Dire Straits for States
Conference on state fiscal crises discusses issues; debunks myths

Summer 2003, Volume 25, Number 1

	Therese McGuire discusses state fiscal crises.

A brief scan of the headlines in just about any newspaper in the nation reveals the extent and gravity of the burgeoning fiscal crises for states. One analyst has estimated that the collective deficit will reach more than $100 billion dollars in the next few months.

For those who are wondering what happened to the record amounts of surpluses of recent years, they should also be experiencing a strange sense of déjà vu. “At least once each decade for the past 30 years, the economy has taken a nose dive, and state revenues have failed to keep up with expenditures,” said Therese McGuire, IPR faculty fellow and professor of management and strategy at Northwestern’s Kellogg School of Management. “The situation is not new, but the reasons behind it differ from previous fiscal crises.”

McGuire was one of the organizers of “State Fiscal Crises: Causes, Consequences, and Solutions” in Washington, D.C. on April 3. The conference was jointly sponsored by the Tax Policy Center, a joint venture of the Brookings Institution and the Urban Institute, the Kellogg School of Management, and the Institute for Policy Research.

The academics and experts wasted no time in challenging some of the myths and preconceived notions of the current crisis and debating the perceived causes. The presenters all concurred that the 2001 recession was shallower than the previous recession in 1991, but that the fiscal crisis facing the states is puzzlingly more severe.

Elaine Maag of the Urban Institute and David Merriman, a professor at Loyola University Chicago, found that the current political climate was exacerbating the states’ fiscal crises. They projected that if state lawmakers would have enacted the same tax increases in 2002 and 2003 that they did in 1991 and 1992—when personal income and sales taxes were raised between 2 and 4 percent—the states would have cut their collective fiscal shortfall by two-thirds.

The legacy, however, of “Read my lips, no new taxes” and the enactment of term limits has encouraged state legislators to embrace popular quick fixes rather than pushing through politically precarious solutions such as raising state income or sales taxes. Maag and Merriman foresee policymakers running out of short-term solutions by 2004.

While the situation for states seems bleak, is it really as bleak as it seems? According to the National Governor’s Association, the states seem to be facing the “most dire fiscal situation since World War II.” In fact, Arik Levinson, an associate professor at Georgetown University, and Christian Gonzalez, a consultant with the World Bank, found that the states entered the recession in March 2001 with the highest level of savings ever. They also pointed out that these “rainy-day funds” seem to be large enough to cover states’ fiscal crises for a few years, and they cast doubt on the idea that the state fiscal crises are the result of a revenue bubble. Overall, they found that the states “entered the recession of 2001 much better prepared than they would have been without those savings and much better prepared than for the recessions of the previous several decades.”

On the other hand, David Sjoquist and Sally Wallace, professors at Georgia State University, did find evidence that the states were affected by a revenue bubble. They examined the contribution of capital gains income to total state personal taxable income. They found that a boost in capital gains realizations lifted income tax revenues. This boost, in turn, led some states to reduce income tax or other taxes. So when the economy soured and capital gains with it, it made it more difficult for states to weather the downturn. “States certainly can’t fully insulate themselves from downturns in the economy, but the lesson of capital gains speaks to the importance of tax base diversification and the need for awareness of transitory versus permanent increases in tax bases,” the authors wrote.

Other researchers found that capital gains were only part of the explanation for the recent deterioration in state and local budgets. Using data from the National Income and Product Accounts (NIPA) for state and local governments, Brian Knight, a professor at Brown University, and Andrea Kusko and Laura Rubin, economists with the Federal Reserve Board, found that the economic slowdown and the decline in capital gains realizations explain roughly one-third of the budget deterioration between 1998 and 2002, with the effects of both of these macroeconomic factors showing up after 2000. They point to other factors, such as reduced taxes and the recent acceleration in Medicaid spending, as having played a larger role in the current crisis than these factors played in the crises of the early 1980s and early 1990s.

“Once again it takes a fiscal crisis to impress upon states the need for structural reform of their revenue systems,” McGuire said, “and the prospects for reform look even bleaker this time around.”

For more information on the conference, please visit www.taxpolicycenter.org/sfc2003.