The States Get Squeezed

Post-boom, they can't count on the same kind of cash flow

As Washington lawmakers struggle to shape the federal budget amid the economic slump, they can take some solace: They're hardly alone. In state capital after state capital, elected officials are huddled over their spreadsheets, watching the gains of the New Economy boom--and their own revenues--disappear.

For much of the 1990s, states were awash in surpluses. They cut taxes and lavished spending on education and other popular programs. All the while, governors and state legislators basked in the glory of growing surpluses and strong bond ratings.

Not anymore. Soggy corporate profits, a lousy stock market, nervous consumers, and recently enacted tax cuts are eating away at state budgets. At the same time, soaring health-care costs and an insatiable public demand for improved schools are quickly draining public coffers. The result: For the first time since the early 1990s, governors and legislators face agonizing choices.

A handful of states, including North and South Carolina, may have serious budget shortfalls this year. And although dozens of others will scrape through 2001 with few spending cuts, big problems may be ahead. Many legislatures are struggling to balance budgets for the coming fiscal year, due to begin in most states on July 1. Already, two dozen states expect revenue growth to slow in the next fiscal year. "Throughout the expansion, everything fell into place beautifully for states," says Steven J. Murphy, managing director for public finance at Standard & Poor's Corp. "All of a sudden, revenues are falling and states are getting hit."

Whether that will lead to actual spending cuts or just the budget freezes now being considered remains to be seen. But after so many flush years, even a freeze will feel painful. Ohio is debating a lock on spending. California legislators, too, are looking to scale back new initiatives. And while there is little talk--yet--of tax hikes, a handful of states, such as Oregon, may delay one-time rebates scheduled for the coming year.

The good news is that states headed into this slowdown with a solid financial cushion. Thirty states, from Massachusetts to Arizona, began the year with surpluses of at least 5%. Nationwide, states were in the black by $29 billion.

But in a prolonged slump, those reserves will dwindle fast. Revenues will falter, and new demands for health care and aid to low-income families will cause spending to explode. In the aftermath of the modest 1991 slump, states quickly drew down their reserve funds by more than 50% and raised taxes by 17%. "Rainy-day funds are not going to cut it, even in a mild recession," says Elizabeth I. Davis, senior policy analyst at the Nelson A. Rockefeller Institute of Government in Albany, N.Y.

Already, the slowdown is taking its toll. In the fourth quarter of 2000, state revenues grew by just 4% overall, the smallest increase since 1993, reports the Rockefeller Institute. But in some statehouses, things are far worse. In Iowa, budget analysts figured revenues would grow by a solid 3.4% this year; though in March, they were running a minuscule 0.3% higher than a year ago. In Kentucky, the budget was on track until six months ago. Now, thanks to plunging sales taxes, it faces a $91 million shortfall. Says James D. Ramsey, executive director of the Kentucky Transportation Cabinet's Office of Technology: "The light switch was turned off."

HIGH PRICE. Other states are paying the price for tax cuts legislated during better days. In 2000 alone, 17 states reduced taxes by $9 billion. Much of that came from cuts enacted two or three years ago but not scheduled to kick in until last year. North Carolina, for instance, cut taxes by $1.5 billion over the past four years. Now it faces a 2001 deficit that may hit $1 billion. And Virginia's governor and legislature are battling over whether to slash spending by $400 million to fund a cut in the personal property tax on cars. The levy was supposed to be gradually repealed between 1998 and 2003.

California officials are sweating over an expected drop in taxes on capital gains and options as they watch Silicon Valley highfliers crash. In fact, with 21% of the state's taxes generated by the stock market, analysts figure its $79 billion in revenues will slump by as much as $2 billion in the coming fiscal year. Already, the legislature is considering trimming a similar amount from Governor Gray Davis' ambitious $82 billion budget. On the hit list: a new university campus and funds to buy new parks. And legislators think the tax shortfall will only worsen. "In the second half of next year, it's going to be a nosedive," says Senate Budget Committee Chairman Steve Peace. "We're going to have to really cut."

Massachusetts, too, was awash in surpluses. But tax collections for the year will be up barely 0.2%, according to the Massachusetts Taxpayers Foundation. While that has led to modest cutbacks, it's nothing like what the legislature is about to do to the coming year's budget. "There won't be enough money to give people the increases they've come to expect," says Michael J. Widmer, president of the foundation.

Holding down spending will be tough for states. That's because their biggest single program, elementary and secondary education, has become untouchable in recent years. It accounts for nearly 21% of spending; in 2000 alone, outlays were up 6.8%, according to the National Association of State Budget Officers.

Medicaid, the health-care program for the poor, enjoys no such political protection. Regardless, a slowing economy will likely force increased spending. It already accounts for 19.6% of all state outlays. And at least 23 states that did not budget enough for the program are being forced to pump millions of extra dollars into Medicaid as the costs of prescription drugs and other benefits rise at nearly double-digit rates. "States are getting clobbered for the same reason everybody else is," says James Fossett, a Medicaid analyst at the Rockefeller Institute. "Put that together with a slowdown in state revenues, and budget guys are saying, `gulp."'

To save money, at least a dozen states have tried to scale back what they pay pharmacies for Medicaid prescriptions. But the effort has generated a firestorm of resistance. In Illinois, drugstore giant Walgreens Co. (WAG ) responded by threatening to reduce business hours in stores in the poor neighborhoods where many Medicaid recipients live. "Virtually all these stores are losing money," says CEO L. Daniel Jorndt. The company is now trying to get the state to raise reimbursements.

Most troubling of all, these costs are swelling while employment remains relatively strong. Rising jobless rates would increase pressure on states to provide assistance to many poor working mothers and their children. States will have to reckon with the consequences of welfare reform, which sharply limits what Washington will pay for such aid.

As they finalize budgets for the coming year, many legislatures still think they can keep their ledgers in the black with only modest spending cuts. But for the first time in nearly a decade, there is a palpable sense of gloom in state capitals. The worst, most legislators and governors believe, is yet to come.

By Howard Gleckman in Washington, with Ann Therese Palmer in Chicago, Christopher Palmeri in Los Angeles, Ushma Patel in Atlanta, Stephanie Anderson Forest in Dallas, and Geoffrey Smith in Boston

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