Commentary: States of Crisis

As the weak economy punishes state budgets, it is driving some politicians to take refuge in almost hallucinatory forms of accounting. Unable to pay vendors, Illinois piled up a $5 billion mountain of IOUs. California Republican Governor Arnold Schwarzenegger warned 200,000 state employees he might temporarily have to cut their pay to minimum wage. And New York, whose fiscal year began on Apr. 1, is limping along without a budget because warring parties are using the negotiating tactic called "delay until you get your way." New York Democratic Governor David Paterson says he almost feels like moving to Vermont. "I think I might just walk over there and see if they'd like me to stay," Paterson joked to a Bloomberg News reporter on July 10 during a break at the National Governors Assn. meeting in Boston.

Crisis needn't breed cravenness. Some state lawmakers are using the mess as an opportunity, a chance to ram through reforms to help fix the structural budget imbalances that, if left unaddressed, will plague them for decades to come. New Jersey Republican Governor Chris Christie has forced the state's unionized teachers, for the first time, to pay for part of their health-care coverage. Indiana cut the cost of a prison meal from $1.43 to 99 cents by contracting out the job. Last year Massachusetts Democratic Governor Deval Patrick signed a cost-saving law permitting the use of civilian flaggers for road work, ending the state's status as the only one requiring uniformed police officers at all road construction sites.

As Supreme Court Justice Louis Brandeis wrote in a 1932 opinion, states can "try novel social and economic experiments without risk to the rest of the country." Economists predict several more years of stress, even though states' tax revenue ticked up in the first quarter of 2010 from a year earlier, according to the Nelson A. Rockefeller Institute of Government. So there's plenty of time for wayward pols to adopt the wisdom of responsible ones. "We've got to fundamentally rethink how we do things and not just go through traditional budget-cutting," says Vermont Republican Governor Jim Douglas, former chairman of the National Governors Assn.

Of course, the fiscal crisis is not a political-science experiment. Deficit-closing measures are cutting into the meat and bone of social programs, pushing up taxes on people already whacked by the weak economy, or both. Hard as it is, though, states have no choice but to bring their budgets into balance—and not just through fiscal legerdemain. Governors have long been adept at one-shot tricks to balance operating budgets, as all states but Vermont require. That goes even for states that are doing some things right: This past fiscal year, Arizona sold off about $1 billion worth of real estate, including the state Capitol and the state Supreme Court. New Jersey is skipping a $3 billion pension contribution even though state plans were underfunded by $46 billion as of a year ago.

Such maneuvers may be hard to avoid, but they don't fool the markets. According to investors in credit default swaps, an insurance-like derivative, as of July 13, Illinois and California are greater credit risks than Portugal. Michigan, New York, and New Jersey are deemed a bit better than Portugal but still chancier than Ireland and Spain, indebted weaklings of the single-currency euro zone. High borrowing costs worsen states' financial plight and increase the risk they could be cut off from credit altogether.

States don't have a chance of getting their houses in order unless they tackle unaffordably generous pension and health-care benefits for public employees. Addressing a special session of the New Jersey legislature in February, Christie related an entitlements horror story: "A retired teacher paid $62,000 towards her pension and nothing, yes nothing, for full family medical, dental, and vision coverage over her entire career. What will we pay her? $1.4 million in pension benefits and another $215,000 in health-care benefit premiums over her lifetime." Spokesman Steve Baker of the New Jersey Education Assn. says that's far more than what most teachers get. But Christie's larger point is inarguable. Budgetary reform is long overdue. How to get started on the kind that will last? Here are some lessons from the states:

Don't Just 'Starve The Beast'

There's no guarantee that simply depriving states of adequate revenue—a conservative tactic dating back to Ronald Reagan—will produce the streamlined budgets everyone wants. It's just as likely that states will cut programs that are valuable but politically uninsulated, or raise money in regressive ways, like gambling. Arizona reduced assistance for 17,000 seriously mentally ill people in the new fiscal year. Cash-strapped California has scheduled a November ballot initiative on marijuana legalization: The state's tax collector estimated last year that fully legalizing consumption could generate $1.4 billion a year in state and local taxes. "No one's clean. No one's pure," says George Mason University Professor Paul Posner.

Apply Targeted Pressure

In New Jersey, Christie decided that the worst overspending was on municipal and school-district personnel. But those were outside of his jurisdiction. So he took his case to the voters, urging them to reject school budgets unless teachers accepted a salary freeze. Only about two dozen of the 500 or so teacher bargaining units went along with the freeze—and then a record 59 percent of school districts saw their budgets voted down. The ballot-box defeats forced school districts to slash teacher jobs, sending the union a message that Christie was a force to be reckoned with.

Prepare for Total War

The more ambitious the reform, the stronger the resistance. California's Schwarzenegger was unable to overcome opposition from the Democrat-controlled legislature and fell short of his smaller-government objectives. Illinois Democratic Governor Pat Quinn started out playing hardball this year but ended up settling for a budget that calls for nearly $10 billion in borrowing to pay vendors and make pension contributions. Colorado Democratic Governor Bill Ritter, who is not seeking reelection, showed more gumption when he resisted lawmakers' calls to restore spending because of a small, unexpected improvement in revenue.

Raise Taxes (Sometimes)

With anti-tax sentiment running strong, state politicians have tried to keep tax hikes to a minimum and to rely mainly on spending cuts to balance budgets. That's probably the right call in high-tax states with bloated spending like New York and New Jersey. But it's harder to justify in low-tax states like Arizona. There, Governor Jan Brewer bragged in January that her state's tax burden as a share of personal income was the lowest in more than 30 years. Nevertheless, she sought to close a fiscal 2011 funding gap mainly through one-time measures and spending cuts. Brewer did get a temporary penny increase in the sales tax—along with her deep spending cuts. An allergy to taxes may seem business-friendly, but even many bond investors favor tax hikes as part of a budget-balancing when complete reliance on spending cuts or gimmicks is unsustainable, says Justin Hoogendoorn, a bond strategist at BMO Capital Markets in Chicago.

Tie Your Hands

States need to set up a mechanism that will tame their own worst instincts—that is, prevent them from caving in to special interests and overspending once the crisis eases. New York Lieutenant Governor Richard Ravitch is proposing an independent review board that would issue quarterly reports on whether the state was making "adequate progress" toward permanent budget balance. If not, the governor would have authority to make across-the-board cuts. That's similar to the oversight mechanism Ravitch and others used to bring New York City back from a near-death experience in the 1970s. It's also similar to the system Washington, D.C., has used to improve its credit rating since the late 1990s. The District of Columbia's watchdog, Chief Financial Officer Natwar Gandhi, is free to speak his mind because if the mayor fires him, Congress can reinstate him. If each of the 50 states had its own Gandhi, the fiscal storm clouds might already be showing signs of clearing.

With Michael McDonald, Terrence Dopp, William Selway, and Esmé E. Deprez

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