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State Fiscal Issues

Presentation at the 2010 Division of Insurance and Research Economist and Analyst Meeting Federal Deposit Insurance Corporation (FDIC) Dallas, Texas
October 7, 2010

click here to view the presentation

Sujit CanagaRetna
Senior Fiscal Analyst

Southern Legislative Conference of The Council of State Governments

It is a great honor to be here and my thanks to Eric and the FDIC for extending this invitation to me and to The Council of State Governments.  The Council, established in 1933 is non-partisan, serves all three branches of state government by fostering the exchange of insights, ideas and policies.  While I work for The Council’s Southern Office, the Southern Legislative Conference in Atlanta, the Council is headquartered in Lexington, Kentucky with regional offices in California, Illinois, New York and Washington, D.C.

My presentation this morning will cover five broad areas.   Part I highlights the fiscal position of states in the aftermath of the Great Recession while Part II highlights some state strategies to balance budgets and generate revenue.  Part III identifies several structural flaws in state tax systems that will continue to plague state finances going forward while Part IV explores some of the major expenditure categories looming on the state fiscal horizon.  Finally, Part V hones in on some of the “green shoots of growth” and the promising economic development projects that will contribute toward reviving state economies.

Part I: The Fiscal Position of States

States continue to warily recover from the Great Recession, the longest, broadest and most severe economic downturn since the Great Depression.  Even though the recession might have technically ended, the devastation caused by the Great Recession continues to batter state finances and will do so for a number of years.  The concurrent crises the U.S. economy faced during the Great Recession—output declines, revenue shortfalls, credit freezes and confidence drops--completely destabilized state economies.  It was almost as if Hydra, the multi-headed monster bore down on the U.S. economy.

Even before the extreme economic turbulence of fall 2008, many states were looking at a very depressed financial picture and the Great Recession only accelerated this trend.  While state revenues have improved from the depths to which they plunged to during the throes of the Great Recession, they are still significantly below prerecession levels.  Moreover, given that state revenues lag the national economic recovery by at least 12-18 months, states’ expectation of their return to peak revenue collections vary with some not expecting a return for at least another five years.

The latest state and local government revenue data released by the Rockefeller Institute indicates that state tax revenues expanded by 2.2 percent in the second quarter of 2010 compared to the same quarter a year earlier, the second consecutive quarter that states reported growth in overall tax collections on a year-over-year basis.  It increasingly appears that fiscal year 2010, the most recently concluded fiscal year in states, was the fiscal trough for state revenues and nearly every state is forecasting that their fiscal year 2011 revenues will exceed last year’s collections.  However, experts emphasize that this turnaround in state tax revenues should not be interpreted as a broad state fiscal recovery given that additional gaps loom ominously as states confront the phase out of federal stimulus funds, expiring tax increases and growing spending pressures.

In fiscal years 2009 and 2010, states closed budget gaps that totaled $302 billion while the cumulative shortfall for fiscal years, 2011 and 2012, is estimated to total another $300 billion.  While 46 states addressed shortfalls in enacting their fiscal year 2011 budgets, the current fiscal year, 32 of these states faced double-digit gaps as a percent of their FY 2011 budgets.  Alarmingly, 16 of these states had gaps exceeding 20 percent of their FY 2011 budgets with Nevada (54 percent) ranking at the top.

A review of the pre- and post-recessionary spending levels in the states, fiscal years 2008 and 2011, demonstrates how the Great Recession has fundamentally altered the relationship between state governments and citizens.  Specifically, state expenditures during this 4-year period declined by an average of 7 percent with 37 states experiencing a percentage decline, 2 states remaining static and only 11 states experiencing an increase.  Of the 37 states that experienced a decline, 22 experienced double-digit percentage declines.  Therefore, the Great Recession has forced states to enact a Great Transformation, a fundamental shift in the relationship between state governments and citizens brought on by the drastic reduction in the size of government.  Despite larger state populations and higher levels of need for services (such as Medicaid and unemployment insurance) between fiscal years 2008 and 2011, state spending has declined.

The perilous condition of state economies is further highlighted in a quick review of key economic data.  For instance, state unemployment rates have soared to heights not seen in decades.  According to the latest state unemployment data (August 2010), there were 13 states with double-digit unemployment rates led by Nevada (14.4 percent) and Michigan (13.1 percent).  Another disturbing statistic: the steep drop in per capita income; in 2009, for the first time since 1954, per capita income in the United States declined by 2.6 percent compared to 2008.   The two-year average median household income in the states between 2006 and 2009 indicates a decline of 3.2 percent with Georgia (13.1 percent) and Hawaii (10.4 percent) demonstrating the largest drops.  The nation’s official poverty rate in 2009 was 14.3 percent, up from 13.2 percent in 2008, the second statistically significant annual increase in the poverty rate since 2004, with real median income declining in the Midwest and West.  Finally, August 2010 information on foreclosure filings—default notices, scheduled auctions and bank repossessions—showed an increase of nearly 4 percent over the previous month, the 18th consecutive month when foreclosure activity exceeded 300,000 properties.  Filings in a number of states—Nevada, Florida, Arizona, California and Idaho—remain particularly challenging.

Part II: State Strategies to Balance Budgets and Generate Revenue

Given the constitutional requirement in 49 of the 50 states to balance their budgets, states have adopted a number of strategies to meet this condition.  Prior to describing some of these strategies, it is important to mention that raising taxes continues to be a politically radioactive move, an option policymakers at every level are loath to pursue.  Consequently, policymakers would rather adopt any other approach to balance their budgets, particularly in an election year.

  • Slashing Spending

As indicated earlier, states have enacted significant spending reductions to meet their balanced budget requirements.  Since 2008, 46 states have enacted cuts in all significant areas of state spending with 31 states reducing healthcare spending; 29 states slashing programs for the elderly and disabled; 33 states lowering K-12 education spending; 43 states cutting aid to colleges and universities; and 43 states shrinking their workforces.  In fact, since August 2008, states, localities, and school districts have eliminated 231,000 jobs.

  • Tapping ‘Rainy Day’ Funds

States have aggressively tapped their rainy day funds to balance budgets.  In the aftermath of the 2001 recession, most states worked proactively to build up their rainy day funds but in fiscal year 2011, 13 states are expected to completely exhaust their rainy day funds.

  • Expanding Gaming

Responding to the drop in gaming revenue last year —5 percent to 14 percent in taxes collected from lotteries, horse racing and casinos—at least 18 states have increased or are working on increasing the number of gaming options.  In New York, Governor Patterson proposed slot machines at the Aqueduct.  In New Hampshire, Governor Lynch pushed for a casino in the southern part of the state while in Florida, the federal government authorized Governor Crist’s gambling deal with the Seminole Indian tribe.

  • Raiding State Funds

Cobbling together one-time pots of money by raiding an assortment of trust funds scattered across state government was another tactic deployed to balance budgets.  The Legislature and Governor in Louisiana, for instance, corralled together $182 million from more than 40 dedicated funds to balance its fiscal year 2011 budget.  In Florida, House lawmakers proposed sweeping $798 million and Senate lawmakers proposed sweeping $295 million from multiple trust funds.  In Hawaii, lawmakers sought to raid city transit funds to balance the state budget.

  • Raising Taxes and Fees

Despite its extreme political toxicity, policymakers were forced to raise taxes and fees in recent years given their dire revenue position.  In fiscal year 2010, states raised a record $24 billion in taxes and fees even though a bulk of that revenue involved tax increases in California and New York.  For the current fiscal year, 2011, there are fewer tax increases in the works ($3.1 billion) given the fact that it is an election year.  Along with the sales and income tax hikes that went into effect in several states (Kansas, New Mexico, Arizona, Oregon), states have also raised cigarette taxes aggressively.  Since 2002, 47 states have increased their cigarette tax rates more than 100 times.  Washington, Colorado and Maine all enacted a soda tax to raise revenue, curb obesity rates and lower healthcare costs.

  • Leasing State Assets

Selling or leasing state assets for cash up front by entering into public private partnerships has emerged as a politically feasible option in many states for some years now.  This includes policies or proposals related to leasing highways for toll roads; lotteries; student loan portfolios; parking meters; state-run liquor stores; naming rights for transit stations and sports stadiums; commuter railroads; airports; bridges; and, advertising space on bus shelters, newsstands and garbage cans.

            Another important trend was the increased borrowing by states.  State net tax-supported debt increased by 10.3 percent from $417 billion in 2008 to $460 billion in 2009.  While there were a number of factors accounting for this sharp increase, the low interest rate environment was one of them.  Of note, median net tax-supported debt on a per capita basis in the U.S. increased from $865 in 2008 to $936 in 2009, or 8.1 percent.  Some states also engaged in deficit financing by refinancing their debt service payments coming due in the current year by borrowing, a practice frowned upon by the rating agencies.

Part III: Structural Flaws in State Tax Systems

While the adverse effects of the Great Recession remain very severe, the unfortunate conclusion is that even when the economy begins to tick, states will continue to face significant challenges on account of structural flaws in their tax systems.  These structural flaws currently pose, and will continue to pose, even more serious fiscal challenges in the future.   As a result, citizens will have to decide on what kind of state government services they want and whether they want to create adequate revenue streams to finance these state government operations or fundamentally reconfigure their expectations of state government.  There are three aspects to this conundrum:

  • Over the past few decades, the role played by services in the economy has grown tremendously.  The service sector is critically important because it accounts for about 80 percent of U.S. jobs and the consumption of services, at about $6.1 trillion a year, accounts for about two-thirds of total consumer spending.  Yet, sales taxes in most states do not cover a wide range of services.
    When state sales taxes were first introduced some 75 years ago, the service sector occupied a miniscule share of the overall economy with manufacturing and agriculture holding sway.  The following example drives home this point: in 1955, the top company on the Fortune 500 list was General Motors, a manufacturing company; some 55 years later in 2010, the top company on this list was Wal-Mart, a service company.  Despite this rapid movement towards a service-driven economy, the traditional state sales tax is applied to an increasingly shrinking proportion of economic activity.  In other words, states currently have 20th century tax systems in a 21st century economy.
    According to a 2008 Federation of Tax Administrators report, there are 168 different services taxed in the states across eight broad categories.   Only Hawaii, New Mexico and Washington have broad-based sales taxes that include a bulk of the services (160 and 158, respectively) while South Dakota (146), Delaware (143) and West Virginia (105) also have tax systems that cover most services.  Beyond these 6 states that tax more than 100 services, 19 states tax between 50 and 100 services and 25 states tax fewer than 50 services.  Utility services are taxed in most all states while admissions and repair services are taxed in many states.  On the other hand, fewer states tax personal and business services.  Professional services (doctors, lawyers, accountants, engineers) are taxed in only 7 states.
    Recently, in order to update their tax systems and account for the structural transformation in the economy, a number of states have moved towards broadening the sales tax to include services and mitigate the long-term decline of sales tax revenues.  In most of these instances, this effort has involved lowering the tax rate and then broadening the base of services captured by the sales tax.  Maine, North Carolina, Kentucky, California, Pennsylvania and Michigan are some of those states.
  • The explosive growth in e-Commerce transactions has profound impacts on many aspects of the contemporary economy.  U.S. retail e-Commerce sales exploded from a mere $8.3 billion in the first quarter of 2001 to an estimated $39.7 billion, in the second quarter of 2010, a remarkable increase.  Of note, the share of e-Commerce sales as a percent of total sales has also risen steadily: from 1.1 percent in the first quarter of 2001 to 4.1 percent in the second quarter of 2010.  Yet, due to U.S. Supreme Court rulings and federal inaction, state and local governments continue to lose sales and use tax revenues because of their inability to collect taxes that are due.
    Recent research by the University of Tennessee indicates that states and local governments lost and continue to lose billions of dollars as a result of this restriction.  Specifically, for the six-year period 2007 to 2012, the University of Tennessee study estimates that total state and local sales and use tax revenue losses from e-Commerce sales amount to an immense $52.1 billion.  In 2012 alone, the aggregate losses are estimated to be around $11.4 billion.  The nation’s larger states, California ($8.7 billion), Texas and New York ($3.9 billion) and Florida ($3.7 billion) all have staggering actual numbers but other states, Louisiana (5.9 percent), Illinois (5.5 percent) and Nevada (5 percent), are estimated to have the highest revenue losses in 2012 as a percent of their 2007 sales and use tax collections.
  • Given their dire fiscal positions, a number of states from Florida to Texas to Colorado to Georgia to Idaho to Kansas to Wisconsin to South Carolina to Washington, have recently initiated measures to first review and then consider eliminating some of the multitude of sales tax exemptions embedded in state tax codes.  While the presence of these sales tax exemptions underscores the influence of special interests, even a partial repeal could result in billions of dollars in new revenue for the states.

In sum, these important, fundamental shifts in the structure of our economy are affecting state fiscal systems and transforming them radically, a development that demands the attention of state policymakers and citizens alike in figuring out the specific services and programs they expect from their state governments and how they are going to pay for these programs and services.

Part IV: Looming Major Expenditure Categories

My presentation so far assessed the fiscal position of states and provided some details on the structural flaws that will continue to erode state finances even when the national economic recovery is more pronounced.  Unfortunately, there is more grim news.  What makes the state fiscal outlook quite daunting is that the current revenue shortfalls and huge budget gaps masks a number of enormous fiscal challenges looming in such areas as healthcare, education, public pensions, emergency management,  infrastructure, transportation and unemployment insurance.  At this point, state policymakers have kicked the can down the road but they will inevitably have to devise solutions to all these challenges too.

If I may briefly touch on two of these expenditure categories:

  • Public Pensions

This is an area I have done an extensive amount of research and it is quite apparent that our entire retirement architecture faces significant challenges.  Every element of our retirement architecture—Social Security and Medicare; corporate pension plans; public pension plans; personal savings—all face unenviable choices.  In terms of public pension plans, in February 2010, the Pew Center on the States documented that there is a $1 trillion gap between what states have promised their current and retired workers in pension, health care and other retirement benefits and what they have on hand to pay for them.

Based on these tremendous pension challenges, states across the country have begun lowering pension costs by trimming benefits.  Here are a few examples from this year.

In New Jersey, benefits levels were rolled back 9 percent for new hires and legislation was enacted to ensure that individuals can only collect a pension from one job in the statewide system.  The state also capped pension spiking by public safety and public works personnel who accumulate overtime by limiting to $15,000 the amount an employee can claim as pensionable income at retirement.  In addition, employees will also be required to contribute 1.5 percent of salary toward health benefits.  Another change was that pension credit will not be provided unless employees work at least 32 hours a week.

Illinois was another state that introduced major reforms this year.  New state employees must wait until they reach the age of 67 to receive full retirement benefits (previously the eligibility age was 62).  Another change placed a ceiling on pensions equal to the current Social Security earnings cap of $106,800 to curb abuses from pension spiking.

Colorado has imposed cuts on current workers, future hires and controversially, on employees who have already retired.  As a result, the retirees have sued to block the cutbacks.  Colorado is basing its legal defense, partially on a 1961 state supreme court ruling, that indicated that pension cuts for current workers were allowed if “actuarially necessary.”

California is another state pursuing cutbacks.  Governor Schwarzenegger, after discussions with several of the unions representing public employees in his state, lowered the state’s contribution rate and increased the amount paid by workers for their pensions.  Specifically, employees will contribute 10 percent of their pay, double the previous rate in some cases, to the state’s pension fund.  In pension circles, this new amount to be paid by employees is considered a sharp increase.

  • Unemployment Insurance (UI)

As a result of the severity of the Great Recession, the doggedly high unemployment rates in so many states and the actions taken by states (such as expanding benefits and cutting taxes), the UI funds in a majority of the states are in perilous shape.  The funds are being attacked at both ends: more people are tapping benefits while a fewer number of companies are paying taxes to replenish the funds.  The federal government forecasted in December 2009 that an estimated 40 state programs will be broke within two years and projected that these programs will need an estimated $90 billion in federal government loans to keep issuing unemployment checks.  Already, as of September 28, 2010, 31 states—ranging from California to North Carolina to Illinois to Rhode Island—have borrowed nearly $41 billion from the federal government to make benefit payments.

Based on different solvency measures reviewed by experts, Maine’s UI program is the best fiscal shape in the country.  This is the result of fundamental changes enacted in the state’s unemployment insurance tax about a decade ago by lawmakers, businesses and labor, through an “array system,” that bases the unemployment tax not only on the type of employer but also how frequently the employer accesses the trust fund.  While contribution rates within each schedule were linked to Maine wages, the maximum taxable wage amount was also increased.  In contrast to Maine’s system, the automatic triggers in a number of states are only activated when their funds are on the verge of going broke.  Consequently, in addition to securing emergency loans from the federal government, states are now raising taxes and/or slashing benefits.

Part V: “Green Shoots of Growth”

In the midst of all this gloom and doom, both in terms of the national economy and in terms of state finances, there are a number of encouraging economic development trends emerging in the states.  This is a strong reflection of the resiliency and vibrancy of the American economy and the astounding ability of the disparate elements within the U.S. economy to innovate, invent and improvise a way out of dire economic times.  It is also evidence of the entrepreneurialism that has always been at the core of the American economic model.  Consequently, documenting that it is not all gloom and doom is important and here are a fraction of the bright sparks and promising economic development projects from across the country:

Solar

  • In Tipton, Indiana, a location abandoned by the auto industry, will soon be the site of a solar panel manufacturing facility expected to generate 850 new jobs;
  • In Dublin, Georgia, a German company will set up its U.S. headquarters and manufacturing facility for solar modules and create 350 new jobs in the next five years;
  • In Oregon, the department of transportation will open the world’s largest “solar highway” with the installation of thousands of photovoltaic solar panels to power freeway lights by night;
  • In Senatobia, Mississippi, a solar panel manufacturing facility will open and create 512 jobs with a company investment of more than $175 million; and
  • Tennessee has emerged as a dominant player in solar industry manufacturing with three major facilities (in Clinton, in Clarksville and in Cleveland) in the last 18 months, totaling nearly $2.5 billion dollars in plant investments.

Wind

  • In Greenville, South Carolina, GE Energy has retooled its production facilities to manufacture wind turbine generators and has already shipped over 10,000 units;
  • In Akron, Ohio, the Karder Machine Company plans to build a $30 million plant to manufacture and assemble giant three-bladed wind turbines that will create 400 jobs initially and an additional 800 to 1,200 jobs after 18 months;
  • In Oregon, GE announced that it will supply wind turbines to what will be the nation’s largest wind farm, a $2 billion project that will employ 400 during construction;
  • In Fort Smith, Arkansas, Mitsubishi will construct a $100 million wind turbine manufacturing facility that will be operational by 2012 and employ about 400 workers; and
  • In Iowa, wind energy now accounts for up to 20 percent of the state’s total electricity production, a fact that allows the state’s power costs to rank among the lowest in the nation.

Bio Tech

  • In Kannapolis, North Carolina, at the site of the former Pillowtex factory which closed down after 100 years of operation in 2003, the N.C. Research Campus (NCRC), a $1.5 billion private-public venture sprang up designed to further knowledge in biotechnology, nutrition, agriculture, and healthcare.

Auto Industry

  • The “drive to move South,” i.e., the location of a number of foreign automobile manufacturers and an array of parts suppliers in nearly a dozen Southern states remains a major economic boost.  After the hiccups caused by the Great Recession, the auto industry in the South stands poised to take off again:
  • Nissan is spending nearly $2 billion to build a lithium-ion battery plant in Smyrna, Tennessee that will power the new mass-market electric car, the Leaf, which also be produced at the plant;
  • In June 2010, Toyota announced that it would resume construction at its $1.3 billion plant in Blue Springs, Mississippi, building compact cars and eventually hiring 2,000 direct employees;
  • In La Grange, Georgia, an automotive parts supplier announced a nearly $9 million investment that will result in 173 new jobs related to the Kia plant.  The new Kia plant in West Point, Georgia will create some 3,000 direct jobs;
  • In Charlotte, North Carolina, Celgard, the lithium-ion battery manufacturer for automobiles, continues to flourish and a recent expansion will lead to 200 new direct jobs and more than 1,000 jobs among contractors and suppliers; and,
  • Also, in the advanced battery sector, A123 Systems opened a new lithium-ion battery plant in Livonia, Michigan, employing about 300 workers while automotive supplier Johnson Controls, began shipping batteries from its Holland, Michigan facility that employs about 90 workers.

Information Technology and High-Tech

  • Dayton, Ohio’s Tech Town is taking shape at a former GM manufacturing site that will transform the beleaguered city’s economy into a center of aerospace, remote sensing and advanced materials expertise, cultivating both startups and industry veterans;
  • In Austin, Texas, Samsung recently announced a $3.6 billion chip plant expansion, adding 500 new jobs;
  • Gramercy, Louisiana will be the site of a $3.5 billion Nucor steel operation that will generate as much as 1,250 direct jobs at the completion of all phases;
  • In North Charleston, South Carolina, Boeing announced that it would build a new assembly plant to manufacture the 787 Dreamliner catapulting the state as an aerospace powerhouse, generating 3,800 direct and thousands of spinoff jobs;
  • Atlanta, Georgia is quickly becoming one of the nation’s hottest hubs for digital entertainment design and development, i.e., video games.  Video game sales now surpass movie sales and Georgia is home to more than 60 game companies and more than 2,000 college students enrolled in classes teaching video game design and development; and
  • In Columbia, Missouri, IBM announced that it would establish a new technology service delivery center and create 800 new direct jobs, the third such new IBM center in the last 18 months, with the centers in Dubuque, Iowa and Lansing, Michigan.

Conclusion

In closing, as foreboding as the severity of the Great Recession has been on both the national and state economies, there is a glimmer of optimism that we are moving in the right direction.  Undoubtedly, there is more anguish on the horizon given the depths to which the economy plunged, particularly for those facing foreclosure and those still unemployed and underemployed.  Policymakers at every level of government must remain vigilant to ensure that the ongoing recovery evolves into a self-sustaining expansion.  At the state level, policymakers have to heed the structural flaws corroding contemporary state fiscal systems and devise adequate responses based on what programs citizens expect from their state governments and how they are going to pay for them.  Redirecting the energies of our economy — beginning at the local and state levels along with engaging the federal government as a partner — will eventually generate broad-based, sustained economic growth in all sectors of the economy.  Thank you for your attention.

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