State Finances in 2008: Return to Red Ink Rising?

Presentation at the 2008 Alabama Legislative Symposium of the K-12 Coalition of Education Associations, Birmingham, Alabama
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Sujit CanagaRetna, Senior Fiscal Analyst

Southern Legislative Conference of
The Council of State Governments

It is a real honor to be here at the 2008 Legislative Symposium and my thanks to Susan Lockwood and Lisa Woodard at the School Superintendents of Alabama for inviting me and my colleague Jonathan Watts Hull to present at this session on state finances.  We 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.  While we work in 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.  Several members of the Alabama Legislature (Speaker Hammett, Senator Ted Little, Chairman Knight, Chairman McDaniel) have been critical players in the progress of the SLC and we greatly appreciate their support and interest.

My presentation this evening will provide a broad overview of national and regional economic trends and how they impact state finances.  Part I reviews national economic trends and demonstrate where states stand on the fiscal front.  Part II highlights structural issues confronting state finances while Part III explores some of the major expenditure categories looming on the horizon for states.  Part IV documents some of the strategies being deployed or being proposed by states to fund these sizable expenses and finally, Part V presents some of the bright sparks on the state economic front.

Part I

          A scant seven years after the last economic recession, there are ominous signs that another is around the corner.  The combined effects of a weakening labor market, slipping housing prices, tightening credit, rising fuel costs, drooping consumer confidence and declining manufacturing output continue to send shock waves rippling through the economy.  The latest (December 2007) employment report revealed that the economy generated just 18,000 jobs, the lowest level in more than four years; in the private sector, the job-creation tally was negative with some 13,000 jobs lost last month.  This pushed the unemployment rate to 5 percent, an increase from 4.7 percent in the prior month.  On the housing front, one of the major growth areas in the economy in the last few years, the news is dismal given the huge inventory of unsold homes and falling prices.  Construction of new homes was down nearly 25 percent in 2007, the largest drop in 27 years and by a whisker, the second biggest decline on record.

The sharp credit contraction, as lending institutions attempt to rally back from the huge losses they continue to incur over sub-prime mortgages, has already begun to crimp economic activity.  The price of oil hitting $100 a barrel a few weeks ago was striking, a steep increase from the $60 a barrel price in the summer.  In fact, the impact of the exploding energy market can already be seen in higher inflation rates; wholesale inflation, according to the Labor Department, shot up by 6.3 percent in 2007, the largest amount in 26 years while consumer prices rose by 4.1 percent in 2007, the largest amount in 17 years.  Then, U.S. consumer confidence, an important barometer of economic health, has plunged with consumer satisfaction with the economy reaching a 15-year low according to the Pew Research Center.  U.S. manufacturing output also declined for the second time in the final quarter of 2007—at the fastest rate since March 2003—as the level of new orders received shrank at the sharpest pace in over six years.  Retailers also suffered their worst December shopping season in five years last month, confirming that Americans cut back sharply on personal consumption, which accounts for 70 percent of the economy.

These disturbing trends have resulted in a number of entities from the Federal Reserve Bank to the Blue Chip Economic Forecasters to The Economist downgrading their gross domestic product (GDP) growth rates for 2008.  Cumulatively, these signs amount to a gloomy scenario with the likelihood of the economy lurching into a recession.  On the positive side, U.S. exports have surged ahead, aided by the free falling U.S. dollar, a development that has promoted state exports.

          All these factors cumulatively impact state finances and a number of states are struggling as they face severe revenue drop-offs and looming budget shortfalls.  Four states in particular – Arizona, California, Florida and Nevada – face recession-like conditions as a result of the fallout from the housing crunch.  Michigan has also been mired in recession-like conditions for some time now as a result of the declining automobile industry.  Unemployment rates are also noticeably higher in a number of states, compared to a year ago, specifically Connecticut, Hawaii, Illinois, Iowa, Minnesota, Montana, New York and Wisconsin.

According to the latest Fiscal Survey of the States even though states experienced stable finances in 2007, overall revenue growth has slowed and tighter fiscal conditions are expected in 2008.  In fiscal year 2008, the current fiscal year, states are only expecting a meager 2.9 percent increase in collections from sales, personal and corporate income taxes while state spending is expected to grow by 4.7 percent.

The most recent Rockefeller Institute revenue survey indicates that after adjusting for inflation, state tax revenues in last year’s third quarter were down by 0.6 percent, the first year-to-year decline in four years.  Then, the latest State Budget Update notes that the housing slump has adversely impacted revenue in 24 states while 18 states indicated that they are “concerned” about their revenue outlook, a tripling of the number from last year.  Also, as 2007 ended, 19 states reported that their overall sales tax collections were lagging forecasts for early 2008.  States in 2008 will also have less reserve funds than in the prior two years with state balances falling to an estimated $51 billion in FY 2008 from $67 billion in FY 2007 and the recent high of $81 billion in FY 2006.

Another December 2007 report indicates that 13 states, including several of the nation’s largest, face a combined shortfall of at least $23 billion for fiscal year 2009 with another 11 states expecting budget problems in fiscal year 2009 or the year after.  States expecting shortfalls in fiscal year 2009 range from California ($9.8 billion to $14 billion) to Nevada ($286 million) to Kentucky ($500 million) to New Jersey ($2.5 billion to $3.5 billion) to Rhode Island ($400 million to $450 million) to South Carolina ($300 million) to Virginia ($1.2 billion).  New York City alone is predicting a shortfall of $3.1 billion in fiscal year 2009, $4.6 billion in 2010 and $6.3 billion in 2011.  In fiscal year 2008, Tennessee expects a shortfall between $147 million and $250 million; also, in Kentucky, ballooning expenses and sliding revenue produced a $434 million hole in the current fiscal year.  Mississippi’s Medicaid program faces an $86 million shortfall in FY 2008.

In preparation for these shortfalls, several states have already enacted tax hikes: Maryland and Michigan both raised taxes substantially and cut spending for the current fiscal year.  The fact that these states raised taxes is very significant given the current anti-tax environment and is indicative of the gravity of the states’ fiscal position.  Florida, Kentucky, Maryland, Rhode Island, Wisconsin and Virginia have also cut spending while mid-year cuts have been proposed by the governors in Arizona, California, New Jersey and Nevada.  In Maryland, Governor O’Malley cut spending by $550 million in his FY 2009 budget, this on top of the $280 million in reductions achieved last July.  Governor Schwarzenegger declared a fiscal state of emergency in California last week and announced a series of radical measures including a $4 billion reduction in the state’s education budget, the early release and relaxed parole requirements for 22,000 state prisoners and the complete or partial closure of 45 state parks, among other measures.

Part II

          Alongside the declining revenue numbers, states also face a number of long-term structural problems that will plague their finances in the coming years.  First, the unfavorable effects of the long-term transition of the U.S. economy away from the manufacturing sector to one dominated by the service sector.  When state sales taxes were largely established in the 1930s, the manufacturing sector was the dominant force in the economy.  This is no longer the case.  A quick stat from FORTUNE magazine reinforces this point: 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.  According to recent data, service industries accounted for some 68 percent of the total U.S. GDP and 79 percent of growth in the GDP.  Despite this transformation, most state sales taxes do not apply to a bulk of services.  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 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 states that rely more heavily on sales taxes as a revenue source suffering the greatest losses.  The steady growth in the number of sales transactions over the Internet, estimated at 10 to 15 percent a year over the next decade, will pose further complications to state and local governments.

Part III

Flanking the challenges described above, states also face an increasing number of complex issues with substantial fiscal implications.  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, based on federal government data released earlier this month, national health spending soared to $2 trillion for the first time in 2006, the latest year available, doubling in the last decade and amounting to an average of $7,000 per person.  Health spending now accounts for 16 percent of total U.S. output of goods and services.  According to this 2006 report, even though Medicaid spending declined—by one percent—for the first time since the program’s creation in 1965, the decline involved the fact that drug costs for six million people shifted from Medicaid to Medicare.  Medicaid, which is jointly financed by the federal and states governments, still amounted to a staggering $311 billion in 2006.  Our changing demographic picture with the increase in the cohort of older Americans will pose additional obstacles 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 challenges.  A December 2007 Pew Center on the States report found that states have promised retired workers $2.73 trillion in pension, health care and other benefits over the next three decades; however, only about $2 trillion will be set aside.  Then, 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.  Furthermore, alongside the “graying” of America, the wave of baby boomers retiring 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.  State corrections budgets have skyrocketed in recent years and are often among the top two or three expenditure categories.  According to the 2007 SLC Comparative Data Report on Adult Corrections, in fiscal year 2007, the 16 SLC state adult corrections operating budgets amounted to nearly $13 billion; in the last 10 years, corrections expenditures in the SLC states increased by nearly 60 percent.

On the education front, states face serious challenges too, and I know my colleague Jonathan will expand on this topic.

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 Texas is looking at a $86 billion shortfall in 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 most 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, raising tobacco taxes and issuing huge amounts of debt.

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 and state-run liquor stores; privatizing commuter railroads, airports and bridges; leasing advertising space on bus shelters, newsstands, garbage cans; and, selling the naming rights to stadiums, university buildings and transit stations.  In this connection, it is important to mention the emergence of transportation-related public private partnerships (P3s) or contractual agreements formed between a public agency and a private sector entity allowing for greater private sector participation in the delivery of transportation projects.  While these P3s are not a new phenomenon, what is different now is that states are increasingly creating legislation that allow for these partnerships to gel.

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 Georgia to Indiana 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 bolstering 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.  There is movement in Arkansas to seek voter approval for an education lottery.  In Illinois, budget woes are driving lawmakers to authorize a land-based casino in Chicago; newly-elected Kentucky Governor Beshear has been a strong advocate of casino gambling in his state and projects $500 million in annual revenues.  Marylanders will vote on introducing 15,000 slot machines to their state this November with the potential to reap $650 million annually and Governor Deval in Massachusetts has been advocating casino gaming in his state with the possibility of securing $900 million in license fees from three new casinos.  In Florida, Governor Crist, a gambling opponent during his 2006 gubernatorial campaign, also inked a deal with an Indian tribe to expand gambling at seven casinos in exchange for hundreds of millions of dollars in payments to his state.  California voters will decide in a few weeks on allowing 17,000 new slot machines at tribal casinos with a projected income of about $400 million annually to the state.

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.

Issuing debt is another popular strategy pursued by states given their aversion to raising taxes.  According to Moody’s 2007 State Debt Medians Report, net tax-supported debt outstanding in the 50 states totaled $378.4 billion, a 5 percent increase from the prior year.  Since 1988, the long-term average annual growth rate of net tax-supported debt is 8.3 percent.  Going forward Moody’s estimates higher debt issuance given the revenue and spending challenges surfacing ahead.

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 $1.3 billion Toyota plant to be built in Blue Springs, Mississippi, is the latest entrant to the impressive roster of automotive plants in the South.  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 and Alabama’s record on this front is particularly impressive.

Alabama’ recent successes on the economic development front (ThyssenKrupp, EADS, National Steel Car and other projects) have also generated a great deal of positive buzz around the region and the country.  Biotechnology projects are also being pursued aggressively by a number of states.  Ports, particularly in the South, have 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.  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.

Another positive development that will assist states in dealing with revenue shortfalls: replenished rainy day funds.  After the fiscal downturn of the early 2000s and revenue and economic conditions rebounded, most states were diligent in building up their rainy day funds to shield against the next downturn.  In fact, some states have already begun drawing down on these funds.  Also on the positive front, several mineral-rich states (Louisiana, New Mexico, Alaska, Montana and Wyoming) continue to see revenue growth.

Conclusion

In closing, the national economic winds sweeping across the country have raised the specter of a recession in 2008 and the impact of the contracting economy is already being felt in a great number of states.  Several states are signaling record budget shortfalls this year and in the next, driven by the shrinking housing sector, rising energy prices and tightening credit market.  The slowing economy has been reflected in dwindling sales tax revenues, rising unemployment rates and falling manufacturing output overshadowed by sagging consumer confidence.  In the short term, states have either enacted or are preparing to enact a number of measures to bridge their budget shortfalls.  In the longer term, state finances are 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 a political environment where raising taxes is toxic, a vast number of states are pursuing public private partnerships to fund an array of urgent transportation and infrastructure projects.  In anticipation of resolving these complex issues, state policymakers and citizens alike have to continue being at the forefront in seeking innovative solutions and making difficult choices in meeting these enormous challenges.  Thank you for your attention.