For release: March. 3, 2004

Contacts:	Charles Henderson
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State Government Finances: More Trouble Ahead?

ST. LOUIS, Mo. — States are facing perhaps the most severe budget crises in the post-World War II era. While the traditional response has been to raise taxes and fees or cut services (or both), state lawmakers may want to consider longer-range revenue and expenditure policies that will allow them to do a better job of weathering future fiscal crises.

That's the perspective offered by economists Thomas A. Garrett and Gary A. Wagner. Their analysis of states' budget problems appears in the March/April issue of Review, the St. Louis Fed's bi-monthly publication of economic and business issues.

Garrett and Wagner noted that 2003 was arguably the worst year in recent history for state budgets and budget forecasts. In April 2003, for example, the National Council of State Legislatures (NCSL) reported that collective state budget deficits for fiscal year 2003 could range from $22 billion to $30 billion. In November 2003, however, the NCSL reported that state budget deficits totaled $17.5 billion, suggesting that the crisis may be softening.

The cause of the current crisis, said Garrett and Wagner, is two-fold. "First, state revenue collections grew markedly during the mid-1990s as a result of unusually high levels of economic growth," they said. "As a result, more than 40 states enacted permanent tax cuts.

The subsequent recession of 2001, the stock market collapse and an increase in homeland security responsibilities hit state budgets hard. At the same time, state tax revenues from personal income taxes, corporate income taxes and sales taxes fell dramatically, forcing nearly all states to run large budget deficits."

The other problem they cited is that during 2000 to 2002, when states' revenue growth was negative, they continued to increase expenditures. "Historically, state governments have continued to increase expenditures even after years of negative revenue growth," they said.

So how did the states respond to this crisis? Increases in cigarette and alcohol taxes, cuts in social programs (such as education), closing tax loopholes, cutbacks on state employees and salary reductions, tuition hikes, and increases in vehicle licenses and registration fees. "These measures helped," said Garrett and Wagner, "but they didn't cure the current situation."

Because many of these traditional responses are unpopular, Garrett and Wagner noted that many states have turned to non-traditional sources of potential revenue, including state lotteries and casino gaming. They pointed out, however, that research has shown that lower-income people tend to spend a higher percentage of their pay on lotteries than other people and that lotteries have not increased expenditures in targeted areas, such as education. And while casinos have been seen as prospective tools of economic development through increased employment and tax revenues, the net effect can vary widely from community to community.

Garrett and Wagner said that all of these approaches are a prelude to another crisis, spurred by several factors. "During economic booms, such as the one in the 1990s, state lawmakers cut tax rates while tax coffers are flush and make additional commitments that they have difficulty keeping when the economy slows," they said. "As economic conditions improve, states will again see rising revenues. If the past is a guide, however, these revenues will be committed to ongoing spending programs or taxes will be cut. Unfortunately, the single step of raising taxes and fees is no panacea to the procyclical 'spend/cut' pattern of state governments."

The other compelling factor, said Garrett and Wagner, is the structure of state revenue systems. "In short, they don't bode well for long-term fiscal solvency," they said. In addition, they noted that many states are currently considering increases in sales and excise taxes, as well as using funds from the tobacco tax settlement and raiding state pension funds. Garrett and Wagner cautioned, however, that "growth in sales and excises taxes has slowed in recent history as the economy moves toward services that are traditionally exempt from state sales taxes. At the same time, a continued decrease in the number of smokers may challenge the ability of cigarette-tax increases to provide a reliable, long-term source of revenue."

In addition, Garrett and Wagner said that although personal and corporate income taxes tend to track overall economic conditions, the growth in corporate tax revenues has decreased over the past 20 years, partly due to decreased tax rates, but also due to "tax avoidance" actions taken by businesses.

"The cyclical variability of sales and income taxes," they concluded, "suggests that state governments will be faced with relatively greater revenue variability in the future as long as increasing portions of state revenues come from personal and corporate income taxes."

Review is also available on the St. Louis Fed's web site.

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve Banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, and provides payment services to financial institutions and the U.S. government.

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