State Budget Cuts, Reconsidered

On May 11, when Wisconsin's State Budget Office announced that two-year tax revenue would be $636 million more than expected, school officials were heartened. They hoped the newfound money would be used to help restore an $834 million cut in school funding proposed by Governor Scott Walker. It wasn't to be. Within hours of the announcement, Walker said he wanted to use the money in other ways, including retiring the state's bond debt ahead of time. "Just like Wisconsin families," he said in a statement, "our first priority is to pay off past-due bills and debts."

A new chapter in the budget drama is playing out in statehouses across the country as the recovery begins to kick in. State revenue tumbled when the effects of the housing collapse rippled through the economy in late 2008. Governments reacted by increasing taxes and cutting services. In a handful of states, Republicans have called for reforms meant to shrink government and reduce the number of state employees. Now the rationale for those policies is beginning to weaken.

Evidence of a turnaround in state finances seemed to surface almost daily in May. California, Texas, Ohio, Connecticut, New Jersey, Michigan, and Colorado all reported higher-than-anticipated tax revenues, setting off a scramble to rejigger budget projections. In nearly every state in the nation, revenue is up, year over year, for the fifth straight quarter, according to reports by Goldman Sachs (GS) and the Nelson A. Rockefeller Institute of Government. The Rockefeller report, released on May 24, pegged the overall increase in the first quarter of 2011 at 9.1 percent, the largest gain since 2006.

Tax hikes played a role in the improvement. Illinois raised its personal income tax rate from 3 percent to 5 percent in January, for instance. Yet most of the new revenue came from an increase in personal and corporate tax collections as the economy rebounded. The biggest bump in state revenue, 15 percent, was in the industrial Midwest. Goldman Sachs's analysis suggests the growth was even stronger in April.

Not everyone is convinced that public finances are on the mend. In a May 18 interview, analyst Meredith Whitney of the Meredith Whitney Advisory Group predicted a "waterfall" of credit-rating downgrades on public debt. Some public policy experts are also cautious, arguing that the recovery in states' finances remains fragile. "It's important to keep in mind that they're in a very, very deep hole," says Phil Oliff, a policy analyst with the Center on Budget and Policy Priorities in Washington. "They're just beginning to dig out."

State tax collections in the first quarter were still down $4.9 billion, or 3.1 percent, from the same quarter three years ago, according to Lucy Dadayan, an analyst at the Rockefeller Institute. In California, Governor Jerry Brown's May 16 announcement of a $6.6 billion upward revision to the state's revenue projections still left the state $10 billion short of its needs. Disappearing federal stimulus funding will also dampen state outlooks.

At least two states, Colorado and Michigan, have softened planned budget cuts. In California, the revenue bump is undermining Republican support for Brown's push to extend about $9 billion in taxes that are set to expire on June 30. Brown wants the issue on the ballot this fall. "States developed a really bad habit of living beyond their means when times were good and then relying on the federal government to bail them out," says Curtis Dubay, a senior policy analyst at the conservative Heritage Foundation.

Governors in Ohio, Wisconsin, and New Jersey want to use new revenue to retire debt or cut taxes instead of restoring funding to programs. "The party is over, and the adults have returned," New Jersey Governor Chris Christie, a first-term Republican, said on a May 19 radio show shortly after the state's legislative forecaster revealed that revenue through June 2012 would be $914 million higher than predicted. "It's time for us to pay our bills, cut the size of government, and cut taxes." Six days later the state Supreme Court rebuffed Christie's plans, ordering him to direct $500 million from next year's budget to the state's poorest school districts.

In Wisconsin, where Walker's battles with teachers and other public workers roiled the capital this winter, the governor's office said he intended to run the state conservatively, including paying down debt. School officials hope lawmakers overrule him. Walker "said these historic cuts were based on the fact that we were going broke," says Miles Turner, executive director of the Wisconsin Association of School District Administrators. "This should have been good news."

The bottom line: A faster-than-expected recovery in tax revenue has some states loosening their belts, while others stick to austerity plans.

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