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February 01, 2008

Fiscal Double Whammy: Combination of Balanced-Budget Rule and Economic Slowdown Forcing U.S. States to Make Tough Fiscal Decisions

Posted by Michel Lazare

A majority of US states are facing a difficult fiscal situation according to the survey made by the Center on Budget and Policy Priorities (CBPP).

In a January 28, 2008 revision of a survey of states fiscal outlook (prepared by Elizabeth C. McNichol and Iris J. Lav ), CBPP indicates that "19 states face a total budget shortfall of at least $32 billion in fiscal year 2009; 9 others expect budget problems." These dire projections were made by the states themselves and were aggregated by CBPP.

Because they have passed a fiscal rule, which forces the state legislators to adopt a balanced budget, "the vast majority of states cannot simply run a deficit or borrow to cover their operating expenditures."  They have to resort to fiscal retrenchment--not a very pleasant perspective at times when the US economy is noticeably slowing down--, which could in turn negatively affect economic growth prospects (procyclical effects).

Owing to the balanced-budget, the states are left with only three basic options during a fiscal crisis: (1) drawing down any available cash reserves--often this is not enough; (2) cutting spending; or (3) raising taxes. Most of the 28 states facing or expecting budget problems are contemplating spending cuts and/or tax hikes.

The projected deficits result from an accumulation of factors:

  • The housing crisis: property tax is a major source of revenues for most state; a drop in housing prices and a slowdown in construction hurt tax revenues; in addition, CBPP indicates, the housing crisis "has reduced state sales tax revenue collections from sales of furniture, appliances, construction materials, and the like;"
  • The slow down in growth and consumption: economic growth in the US is slowing down, household consumption was also negatively affected in the last quarter of 2007; All this is having an immediate effect on consumption tax receipts and will ultimately impact on revenues from income tax.
  • The rise in construction costs which is hurting states' capacity to complete investment projects or start new ones.

On the latter bullet point, the New York Times recently published an interesting article: "Building Costs Deal Blow to Local Budgets" (via the Bayesian Heresy blog), which contains anecdotal evidence about the impact of the rise in construction costs.

Consequences of the states' fiscal problems: CBPP's view is that: "In states facing budget gaps, the consequences could be severe — for residents as well as the economy.  [...] The experience of the last recession is instructive as to what kinds of actions states may take.   

  • Cuts in services like health and education. In the last recession, some 34 states cut eligibility for public health programs, causing well over 1 million people to lose health coverage, and at least 23 states cut eligibility for child care subsidiesor otherwise limited access to child care.  In addition, 34 states cut real per-pupil aid to school districts for K-12 education between 2002 and 2004, resulting in higher fees for textbooks and courses, shorter school days, fewer personnel, and reduced transportation.

  • Tax increases.  Tax increases may be needed to prevent the types of service cuts described above.  However, the taxes states often raise during economic downturns are regressive — that is, they fall most heavily on lower-income residents.

  • Cuts in local services or increases in local taxes.  While the property tax is usually the most stable revenue source during an economic downturn, that is not the case now.  If property tax revenues decline because of the bursting of the housing bubble, localities and schools will either have to get more aid from the state — a difficult proposition when states themselves are running deficits — or reduce expenditures on schools, public safety, and other services."

Against this background, CBPP is calling for "the federal government — which can run deficits — [to] provide assistance to states and localities".

According to CBPP, only a few states can hope to escape fiscal problems:

"Some mineral-rich states — such as New Mexico, Alaska, Montana and Wyoming — are seeing revenue growth as a result of high oil prices.  Other regions’ economies are less affected by the national economic problems.  For example, states with high levels of farm exports are benefiting from the high price of corn and soybeans and the falling value of the dollar.   This does not mean, however, that local governments in those states will escape fiscal stress.  Some states with mineral revenues or farm exports have been affected by the housing bubble and could face widespread local government deficits."

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