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Taxes and Budgets: Key Trends from the States

Presentation at the 2007 Association of Capitol Reporters and Editors annual meeting, Philadelphia, Pennsylvania

click here to view the presentation

Sujit CanagaRetna
Senior Fiscal Analyst

Southern Legislative Conference of The Council of State Governments

Introduction

It is wonderful to be here in Philadelphia and my thanks to ACRE for inviting me again to present at the session on state finances.  I work for The Council of State Governments, an organization established in 1933 that works primarily with state legislatures in tracking trends, carrying out research and analysis and promoting state interests through continuing education.  While I work for The Council’s Southern Office, the Southern Legislative Conference (SLC) in Atlanta, the Council is headquartered in Lexington, Kentucky with regional offices in New York, California, Illinois and Washington, DC.

My presentation this morning will quickly cover five broad areas.  Part I focuses on where states stand on the fiscal front while Part II highlights some structural issues confronting state finances.  Part III explores some of the major expenditure categories looming on the horizon for states while Part IV demonstrates some of the strategies being deployed or being proposed by states to fund these sizable expenses.  Finally, Part V presents some of the bright sparks on the state economic front that will contribute towards bolstering state finances.

Part I

         State finances have recovered from the depths to which they were plunged to in the early years of this decade when cumulative state budget shortfalls amounted to several hundred billions dollars and states endured their worst fiscal downturn in decades.  According to the June 2007 NGA/NASBO report, in fiscal 2007, total revenue exceeded original budget projections in 27 states; they were on target in 14 states and below budget projections in 9 states.  For the current fiscal year, 2008, total revenues in Governors’ recommended budgets are forecasted to surpass fiscal 2007 levels by 3.3 percent.  The boost to state coffers has resulted in states enacting tax cuts, expanding health coverage for children, initiating long overdue maintenance work on highways, schools and public buildings and replenishing rainy day funds.

Part II

         Notwithstanding the improved revenue picture, the latest June 2007 revenue report from the Rockefeller Institute indicates that while state revenue growth increased in the first quarter of 2007, it still lags behind long-term historical levels.  Two of the three major taxes showed a weaker performance than the previous quarter; however, the increase in personal income tax collections outweighed the weaker increases of the corporate income tax and sales tax.  In addition, according to the federal Bureau of Economic Analysis, state and local government tax collections in quarter 1 of 2007 demonstrated their lowest growth rate since quarter 1 of 2003.  A number of states are also signaling a weakened fiscal scenario in the upcoming years: Virginia, a $200 million to $300 million shortfall in the current FY 07-08 biennium; Alaska, $500 million gap in FY 09; Florida, $1.5 billion combined shortfall in FY 07 & 08; Arizona, revenues are already short of projections for FY 08; Maryland, $1.5 billion deficit in FY 08; California, $764 million in FY 07 and $1.4 billion in FY 08; Illinois, $874 million shortfall in FY 08; Massachusetts, $1 billion gap in FY 08; Michigan, at least $1.6 billion in FY 08; and, Rhode Island, nearly $400 million in FY 07 and 08.

States also face a number of long-term structural problems that will plague their finances in the coming years such as the fact that state sales taxes do not cover services, an activity that now accounts for some 80 percent of our economy.  State sales tax systems were originally designed to tax transactions of tangible goods; in recent decades, our economy has been transformed to one driven by the service sector.  A quick stat from FORTUNE magazine is very revealing: in 1955, in the inaugural FORTUNE 500 issue, the top company in terms of revenue was General Motors, a manufacturing company.  In 2007, the top company was Wal-Mart, a service company, a clear reflection on how our economy has been re-configured.  In fact, the latest Federation of Tax Administrators report on states taxing services notes that only six states (Delaware, Hawaii, New Mexico, South Dakota, Washington and West Virginia) tax more than 100 of the 168 services currently with a sales tax.

Another structural problem confronting states involves the significant revenue erosion arising from e-commerce.  According to a July 2004 study by the University of Tennessee, by 2008, estimated revenue losses for state and local governments is expected to range between $22 billion and $34 billion, with the states that rely more heavily on sales taxes as a revenue source suffering the greatest losses.

Part III

Alongside the challenges described above, states also face an increasing number of complex issues with substantial fiscal implications in the future.  These include sizable healthcare, pensions, prisons, education, emergency management, transportation and infrastructure expenditures.  During the last fiscal downturn, essential expenditures in these areas were postponed adding to the urgency of attending to these expenses in coming years.

On the healthcare front, even though for the first time since 1998, according to the Kaiser Family Foundation state revenues increased faster than state Medicaid spending in FY 2006, in the first quarter of 2007, Medicaid took off again and rose by 9.2 percent, the highest quarterly growth rate in almost a decade.  Our changing demographic picture with the expected increase in the cohort of older Americans will pose additional complications to states on the healthcare front.

In terms of pensions, states face a series of unenviable challenges because every element of our nation’s retirement architecture—Social Security and Medicare; corporate and public pension plans; personal savings—face complications.  According to the latest 2007 Standard & Poor's survey, the mean funded ratio—or actuarial value of assets divided by the actuarial accrued liabilities—of state pensions was 81.8 percent, a marked drop from 2000, when average levels exceeded 100 percent.  Further complicating this scenario is the Governmental Accounting Standards Board (GASB) ruling that states determine and report their Other Post-Employment Benefits (OPEB) liabilities and annual required contributions, comprising mostly health care costs, for retirees.  Cumulatively, the unfunded liability levels in public pension plans and retiree health care amount to hundreds of billions of dollars.  Furthermore, alongside the “graying” of America, the wave of baby boomers expected to retire in 2008 and the declining worker-to-beneficiary ratio will pose problems.

Expanding prison populations that have led to severely overcrowded prisons, rising inmate health care costs and surging personnel expenses have applied significant pressure on state budgets too, forcing policymakers to explore alternatives to building expensive new correctional facilities.  For instance, in California, Governor Schwarzenegger has proposed a $7.7 billion prison spending plan in response to last year’s overcrowding crisis.  In FY 2006, state spending on prisons surged 10 percent nationally and in FY 2007, states budgeted nearly $38 billion for this cost category.

On the education front, states face serious challenges too.  According to the National Center for Education Statistics, K-12 expenditures in the 50 states leapt by 119 percent between 1996 and 2005 (in constant dollars). Why have costs increased so much?  Experts cite the rising costs of pensions, retiree healthcare and the increased expense of meeting the requirements of the federal No Child Left Behind Act.  Increased testing, higher qualifications for teachers, interventions for students failing to meet achievement targets, and greater data collection and analysis costs have all hit state and local education systems pretty hard.  States are also under pressure to reduce class sizes and expand early childhood education programs.  As we near the 2014 deadline for all students to be at or above grade level, these costs are expected to increase further.  A number of states have seen and will have to endure higher costs as a result of, or in order to avoid, school funding litigation.

States also face looming fiscal challenges in preparing for both natural and manmade disasters in an environment where assistance from the federal government is shrinking.  Another area of concern involves the huge projected shortfalls in state transportation programs.  State after state has recently released data indicating these shortfalls at a time when traffic and congestion levels are at an all-time high and road, bridge and other infrastructure conditions have declined precipitously.  Georgia faces a $7.7 billion shortfall in coming years while New Hampshire indicates it will take 35 years and $4.5 billion to complete its 10-year plan to construct and repair bridges and highways.  Nevada has a $3.8 billion highway construction shortfall while a recent report noted that Oregon stands to lose $1.7 billion in income annually as a result of failure to invest adequately in transportation improvements.  The city of Chicago needs $6 billion to bring its subways into a “state of good repair,” while a Texas Department of Transportation report earlier this year indicated a $86 billion shortfall in Texas transportation funding over the next generation.  Louisiana’s backlog of road needs amounts to $14 billion.

Part IV

In the light of these looming challenges, how are states responding?  At the outset, it is important to stress that the option of raising taxes to fund these expenditures continues to be a politically radioactive approach that a majority of state policymakers have avoided.  Consequently, states have responded by seeking to sell or lease major state-owned assets, opting for toll roads, expanding gaming, increasing fees and raising tobacco taxes.

Selling or leasing state assets has emerged as a politically feasible option for policymakers and some of these proposals have included leasing highways; lotteries; student loan portfolios; state-run liquor stores; naming rights for transit stations; privatizing commuter railroads; airports; bridges; advertising space on bus shelters, newsstands, garbage cans; naming rights to stadiums.

Pursuing toll roads, closely connected to leasing public highways, is another popular option and one that is being promoted by the federal government in the light of the dwindling federal highway fund.  A number of states—from Alabama to Kansas to Virginia—are actively considering either expanding their current toll roads, increasing toll rates or introducing new toll roads.

Another popular state strategy to bring in more revenue: expand gaming.  Currently, every state except Utah and Hawaii, have some form of gaming to bolster state coffers.  Lotteries directed to fund education programs are particularly popular and several Southern states (North Carolina, Oklahoma and Tennessee) are the latest entrants to this arena. 

Hiking tobacco taxes is another favored tactic for additional revenue and since 2002, 43 states—including the tobacco strongholds of Kentucky, North Carolina and Virginia—have increased their cigarette tax rates more than 70 times.  In 2007, 11 states enacted cigarette tax increases.  Raising fees, such as Virginia assessing fees as high as $3,000 for reckless and drunken driving, are also gaining popularity.

Part V

In the midst of the significant challenges looming on the fiscal horizon for states, there are a number of bright sparks on the state economic front that reinforces that it is not all doom and gloom.  For instance, the automobile industry in the South has shown impressive resilience for some two decades now, a trend confirmed by the increasing number of foreign automakers setting up operations in the South. The most exciting news concerning the automobile industry and the South in recent months involved Toyota’s February 2007 announcement that it would invest $1.3 billion to build its eighth North American assembly plant in Blue Springs, Mississippi, in the northeastern corner of the state.  Toyota will soon join Nissan’s manufacturing plant in Canton, Mississippi.  In similar vein, Texas (Toyota); Georgia (Kia); South Carolina (BMW); Alabama (Mercedes, Hyundai, Toyota, Honda, Isuzu); Kentucky (Toyota); Tennessee (Nissan) all have operations that generate thousands of direct and indirect jobs and billions in economic impact.  The auto industry has really been an economic driver in the South.

Also, on the economic development front is the striking news from Alabama.  In recent months, the state announced that the German steelmaker ThyssenKrupp will establish a 3,500-acre, $3.7 billion facility that will employ 2,700 workers in Mobile and become the company’s flagship facility when it begins production in 2010.  Mobile, Alabama, also beat out 70 sites in 32 states, to be selected as the site for the EADS KC-330, the advanced tanker that will recapitalize the U.S. Air Force's aerial refueling fleet.  Total facility investment will $600 million and direct employment will be as much as 1,000 highly-skilled workers.  Then, a few weeks ago, a Canadian rail-car company announced plans to build a $350 million manufacturing facility in North Alabama that would create 1,800 jobs.

Biotechnology and stem cell research projects have also been pursued aggressively by states to spur economic growth.  California voted a few years ago to borrow and spend $3 billion over 10 years on stem cell research projects and research universities and non-profit labs in the state have already won hundreds of millions in grants.  In North Carolina, a $1.5 billion project is underway to convert a 350-acre site in a former mill town to a cutting-edge bio tech center.  Florida secured $310 million in funds to lure Scripps, the renowned California biotech company, to open a facility in Palm Beach County recently.  Governor Spitzer in New York also won legislative approval this spring to spend $600 million for stem cell research projects.  Connecticut is another state that is focusing on stem cell research and intends to spend $100 million over the next decade.  New Jersey and Illinois are also pursuing this strategy.  In January 2007, Texas announced plans to invest $3 billion over the next decade to become a global leader in cancer research.

On the technology front, Intel’s announcement a few years ago that it chose Chandler, Arizona (beating out two other states and two foreign countries) as the location for its newest manufacturing facility reiterated the company’s status as one of the state’s largest employers (some 10,100 employees).  The new $3 billion plant will create 1,000 new, high-paying jobs for computer engineers and technicians.

Ports, particularly in the South, have also seen a surge in activity that has generated a range of positive economic ripple effects.  Seven of the top 10 U.S. ports in terms of cargo volume and three of the top 10 U.S. ports in terms of container traffic are Southern ports, according to the latest statistics.  While U.S. ports and waterways handle more than 2 billion tons of domestic and foreign cargo annually, by 2020, the total volume of cargo shipped by water is expected to be double that of 2001 volumes.  Automobiles and the passenger cruise industry are also highly dependent on ports.

Another emerging trend on the economic development front has been state efforts to attract the motion picture industry to work within their borders.  Led by Louisiana’s incentive program in 2002, over three dozen states now have legislation to lure the film industry.  The estimated total output of the film industry in Louisiana—direct, indirect and induced outputs—has soared from $22.1 million in 2002 to an astounding $1 billion in 2005 and propelled the state to rank third in the number of films produced in the country (behind California and New York).

Finally, on the economic development front, a notable development has been the move to create regional alliances across state lines in securing major economic development projects.  States have realized the tremendous cumulative benefits of these partnerships, both in the bidding and post-bidding process.

Conclusion

In closing, even though the fiscal crisis that swept across states earlier on this decade has abated and the state revenue picture has improved, the severity of the crisis continues to haunt state finances.  In the short term, the impact of the economy on state finances remains mixed.  The aftermath of the recovery was characterized by growing GDP numbers, rising productivity and low interest rates even though experts project slower GDP growth this year and next.  The enormous federal budget and trade deficits, along with the specter of rising energy costs and raging turmoil in the housing market, will continue to impact state finances.  In the longer term, state finances will be roiled by the sharp structural changes that are in progress along with the major expenditure categories listed earlier that could cumulatively amount to a fiscal tsunami.  In anticipation of resolving these complex issues, state policymakers and citizens alike have to continue being at the forefront in seeking innovative solutions and policy experiments for these enormous challenges.  Thank you for your attention.

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