatives (consolidating departments, streamlining information-technology services, and encouraging early retirements among employees).

But that fiscal fix also included cuts in high-priority areas such as higher education. Even after increases this year in appropriations to Iowa’s university system and community colleges, the levels remain below what they were in 2008, Bolkcom says.

One of the questions for lawmakers is how quickly to try to restore some of those cuts, in higher education as well as other areas of state government.

On the flip side, there is also a continuing push to enact new tax cuts.

In Iowa, the debate has centered on proposals to reduce the property tax burden of business owners.

Legislative leaders on both sides of the aisle have expressed support for the idea, but differences over the scope of the tax cuts and how they would be paid for have thus far derailed legislative passage.

“It got to the point to me where it [the tax cut] was too much money for me to support it, to the point where we would be jeopardizing the other obligations of state and local governments,” Iowa Democratic Sen. Rob Hogg says.

Other lawmakers wanted property tax cuts larger than the measure being considered in the Senate.

Republican Gov. Terry Branstad, who pushed for an eight-year plan to reduce property taxes by $1.2 billion, says the property tax reform was the biggest piece of unfinished business from the 2012 session. It will again be a high-priority issue for him in 2013.

Major cuts to income tax mark legislative year in Kansas

In contrast, the Kansas Legislature moved ahead this year with a plan to slash taxes.

After months of negotiations on various legislative proposals, Republican Gov. Sam Brownback signed HB 2117, a measure that overhauls the state’s income tax structure.

“It was the largest tax cut of all the packages that were out there,” notes Republican Rep. Richard Carlson.

For starters, Kansas will now have only a two-rate structure: 3.0 percent for joint filers with incomes below $30,000 a year, and 4.9 percent for incomes above that amount. This replaces a system that had three tiers and higher rates (3.5 percent, 6.25 percent and 6.45 percent). Lawmakers also increased the standard deduction amount for single head-of-household filers from $4,500 to $9,000, and for married taxpayers filing jointly from $6,000 to $9,000.

Lastly, HB 2117 will exempt certain non-wage income for most of the state’s 221,000 businesses. Dubbed a “small-business accelerator” by supporters, this exemption is viewed as the key part of the package in terms of growing Kansas’ economy.

“When you’re coming out of a recession, small businesses are generally going to be your engines of growth,” Carlson says.

But what will the changes do to the state’s budget in the coming years? The nonpartisan legislative staff projects that in FY 2014, HB 2117 will result in a net decline in tax receipts of $803 million. (The state’s total general fund budget for FY 2012 is just over $6 billion.) Those numbers increase in future years.

If economic growth can’t make up that difference, lawmakers will have to revisit the tax cuts or consider additional spending reductions in order to balance their budgets.

“Right now, those are just projections, and a lot can change,” Carlson says. “Just as an example, two or three years ago, we were showing a $1 billion or $1.3 billion negative ending balance for the year right now.

"We showed there are things you can do in between. We reduced expenditures last year by $500 million, and revenues did increase somewhat. We ended up with a $200 million ending balance last year, and this year it’s hundreds of millions of dollars.”

In South Dakota, new revenue is going to a few targeted areas

South Dakota was the first Midwestern state to adopt a new annual budget this year, and Dilges says it was a much easier process after the heavy lifting done in 2011.

No area of state government was spared cuts last year, when most state agencies faced double-digit reductions and appropriations for high-priority areas such as education and Medicaid declined as well (though not as precipitously, due in part to some one-time payments tapped by the Legislature).

Lawmakers returned this year with some additional revenue to work with, and it used that money to raise state employee pay (it had been frozen for three years) and bolster spending on education and Medicaid.

“What we’re seeing is a reallocation of the state budget,” Dilges says. “State departments are still not seeing any growth in revenue. As a state, we’re taking any [revenue] growth and giving it all to K-12 education, medical providers and higher education.

"My sense is we’re going to do it again next year.”

The cuts of 2011 created a new, lower base of spending in South Dakota’s state government, and it is likely going to stick.

“The mantra here is, Sustain the cuts, live within the new base, and then make targeted investments in a few areas,” Dilges says. “Sometimes it takes a motivator that is beyond most general comprehension to make us all think outside the box. The impending 11 percent structural deficit that we faced [last year] with a new governor was the catalyst. It was the perfect storm, and the result was a leaner government. We don’t want to give that up.”

Michigan adopts modest spending increase after big year of cuts

Like South Dakota, Michigan was coming off a year when historic budget cuts were made, including a 13.7 percent reduction in spending on higher education and a 5.1 percent drop in K-12 school aid. On top of that, legislators revamped the state’s business tax (which resulted in a tax cut); chose to tax pension income for the first time; reduced the earned income tax credit (EITC); and eliminated most other tax credits, deductions and exemptions.

“There were a lot of tough choices, but we did get the budget back into structural balance,” Weiss says. “Now we’re starting to add back.”

But not nearly enough, according to Democratic leaders who believe the steep cuts made in 2011 to areas such as education and health care need to be restored more quickly. They noted, for example, that per-pupil spending in FY 2012 was increased by $120 — but that comes after a year in which funding was cut by $470 per student.

In the area of higher education, legislators agreed to allocate more money for the state’s universities, but the exact amount going to each campus will vary, depending in part on how well the school meets a new set of performance measurements.

For example, is the university keeping tuition down? How many students are graduating with degrees in high-need areas such as science, technology, engineering and math? And how well is the school doing in terms of cost containment and student achievement?

While approving increases in state spending, the Michigan Legislature also adopted two more tax changes: expediting a planned cut in the state’s single income tax rate (it will drop from 4.325 percent to 4.25 percent), and raising the personal tax exemption for individuals from $3,700 to $3,950.

Illinois adopts historic changes to Medicaid program

Early in the legislative year, Democratic Gov. Pat Quinn laid out what he saw as Illinois’ two top fiscal priorities for 2012: containing costs in the state’s Medicaid program and pension system. Those two issues subsequently consumed much of the news coming out of Springfield this year.

A final agreement on pension reform has thus far eluded lawmakers. However, historic changes to the state’s Medicaid program were adopted before the legislature adjourned.

“It was one of the toughest challenges that I’ve ever endeavored as a legislator,” Rep. Feigenholtz says.

A prime example of that challenge was the decision to eliminate coverage for individuals in the state’s Family Care program, which had extended health care coverage to many low- and middle-income individuals.

Feigenholtz was a sponsor of the original Family Care legislation. This year, as a member of a four-member, bipartisan group of Illinois legislators charged with leading efforts to cut Medicaid spending, she agreed to restrict eligibility to individuals at or below 133 percent of the federal poverty line.

It was one of many hard choices that had to be made. At the beginning of the process, the four-member group of legislators was given a spreadsheet with a list of all of the optional Medicaid services (not mandated by federal law) that the legislature could cut. The list totaled $3 billion.

But as Feigenholtz notes, those optional services were included in the state’s Medicaid program in the first place because they were believed to reduce costs over the long run — by giving individuals access to preventative services that reduce the need for more-costly procedures or the prevalence of chronic conditions.

In the end, Feigenholtz says, legislators eliminated only a few optional services, choosing instead to limit the use of them (restricting the number of visits to a health provider or limiting the number of prescriptions that would be covered, for example) and to require more prior state approval. Illinois also expects savings from the elimination of a prescription-drug assistance program, tighter eligibility requirements and enhanced eligibility verification.

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