From surplus to deficit: suddenly America's states find that their finances are ailing. Revenues have plunged. Costs, particularly medical costs, are spiraling. In California, the worst afflicted state of all, the budget office predicts deficits for the next five years if tax rates are not raised or spending cut. Harsh choices must be made. America's least fortunate are the likely victims.
This is the unhappy end to seven years of plenty. Figures produced by the National Governors Association in Washington show that in every year from 1984 to 2002 state governments have been able to make real, or above inflation, increases in their spending.
In the closing years of the 1990s, with inflation modest and economic growth high, the gains in revenues and rises in spending were particularly high. In 1998, 1999 and 2000, the nominal increase in spending by all states was of 5.7 percent, 7.7 percent and 7.2 percent, respectively. The real increases, after inflation, were of 3.9 percent, 5.2 percent and 4.0 percent.
But it would be wrong to characterize the late 1990s as a time of spending binge. Not only did the states spend, they saved. Most states sensibly placed some of their excess revenues into rainy day or reserve funds. By the end of the 2000 fiscal year these rainy day funds constituted an ample umbrella, amounting to 10.4 percent of the states' total budgets, compared with less than 1 percent 1992, when the United States was exiting the early 1990s' recession.
And there was another happy element to the time of plenty. For seven fiscal years --years that in most states run from July to June -- the states were able not only to spend more on services but also to cut tax rates. The tax cutting began in the 1995 fiscal year and continued into the 2001 one, which ended in mid-2001, the point at which U.S. growth was beginning to wobble.
From that point on, things have changed drastically. According to a late August report from the National Conference of State Legislatures, the 2002 fiscal year that ended this summer "was tumultuous in nearly every state in the nation." In the course of the 2002 FY, almost all states had to take action to close growing budget gaps. Twenty-nine states implemented budget cuts. Nineteen states tapped rainy day funds. Sixteen states raised tax rates.
For Ray Scheppach, Executive Director of the National Governors' Association, it is now that represents normality, not the boom years. The boom, with its high revenues and, in particular, high capital gains and stock options revenues from the stock market bubble, "camouflaged serious structural problems in state finances."
On the one hand, state budgets are being eaten up by rising health care costs. Approximately 27 percent of state budgets are devoted to health care and 20 of these percentage points are for Medicaid, government-funded medical care for low-income families, the disabled and the elderly in nursing homes. The Fiscal Survey of States published by the NGO in May estimated that states' Medicaid expenditures were rising by 13.4 percent in the 2002 FY and by a quarter in the past two years. Scheppach estimates that the cost of drugs for Medicaid is currently rising at an annual rate of about 18 percent. The states do not have the fiscal resources to cope, Scheppach says.
In his view, a structural change is needed. More of the burden of Medicaid should be borne by the federal government (which currently assumes approximately half of states' costs, the percentage varying from state to state, depending on the wealth of the state and its relative burden.) There are two main reasons for this shift. First, the federal government has a stronger revenue base and is better able to assume the burden. Second, Medicaid, in Scheppach's view, is better handled federally because some states have higher proportions of elderly people requiring medical treatment. The states, he says, "should do Mums and kids, but not the elderly."
On the revenue side, too, Scheppach argues that secular trends are helping to create a structural problem for the states. Sales tax is levied by most states and contributes 40 percent of states' revenues. But the role in the economy of services, on which the states do not collect tax, has grown steadily, eroding states' revenue base. Another negative factor, Scheppach says, are growing sales via the Internet, which often means that states' sales tax is not levied.
These problems have been developing for some time. Now the political will is needed to address them. "We are trying to build the case in the Congress," Scheppach says, "for Medicaid reform." But he sees change taking time. Meanwhile, even if the economy recovers in 2003, he sees state finances remaining "in not very good shape."
They are in least good shape in the huge state of California, whose economy, if stripped off from the United States, would be the world's sixth largest. According to the NCSL, the initial estimate for the states budget deficit in the 2003 fiscal year came to $57.4 billion, with "California's astonishing $23.7 billion gap" accounting "for over 40 percent of the total."
California is most afflicted in part because it was previously most blessed: by high tax revenues from stock options and capital gains. According to Jean Ross, of the non-partisan California Budget Project, 24 percent of state tax revenues came from these sources in the 2001 fiscal year. But, unlike most states, California did not put much of its windfall aside into a rainy day fund. Now that capital gains tax revenues have plummeted, Gray Davis, the state Governor, and the legislature haggled this summer over how to close the projected 2003 FY gap.
The solution found involved, according to Ross, "a lot of one-time fixes and did not include a permanent revenue increase." The biggest single fix is of $4.5 billion, the amount expected to be raised by issuing a bond that will be funded by 23 years in future payments from tobacco companies. Thus, almost a quarter century of future income will be spent in one year. This, in Ross's words, is "extremely short-sighted."
Loans will provide another $2 billion; debt restructuring another $1.1 billion; deferral of education disbursements another $1.7 billion. One way and another the budget proposal finally agreed to in California at the end of August, two months behind schedule, pencils in numbers that, in theory at least, balance the 2003 FY budget.
Is spending in California far too high? Ross says this is a myth. She says California is among the lowest spending states per head of population on health and education. In her view, the "long-term revenue problem" must be addressed. The Kaiser Family Foundation's comparisons of state spending per capita put California 27th of 50 states for overall spending, and 29th of 50 for health spending.
"Big elections," as Scheppach puts it, are near at hand and may be a factor in deterring a serious effort to tackle states' fiscal problems. In October, 36 Governors are up for re-election.
In the 1991-92 recession, Scheppach says that two-thirds of the adjustment to the then fiscal problem came from tax increases. Now, when the effort does come, he sees 70 percent of the adjustment coming on the spending side. This may mean that women, children and the elderly on low incomes find that Medicaid payments and benefits are cut.
A difficult period lies ahead for fiscal finances in the United States. The booming economy and stock market of the 1990s hid growing weaknesses. Health costs are rising out of control. Dan Crippen, Director of the Congressional Budget Office, projected in March that between now and 2030 "spending on the 'big three' entitlement programs -- Social Security, Medicare, and Medicaid -- will grow from 7.8 percent of GDP to 14.7 percent."
It was not just the owners of stock options who made good in the late 1990s. Nourished by the stock market boom, the finances of Americans, their companies and even their Government did well.
In state governments distress is now being felt but, as elections loom, short-term fixes are being found, some of them, such as the burning now of years of tobacco payments, damaging to the longer-term budgetary position. This is yet another obstacle to economic recovery in the United States. The period of fiscal adjustment appears hardly to have begun.
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