The nation that stormed into Iraq has some alarming problems in its own backyard. Across the country, state and local governments are grappling with budget deficits adding up to more than $40 billion--and still rising. Localities large and small are hiking taxes and slashing budgets. And that means almost everybody, from the children of Middleborough, Mass., where elementary schools are being closed, to state and city workers nationwide, will feel the pain.
The effect of all of this on the American economy is equally distressing. The drastic measures that states and cities are taking to clean up their fiscal houses could prolong the current downturn. Higher taxes leave less income for other spending, and government cutbacks mean fewer jobs, less construction, and increased unemployment. In previous recessions, state and local spending typically boosted real gross national product by an average of one-half of a percentage point in the first year of a recovery. That would add about $27 billion to GNP if a recovery were to start now.
But this time around, many economists expect that state and municipal budgets will dampen the recovery--subtracting as much as $10 billion from GNP growth this year. "The state and local government fiscal situation is one of the most important reasons why economic expansion will be rather muted in 1991," says Mark Zandi, economist at Regional Financial Associates Inc., an economic forecasting firm.
NO QUICK FIXES. Indeed, the deficits promise to outlast the recession. Many states and localities were in trouble even before the downturn started, with spending long outrunning revenues. Accounting gimmicks succeeded in papering over deficits for a few years. But once the recession hit, tax revenues plunged and deficits deepened beyond the help of any legerdemain. Now, some 30 states face deficits, as do dozens of cities, towns, and counties.
The fiscal situation is so bad that the remedies could redefine state and local government. The old quick fixes no longer suffice. "We're trying to make the machine leaner and meaner," says Sam Yockey, San Francisco city budget director. Adds R. Scott Fosler, director of governmental studies at the think-tank Committee for Economic Development: "We're seeing the beginning of a painful, wrenching rethinking of the way government does its work."
It must be said that no one expects to see widespread public-sector insolvencies. States and most cities have the resources to cope with their troubles, albeit with difficulty. And most governments--including California and New York--can still borrow at attractive interest rates in the credit markets.
Just the same, more and more states are projecting budget deficits in excess of a billion dollars (table). Topping the list is California. As recently as last July, Sacramento foresaw a $1 billion surplus. Then, the Golden State suddenly found itself amid woes of Old Testament magnitude: a freeze that killed much of the state's citrus crop, a five-year drought that reached a crisis point, widespread layoffs in key industries, and a war that turned consumers into pillars of indecision. By early January, newly elected Republican Governor Pete Wilson was projecting a $7 billion deficit for the current fiscal year, which ends in June. By March, Wilson had to whip out his eraser and write in $12.6 billion in red ink--the largest state budget deficit projection ever.
Even states that have ducked the recession are not immune. Take Texas. Employment in the Lone Star State has grown by 2% over the past 12 months, and tax revenues are expected to rise by almost $2 billion by 1993. Yet Texas faces a $4.7 billion shortfall in its 1992-93 biannual budget, the state Comptroller's Office estimates. "What makes Texas different is that our shortfall is not caused by a bad economy," says Thomas R. Plaut, the state's chief revenue estimator. The chief culprits: education and medicaid.
In the 1980s, almost every state found its budget being pulled upward, willy-nilly, by the relentless rise in education, medicaid, and prison expenses. These trends show no sign of slowing. The number of school-age youngsters is expected to grow by 3.2 million in the 1990s, after shrinking by 3.4% during the `80s. Persistent medical inflation and wider eligibility for poor children guarantee that medicaid costs will continue to soar. And almost every state is building and expanding prisons to keep up with growing inmate populations.
HARD WEANING. These costs are hard for state governments to control. Worse yet, the feds have become less willing to aid their smaller siblings. As part of a decade-long effort to shift government spending from Washington to the states and cities, federal aid to state and local governments has shrunk in the last decade. It now pays for only 15% of state and local expenditures, down from 21% in 1981 (chart). At the same time, Congress has remained willing to pass along to the states new social and environmental responsibilities without added funding. "Who is the bad guy? For the states, it's the federal government," says David Perko, economist at the research group DRI/McGraw-Hill.
With next to no chance of being bailed out by Uncle Sam, who has his own $320 billion budget gap, local politicians are being forced to raise taxes. According to a survey by the Tax Foundation, a nonprofit research organization, state legislators and governors are mulling proposals that could boost taxes in 1992 by almost $12 billion. Strikingly, Tennessee and Connecticut are seriously considering adopting income taxes for the first time, something no state has done since New Jersey in 1976. Even in Texas, an incipient income tax movement is garnering some support from influential business groups.
TAX JITTERS. But there are limits to how far taxes can be raised. New Jersey's recent tax hikes touched off a popular revolt that rocked the state's polling booths last November and spooked politicians elsewhere. And states, more keenly aware than ever of how taxes affect business' choice of where to locate, are afraid to get too far out of line from neighbors.As a result, most of the budget gaps will be closed by slashing spending. In Rhode Island, Democratic Governor Bruce Sundlun has already closed all nonessential government offices for two weekdays this year, and he has proposed shutting down state government for 19 more days over the next fiscal year.
Elsewhere, cost-cutters have found state aid to cities and suburbs to be a tempting target. In New York, Democratic Governor Mario Cuomo's budget calls for cutting local aid by about $500 million. And in California, where San Francisco projects a 10% shortfall in its budget, the gap could widen considerably if the state slashes local aid. "We're at the bottom of the food chain," laments budget director Yockey.
Apart from medicaid, where spending keeps rising, poor people are especially vulnerable. Governors are using the fiscal crisis to work their version of welfare reform. Two examples: In Ohio, which faces a $1.5 billion revenue shortfall for 1992-93, newly elected Governor George V. Voinovich, a Republican, has suggested turning over welfare support for able-bodied adults to local governments and cutting the program by $50 million. Michigan's new GOP Governor, John Engler, wants to cut benefits to families whose children drop out of school. He also would end general assistance to some 100,000 people who Engler says are able to go out and find work.
Even when people agree more spending is needed, it's hard to find the money. Crumbling roads, for example, are attention-getters. But most state and local governments won't be able to boost their infrastructure spending over the next few years unless the feds foot more of the bill. And hard-pressed cities may very well cut back on capital improvements. "Infrastructure, unfortunately, will just have to be deferred some more," says Robert D. Ebel, senior manager of policy economics at KPMG Peat Marwick.
TEAMING UP. The budget crunches have governors, mayors, and legislators looking for ways to deliver the same level of public service, but more cheaply. Denver, which saw its economy collapse with oil prices in the mid-1980s, joined with five suburban counties in forming a cultural tax district. Voters approved a sales tax hike to fund such institutions as the art museum and the zoo. And the city also formed a six-county baseball district to build a stadium if the city wins a major league franchise. "You cannot do business as usual," says outgoing Mayor Federico Pena. "You have to look at new relationships, new partnerships, new opportunities."
Yet such measures can't relieve the acute fiscal distress that states and cities now suffer. In the short term, the need to balance their budgets will only worsen the recession. And even when the economy swings back up, as it surely will, the effects of their decisions will linger on. Cuts in roads and bridges--not to mention schools--ultimately lower productivity, which, in turn, leaves a lower standard of living. The transfer of federal responsibilities to local governments, without a commensurate increase in state resources, will then have come at a steep price.
BITTER MEDICINE FOR MANY STATES AND CITIES
Projected deficit: $12.6 billion. New Governor Pete Wilson has set education and welfare as the biggest targets for spending cuts. Legislature debating all kinds of taxes, including one on lawyers, accountants, and other professionals
Projected deficit: $1.7 billion. May adopt a personal income tax to raise $2.4 billion, cut other taxes for net gain of $836 million. Could slash $1.2 billion from budget, freeze aid to localities, cut compensation, lay off workers
Projected deficit: $1.2 billion. Proposals call for cutting $149.5 million from education and some $750 million from state agencies. Payroll likely to be trimmed by 5%. No new taxes or tax hikes
Projected deficit: $850 million. Spending cuts may total $330 million, with another $397 million saved by postponing pension payments, cutting jobs, trimming medicaid outlays, and selling assets. Reducing taxes
Projected deficit: $800 million. New Governor John Engler wants to cut property taxes by 20% and boost education outlays 4%. To do so, he would cut other spending by 9.2% across the board, plus lay off 2,700 workers
Projected deficit: $6 billion. Cuts may hit education, medicaid, aid to localities. Layoffs of about 5,500 loom. Taxes could climb by more than $1 billion, including motor fuel levies. New York City faces its own $3.2 billion deficit in 1992
Projected deficit: $4.7 billion. Eyeing $300 million in cuts. Income tax under debate, but opposition by Governor Ann Richards makes it unlikely. Instead, will probably increase sales tax, broaden sales tax base, and reform business taxes