EconSouth (Third Quarter 2003)


State of Decline:
State Budgets Feel the Pinch

Much attention has been focused on the federal budget situation, but state budget circumstances have also changed significantly over the past few years. In 2001 and 2002, states experienced the largest revenue declines since complete and comparable record keeping began in the late 1970s. The states of the Sixth Federal Reserve District (Alabama, Florida, Georgia and parts of Louisiana, Mississippi and Tennessee) are no exception. Their budget problems pose a continuing challenge and have important implications for regional and national economic performance.

The state fiscal story can be summed up as follows: Revenues are down significantly, and spending pressure is up — especially with regard to Medicaid. The budget difficulties began in 2001, a result in part of the recession and increased security costs following Sept. 11, 2001. Increased demand for unemployment benefits also added to the pressure faced by state budgets. State financial stress has continued despite the economic recovery, and state officials have implemented a number of fiscal policy changes designed to address the shortfalls.

For example, Georgia Gov. Sonny Perdue has instituted a new budgeting policy that will begin with a review of the costs of state services and the departmental priorities of programs in order “to bring our spending and our actions into alignment with the true human needs of Georgians.”

In Florida, where economic performance has outpaced most other areas of the country, Gov. Jeb Bush nevertheless faces budget challenges. “I’m proud that Florida is one of the few places in the country that will see increases in education, child welfare and services for the elderly. At the same time, cost pressures related to the constitutional amendments, as well as a still-recovering economy, will force us to make some very difficult choices,” he said.

Hit hard in the pocketbook
The fact that the national economic recovery began in late 2001 did not translate into an immediate improvement in state tax collections (see chart 1). The recovery has been rather weak and uneven across regions so far and has not yet translated into a significant increase in employment or income. At the same time, demands on state finances have increased.

As in fiscal year 2002, estimates show that revenues fell short of projections in fiscal year 2003. (For most states, the fiscal year runs from July 1 through June 30. Alabama is an exception — that state’s fiscal year begins Oct. 1 and ends Sept. 30.) It’s important to note, however, that the situation in fiscal year 2003 was not as bad as in the previous year. According to the National Association of State Budget Officers (NASBO), 41 states missed revenue targets in fiscal year 2002. In fiscal year 2003 the number was down to 30. In the Southeast, Georgia, Mississippi and Tennessee failed to meet their revenue targets, according to NASBO.

For the United States as a whole, estimates of combined fiscal 2003 sales taxes, personal income taxes and corporate income taxes are 5.9 percent below original estimates. Current estimates of sales tax collections are 2.5 percent below budgeted projections, personal income taxes are 8.6 percent lower, and corporate income taxes are off by 8.3 percent, according to NASBO.

State Tax Revenues
Sources: U.S. Bureau of the Census and Federal Reserve Bank of Atlanta

For Sixth District states, estimates of the three combined fiscal 2003 taxes are 3.5 percent below original estimates. Current estimates of sales tax collections are 3.8 percent below budgeted projections, and personal income taxes are 5 percent lower, but corporate income taxes are 5.7 percent higher than estimated because of higher-than-expected receipts in Alabama, Florida and Mississippi. However, corporate taxes account for only 6.6 percent of total receipts in Sixth District states (a figure similar to the U.S. total), and the higher corporate tax inflows did little to offset lower revenues in other tax categories.

The scope of the problem can also be seen in the high number of states that were forced to change already-enacted budgets. Fiscal year 2003, which ended June 30, saw 37 states reduce budgets by a total of nearly $14.5 billion. This spending cut was the largest in the history of the Fiscal Survey of the States, a report published by the National Governors Association and NASBO since 1979. States had counted on a stronger economic recovery to boost revenues, but when that failed to materialize, most state governments raised taxes or cut spending or both.

According to NASBO’s June 2003 Fiscal Survey of the States, 28 states enacted across-the-board cuts, and 22 states withdrew amounts from their rainy-day funds. This was the case in the Sixth District as well. For example, Louisiana’s rainy-day fund remains healthy,” said Gov. M.J. “Mike” Foster, “even though we used $86 million of those funds this fiscal year to help offset otherwise devastating cuts in state services.”

In addition, 17 states laid off employees, eight states offered early retirement, and 10 states reorganized agencies and programs. A number of other measures were also used. Some states refinanced debt, froze hiring and borrowed against tobacco settlement proceeds. The bottom line is that state governments struggled to balance budgets in the face of revenue shortfalls. For instance, Tennessee Gov. Phil Bredesen acknowledged having to make a number of painful choices in assembling the new budget, including 9 percent across-the-board reductions in state agency funds and shared revenues with local governments.

Chart 2 shows that the states of the Sixth District have seen their revenue declines stabilize, and in many cases improvement is clear. Without a notable increase in tax revenues, however, the fiscal situation in some states will not improve much.

District State Tax Revenues
Sources: State Departments of Revenue and Federal Reserve Bank of Atlanta

Refilling the coffers
Accurate planning for future budgets is a priority. In Mississippi, for example, Gov. Ronnie Musgrove has proposed the creation of a Commission on Revenue Estimates. “It is critically important that the governor and legislature work together in crafting an accurate and fiscally responsible revenue estimate for the state each year,” he said.

Realizing that a quick return to solid revenue growth was unlikely, other governors and state legislatures also enacted conservative budgets for fiscal year 2004. To address budget shortfalls, 2004 budget proposals include spending reductions, revenue increases and deployment of reserve funds. Revenue projections show that states expect some increase in tax collections, but the damage done to past budgets by revenue shortfalls is also reflected in fiscal year 2004 budgets.

Twenty-nine states’ budgets include revenue increases for fiscal year 2004, resulting in a total revenue increase of $17.5 billion. California, which is in the middle of a serious financial crisis, accounts for nearly half of that total. When New York, Pennsylvania and Ohio are added to California, the four states account for roughly 75 percent of all proposed tax increases in fiscal year 2004. Alabama’s legislature passed a tax reform bill that would result in higher state government revenue, but voters rejected it on Sept. 9. As a result, the state government will have to raise $675 million to balance the budget in fiscal year 2004.

Cover Story Callout

Fifteen states proposed sales tax changes in fiscal 2004, for a net increase of $6 billion. California accounts for $4.4 billion of the total amount. Other increases were recommended in Ohio and New York. Five states proposed small decreases; most of the reductions, including Florida’s, reflect sales tax holidays.

Several states also planned changes to personal income taxes, resulting in a $5 billion increase. Again, California accounts for much of the total state increase ($2.6 billion). Pennsylvania also planned to raise the personal income tax rate by $2.2 billion. Eleven states proposed corporate income tax changes that would net an additional $759 million.

Fourteen states recommended changes to “sin taxes” — surcharges on cigarettes, tobacco and alcohol — to the tune of $2.5 billion. The $337 million rise in Georgia’s sin taxes accounts for the only major tax increase among Sixth District states for fiscal year 2004.

Local authorities fare better
Local budgets have not escaped the fate of state budgets over the last few years, but important differences exist. Perhaps the most striking is in their income sources — local authorities rely more on property taxes than do state officials. Since real estate held up remarkably well during the recent downturn, property tax intake has not suffered like sales taxes or income taxes — the two sources of revenue most important to state coffers. Also, there is no uncertainty about Medicaid on the local level, which allows more flexibility for contingency planning. That is not to say that local sales tax intake has not been affected, but, as Chart 3 shows, local authorities have not suffered to the same extent as state authorities.

State vs. Local Tax Revenues
Sources: U.S. Bureau of the Census and Federal Reserve Bank of Atlanta

Help from Washington, D.C.
States received a welcome surprise in the most recent federal tax bill — $20 billion in aid from Washington, D.C. The $20 billion will be divided equally between a flexible grant and Medicaid funds (see the sidebar for a more detailed description of how the Medicaid program has affected state fiscal policy) and will be distributed over the next two years. The amount of fiscal assistance received by each state will be determined by total population.This aid is partially offset by requirements that reduce state revenues by $3 billion over the next three years and $16 billion over the next 10 years; however, the fact that states are receiving funds now when they are in serious need is a positive development.

State of flux: What’s next?
Sixth District states have generally seen their tax revenues stabilize in 2003, but significant improvements remain elusive. Without improvements, states still face serious fiscal difficulties. While the current economic situation is clearly looking up for the District and for the nation, an immediate turnaround in revenues is not likely because such a turnaround usually follows improving economic conditions only after several months have passed.

The main question facing economists and business people is whether rising state taxes will offset the federal tax cuts and rebates designed to stimulate the national economy. The question is difficult to answer because the exact impact of the federal tax cuts and whether state and local authorities will be forced to take additional steps to balance budgets in fiscal year 2004 is unknown. But based on current estimates, the fiscal drag to the economy caused by the state and local fiscal problems is unlikely to fully offset the positive impact on the economy of federal tax cuts. This outlook is especially true for the states of the Sixth District, where tax increases and job cuts have been modest compared to other areas.

As noted, the total tax increases that states intend to impose in fiscal year 2004 amount to $17.5 billion. When the $8.3 billion in increases from fiscal year 2003 are added, the total amount reaches $25.8 billion. The Congressional Budget Office and Congress’ Joint Committee on Taxation estimate that 2003 tax cuts would reduce federal revenues by $35 billion and increase outlays by $4 billion — for a total net impact of $39 billion. Therefore, the overall decline in estimated federal revenues brought on by the federal tax cuts more than offsets the expected increases in state taxes. Although state tax increases will be a drag on the national economy, they do not wholly offset the positive impulse created by federal tax cuts.

The situation for the Southeast is even more pronounced and better than the overall national picture. Tax increases announced in the Sixth District amount to $337 million. When the projected impact of Florida’s planned tax holidays is subtracted, the number falls to $278 million in total state tax increases. If state governments resort to outright job cuts, the overall impact of the state fiscal crisis will be much greater, but to date there have been no widespread programs to eliminate state government jobs. Wage and hiring freezes will have an impact on economic activity but should not unduly affect the positive fiscal impulse coming from federal tax cuts.

State governments, including those in the Sixth District, have addressed the challenge of record-breaking revenue declines by raising taxes, curtailing spending and dipping into reserve funds to balance their budgets. The accelerating economic recovery should lead to an increase in revenues, but it will be some time before states’ financial health improves.

This article was written by Michael Chriszt, the director of international and regional analysis in the Atlanta Fed’s research department.

Medicaid Takes a Bite out of the Budget

Growth in Medicaid expenditures is a major factor behind the state budget shortfalls following the most recent economic downturn. Medicaid, a $280 billion joint federal-state entitlement program, provides medical care for over 40 million low-income, elderly and disabled individuals. The program covers a broad range of health care services, including hospital and doctor visits, prescription drugs and nursing home care. States have considerable administrative leeway, and eligibility criteria, health care coverage and provider reimbursement rules differ from state to state.

Medicaid expenditures, in both levels and growth rates, are substantial. Even though the federal government pays for about 57 percent of Medicaid costs, the program accounts for about 20 percent of funds spent by states. Medicaid also accounts for the largest share — about 43 percent — of federal funds transferred to states. Costs rose by about 13 percent last year, and the combined shortfall for fiscal 2002 and 2003 was over $6 billion. In the Sixth District alone, Medicaid expenditures exceeded budgeted amounts by over $1 billion during fiscal 2002. The recent federal tax cut included $10 billion earmarked to help states cover Medicaid budget shortfalls.

Higher enrollment rates and rising pharmaceutical prices are the primary contributors to rising Medicaid costs. Because Medicaid must cover certain groups and services, states have limited control over enrollment and costs. Enrollment is countercyclical; when the economy weakens, more people become eligible as their incomes fall, and more eligible people pick up the program because fewer have employer-provided health insurance. Medicaid enrollment in the Sixth District rose by almost 16 percent during fiscal year 2002. Add to this the increased costs of prescription drugs and medical supplies, which have risen at twice the rate of overall consumer prices, and the burden becomes even greater.

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