State Races: To the Victors Belong the Budget Mess

Bare cupboards await the new platoon of governors

During the Prosperity Decade of the 1990s, life was sweet at the governor's mansion. Gushers of revenue let states slash taxes while spending generously on schools, health care, and seniors. And it's no accident that four of the five past Presidents came from the governors' ranks.

Now, 24 new governors are about to take office--and some may want to follow the path of George W. Bush and Bill Clinton. But before they get from the statehouse to the White House, they'll have to confront a harsh reality: Collapsing tax revenues and exploding costs, especially for health care and education, have hit budgets with a double whammy. And this across-the-country crisis may make or break the Class of '02.

States in tatters is quite a change from the good times. From 1992-2001, overall state spending grew by 5.8%. In the last six years of the decade, taxes were slashed an average of $4 billion a year. And employment in the '90s rose by 20%--almost all in education.

Since the boom went ka-boom, spending has slowed markedly, rising barely 1.3% in the past two years. But Medicaid, the health-care plan for the poor, is still growing by over 12% a year and now eats up 20% of state budgets. Meanwhile, education costs remain high, and states are struggling to use technology to cut operating costs.

States have been battered by the stock market, too. Tax revenues from capital gains and stock options have plunged even as pension funds have been hammered by market losses.

In the past year, states struggled to close a fiscal gap that topped $50 billion. When lawmakers resume work in January, the situation could be worse. And unlike the feds, states must balance their budgets each year (box). "It's a tremendous challenge," says South Carolina's new chief executive, Mark Sanford (R).

One reason the task is so daunting: The easiest steps have already been taken. During the past three years, many states avoided painful tax hikes or spending cuts by tapping rainy-day funds. But they've drained those balances down from $49 billion to less than $15 billion, according to the National Governors Assn. In states with new governors, including Illinois, South Carolina, and Wisconsin, reserve-fund gauges read "empty." Says Iris J. Lav, deputy director of the Center on Budget & Policy Priorities, a Washington think tank, the question for many new chief executives is: "O.K., buster, what are you going to do now?"

Not only must states address their 2004 budgets but nearly half must also clean up their '03 books, which remain $17 billion in the red. One reason: Lame-duck governors and those running for reelection ignored growing shortfalls. In Maryland, incoming Governor Robert L. Ehrlich Jr. has to tackle a $1.2 billion deficit for fiscal '04, plus a $600 million '03 shortfall. In Minnesota, Republican Tim Pawlenty must find $500 million for '03 before he fills a $1.6 billion hole in '04.

To complicate matters, nearly every new governor--Democrat as well as Republican--has sworn off tax hikes. Democrats such as Illinois' Rod Blagojevich and Wisconsin's Jim Doyle won in part by convincing voters they would not raise taxes. And most soft-peddled business tax hikes. South Carolina's Sanford even vowed to abolish the income tax. In Massachusetts, which elected anti-tax Mitt Romney, voters nearly did that themselves. A referendum to end the Bay State's income tax almost passed.

Romney is up against a shortfall of up to $2 billion in the fiscal year beginning next July. And that's despite $1.2 billion in tax hikes and $1 billion in spending cuts this year alone. Says Michael J. Widmer, president of the Massachusetts Taxpayers Foundation: "This is the worst fiscal crisis in at least 50 years."

To help close the gap--and give himself some political cover--Romney has asked some high-profile execs, including Staples Chairman Thomas G. Stemberg and Fidelity Investments Vice-Chairman Peter Lynch, to suggest solutions. On the table: a broad government restructuring that may shift much state work to private contractors. The biggest target may be the massive Health & Human Services Dept. But to enact reforms, Romney must deal with an aggressive and overwhelmingly Democratic state legislature.

Such partisan wars will break out all over. Maryland's Ehrlich, a Republican, must battle a Democratic legislature. In Michigan, newly elected Dem Jennifer M. Granholm will wrestle with a GOP-dominated statehouse.

Granholm faces an '03 deficit of at least $500 million and an estimated $1.5 billion shortfall for '04. Michigan expects to be $275 million short on Medicaid funding, which is shared by the states and the feds. In Illinois, Blagojevich must struggle with a $600 million hike in health costs--for both Medicaid and state employees. Overall, according the National Association of State Budget Officers, at least 41 states expect to run out of Medicaid money this year. Next year, Congress may ease the problem by giving states about $5 billion, but it won't be enough.

Michigan raised cigarette taxes by 50 cents a pack last summer, but Granholm will find it tougher to hike taxes. "Increasing taxes isn't on most people's radar screens," says Tom Clay, senior associate at the Citizens Research Council of Michigan, a fiscal watchdog group. Indeed, the state has big income tax cuts scheduled for 2003 and 2004 and no plans to delay them.

South Carolina's Sanford has taken the anti-income tax sentiment a step further: He would wipe out the levy over the next 18 years. But he still must close a $331 million deficit this year and deal with a shortfall of twice that next year. He's calling for management reforms and wants to subject gasoline to the state's 5% sales tax.

Unable or unwilling to hike taxes, new governors are looking to more unusual sources of revenues. Ehrlich wants to put slot machines in Maryland's racetracks (BW--Dec. 2). Pennsylvania Democrat Ed Rendell would use such revenues to reduce property taxes. Massachusetts may borrow against some of the $8 billion it's owed as part of the 1998 tobacco settlement. And states are boosting fees, from college tuition to museum admissions, wherever they can.

If revenues don't improve soon, the new governors may want to start playing the slots themselves. Without a quick economic turnaround, they'll have little to look forward to beyond the unpleasant tasks of finding stealth revenue hikes and slashing popular programs. That's no way to build a political future. And it may explain why every politician's onetime dream job has become a nightmare.

By Howard Gleckman in Washington, with William C. Symonds in Boston and Ann Therese Palmer in Chicago

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