States: A Rebound Won't End Red Ink

Medicaid bills are soaring as corporate and sales taxes shrink

For harried governors, there's bad news--and worse news--on the budget front. The bad news: The recession-driven tax shortfall continues to deepen. The worse news: Even when the economy recovers, state bud-gets could be wrecked by a nasty mix of anemic revenues and exploding health-care costs into the forseeable future.

In the short run, the National Governors' Assn. and four other groups report that income tax revenues for January to April--the months when most taxes are paid--fell a staggering $14.5 billion, or 14%, from 2001.

The NGA estimates that up to $10 billion of that shortfall may have been caused by a decline in capital gains, dividends, and options--the reverse wealth effect driven by a sagging stock market.

Once the market regains its legs, those dollars will gradually return, easing the states' short-term budget crunch. But swings in income taxes mask far more serious long-term revenue and spending problems. Together, they point to a fiscal squeeze continuing well after the economy recovers.

On the revenue side, states increasingly are failing to collect taxes on the goods and services that businesses and consumers buy. To make matters worse, corporate taxes are dwindling as companies find new ways to avoid them.

Meanwhile, health-care costs, especially for Medicaid, threaten to drain whatever new dollars do flow into state coffers. "States are setting themselves up for trouble," says Iris J. Lav, deputy director of the Center on Budget & Policy Priorities, a liberal think tank. "They have a basic problem that doesn't have much to do with today's economy."

Adds Mark M. Zandi, chief economist at consulting firm Inc.: "A governor's job in the '90s was basically ribbon-cutting. In the next decade, they are going to have to make some very hard choices."

Much of the revenue shortfall is a result of limits on sales taxes. Most states tax the purchase of goods but exclude services. Increasingly, though, services are what families and businesses buy--whether legal advice or New Economy purchases such as broadband. In 1960, families spent only about 41 cents of every dollar on services. By 2000, it was 58 cents.

Yet only a handful of states make much of an attempt to tax such expenditures. "We've got a structur-al problem," concedes Kentucky Governor Paul E. Patton.

At the same time, fast-growing Web sales are draining even more tax dollars. While consumers technically owe taxes on Internet purchases, they rarely pay them. As a result, states and localities could see expected revenues shrink by up to 4% annually by 2006 as e-commerce grows.

In addition, a growing share of the economy is built on intangible assets, such as copyrights, databases, and employee expertise. And much of that added value is also untaxed. "We're talking about a long-run, insidious problem," says Robert Tennewald, assistant vice-president of the Federal Reserve Bank of Boston.

That's one reason why corporate income taxes are shriveling. Here's another: Businesses are shifting income to low-tax states or to foreign subsidiaries. As a result, such taxes shrunk from $35 billion in 1998 to just $23 billion this year, barely 5% of all state taxes.

Just as revenues are falling, states are being hit by exploding health-care costs, especially for Medicaid, which targets the poor.

Today, Washington pays roughly half the program's cost. The rest is picked up by states and counties. Over the past five years alone, their costs have ballooned from $72 billion to a staggering $105 billion. And they will keep rising at double-digit rates. "Medicaid is our real problem," says Michigan Governor John Engler.

In North Carolina, state officials expect the program to grow by at least $1 billion a year through the decade. "This simply is not sustainable," says Lanier Cansler, deputy secretary of the state's Health & Human Services Dept. "In 10 to 15 years, every new dollar the state takes in will go to fund Medicaid."

In most states, the increase is being driven by nursing-home and prescription-drug expenses for the elderly poor. In Ohio, 80% of Medicaid spending is for the aged, blind, and disabled. And the program now represents 24% of the state's budget, rivaling elementary and secondary education as its biggest expense. The Citizens Research Council of Michigan, a taxpayer watchdog group, has calculated whether that state's revenues will catch up with spending through 2009. "Our conclusion is that they can't," says Tom Clay, the group's senior research associate.

Governors would like Washington to fix the Medicaid mess by increasing the federal contribution and by paying for drugs for seniors through Medicare, which is 100% funded by the feds. That would cut state drug costs for 7 million seniors.

States have attempted to solve their own revenue problems, but with little success. Kentucky, for instance, tried to tax services such as auto repairs. But it abandoned the idea in the face of heavy business lobbying and the fear that consumers would simply purchase such services out of state. Unable to reform their tax systems, states are patching their leaky revenue streams by raising fees, boosting cigarette taxes, and jacking up sales tax rates. But these strategies are unlikely to make up for the shrinking sales and corporate tax base.

In the end, governors will have to dramatically reform their tax systems, in part by tapping services and products that now go untaxed. And they'll have to make tough decisions about spending, including asking whether they can continue to pay for so much of the care of a growing elderly population. Ribbon-cutting was a lot more fun.

By Howard Gleckman in Washington, with Ann Therese Palmer in Chicago

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