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Fiscal Outlook for the States

Presentation at the 2009 SLC Legislative Service Agency (LSA) Spring Meeting, Miami, Florida, May 2009

click here to view the presentation slides

Sujit CanagaRetna
Senior Fiscal Analyst

Southern Legislative Conference of The Council of State Governments

Until quite recently, the outlook for the U.S. economy remained very grim.  While there continues to be grave and complex challenges looming on the horizon, a number of positive developments have surfaced in the past few weeks.  Notwithstanding these “green shoots of growth” on the dry, parched economic landscape and the diffuse rays of light indicating brightening economic indicators, we still have a very long way to go.  The goal of my presentation is to provide you with data and information related to the gravity of our economic challenges, some insights into what states are doing to cope with these tests, the results of an SLC survey on state finances and indications of bright spots visible in the distance.

The U.S. economy faces monumental challenges of the magnitude not experienced since the Great Depression.  Our economy has been ensnared in a recession since December 2007, a recession that has already exceeded the average length of all post World War Two recessions.  It will last well into 2009, making it the longest since the 1930s.  In terms of output, U.S. gross domestic product, GDP, fell at an annualized rate of 6.1 percent in the first quarter of 2009, the third straight quarter of declines that capped the worst six months of economic activity since the 1950s.  The national unemployment rate soared to 8.9 percent in April 2009, its highest rate point in a generation; the U.S. economy lost 539,000 jobs last month and the economy has shed 5.7 million jobs since the recession began 17 months ago.

There are several disturbing features about the current recession but the most alarming development is the fact that the U.S. economy faces concurrent crises on multiple fronts, a development not experienced in decades.  The roots of the current recession are traceable to the collapse of the housing and construction sectors and the mortgage meltdown that began in 2006.  In the aftermath of the 2001 recession, the housing and construction sectors played an increasingly important role in the economic recovery and ensuing growth in so many states.  Yet, these sectors have completely collapsed and homeowners across the country face tremendous pressures in meeting their mortgage payments or are “upside down” on their mortgages, i.e., their mortgages are greater than the value of their homes.

The latest S&P/Case-Shiller Index of National Home Prices, the leading measure of U.S. home prices, dropped by nearly 19 percent in February 2009 versus February 2008, with 10 of the 20 metro areas showing record rates of annual decline, and 15 reporting declines in excess of 10 percent.  Then, in the first quarter of 2009, foreclosure filings (default notices, auction sale notices and bank repossessions) were reported on over 803,000 properties, a 9 percent increase from the previous quarter and an increase of nearly 24 percent from the first quarter of 2008.  While one in every 159 U.S. housing units received a foreclosure filing during the quarter, Nevada continued to be the state with nation’s highest foreclosure rate this period, with one in every 27 housing units receiving a foreclosure filing — more than five times the national average.  Other states with foreclosure rates ranking in the top 10 in the first quarter included Arizona, California, Florida, Illinois, Michigan, Georgia, Idaho, Utah and Oregon.  In fact, five states (California, Florida, Arizona, Nevada and Illinois) accounted for nearly 60 percent of the nation’s foreclosure activity in the first quarter.

The complete collapse of the housing and mortgage sectors has resulted in an output crisis – or GDP crisis – causing severe revenue shortfalls at the government, corporate and individual levels.  In enacting their FY 2009 budgets, 29 states bridged shortfalls that amounted to $48 billion; an additional $53 billion in gaps opened up in 42 states during the middle of the current fiscal year.  For individuals, U.S. personal incomes fell 0.3 percent in March 2009; incomes have fallen in four of the last five months as employers trying to weather the recession cut pay, furloughed workers and slashed jobs by the thousands.

This recession is also characterized by a major crisis in the banking, financial and credit sectors with the nation’s economic landscape littered with the carcasses of storied but now defunct financial entities such as Merrill Lynch, Bear Stearns, Lehman Brothers and banks such as Washington Mutual and Indy Mac.  The freezing up of the credit markets, given that credit is the lifeblood of the U.S. economy, has posed severe restrictions to governments, businesses and individuals.  For a number of years now, credit flowed very easily but starting in October 2008, when the credit markets went through their initial round of “freezing,” accessing credit has proven to be very difficult.  State and local government new bond issues tumbled by more than 9 percent in 2008 with fourth quarter volume plunging by more than 33 percent, the lowest for any quarter since the first three months of 2002.  At the individual level, according to the Federal Reserve Bank, consumer credit decreased at an annual rate of 5.25 percent in March 2009.

The current recession has also sparked a crisis of confidence among investors, businesses and consumers.  Given that consumer spending accounts for over two-thirds of all U.S. economy activity, the deepening recession has only further throttled consumer confidence.  The U.S. Consumer Confidence Index stood at 26.9 in March 2009, a tiny increase from the all-time low of 25 in February 2009.  For the 2008 calendar year, the S & P 500 Stock Index, considered the most reliable measure of the broader market, lost nearly 39 percent of its value and the technology-laden Nasdaq posted its worst year ever, a nearly 41 percent drop.   The 2008 losses extinguished $7 trillion in shareholder wealth, the gains of the last six years.

While any one of these negative developments – output declines, revenue shortfalls, credit freezes, confidence drops – has the potential to stall the economy, all of them operating in concert – as they are now — has completely destabilized the U.S. economy.  In fact, it is almost as if Hydra, the multi-headed monster is bearing down on the U.S. economy.

Even before the extreme economic turbulence of fall 2008, states were looking at a very depressed financial picture.  For the upcoming fiscal year 2010, the situation has plunged to staggering depths and budget deficits are already projected in 44 states with initial estimates of these shortfalls totaling almost $105 billion.  While the full extent of the 2010 deficits are forecasted to equal $145 billion, when combined with the final six months of the current fiscal year and fiscal year 2011, or the 30 month period between January 2009 and June 2011, the cumulative budget gaps are estimated to total a mind-numbing $350 billion to $370 billion.  In fact, 47 states (Montana, North Dakota and Wyoming being the exceptions) currently face or will face shortfalls in their budgets for this and/or next year with these fiscal problems likely to continue the following year as well.  Already, 23 states are forecasting double-digit gaps as a percent of their general funds in their FY 2010 budgets with Nevada (30 percent), Arizona (29.8 percent), California (26 percent) and New York (24 percent) ranking high in this category.

On the unemployment front, states are looking at sizable challenges as unemployment rates soar to heights not seen in decades.  Based on March 2009 figures, the latest available, 35 states have an unemployment rate that is at or greater than 7 percent, an increase from the 22 states with that dubious distinction in December 2008.  The five states with the highest unemployment rates are Michigan (12.6 percent), Oregon (12.1 percent), South Carolina (11.4 percent), California (11.2 percent) and North Carolina (10.8 percent).  What is most disturbing about the current downturn is that states like Georgia, Florida, Nevada and Washington, all states that enjoyed bustling economic growth and ranked among the fastest growing in the nation for so many years, currently have unemployment rates well above 8 percent.

In terms of state responses to deal with the massive deficits looming on the horizon, policymakers have and are pursuing four broad strategies: One, slashing spending; two, tapping rainy day funds; three, expanding gaming; and four, raising taxes.

Cutting spending is the favored approach among many governors and lawmakers and some of the programs that have been cut include public health programs (28 states), K-12 education (26 states), programs for the elderly and disabled (22 states), colleges and universities (32 states) and state workforces (38 states).  In what has been described as the most widespread use of furloughs since World War II, nearly two dozen states in every region of the country are considering or carrying out mandatory state employee furloughs.

State rainy day funds are projected to reach $35.3 billion at the end of fiscal year 2009 and it is expected that states have and will continue to tap these funds to balance their budgets this year and the next.

Expanding gaming is also popular because it enables states to raise revenue without raising taxes.  While at least a dozen states added new gaming options or expanded existing ones in 2008, already in 2009, states as diverse as Hawaii, Maryland, Florida, Ohio, Wyoming, Nebraska, Maine, Kentucky, Pennsylvania, are considering both approaches.

In terms of raising taxes, as politically toxic as this strategy is, several governors and lawmakers have either enacted or proposed this approach to bridge shortfalls, a demonstration of the dire fiscal situation states find themselves in.  Consequently, at least a dozen states are considering or have enacted major increases in sales and/or income taxes.  Another proposal gathering steam across the country involves pushing top income earners into higher tax brackets.  Several states have also initiated discussions on reforming their tax systems (North Carolina, Kentucky, for instance) while others now cover more services in their sales taxes (vet services in Rhode Island, software and cell phone ring tones in Kentucky) along with discussing removing sales tax exemptions (graphic arts equipment and coffee products in Illinois and a host of products from Super Bowl tickets to bottled water in Florida).  A number of states have also proposed and/or hiked corporate income taxes.  Finally, we are also seeing a blizzard of fees sweeping the country.  The governor’s budget in Florida included increases to 22 fees to generate $529 million and in New York, the governor’s budget called for 88 new fees or fee hikes.  From raising hunting licenses to vehicle registration to rental car charges to motor fuel taxes, fee hikes have quickly emerged as a viable strategy.

There are also proposals and enactments in at least 16 states to hike cigarette taxes including Mississippi, Florida, South Carolina, Kentucky, Wisconsin, Arkansas, Illinois, North Carolina and Rhode Island to fill gaping budget holes or fund programs.  Higher taxes on alcohol are another trend and New York and Kentucky already did this while proposals are either in place or pending in California, Hawaii, Massachusetts, Michigan, Nevada, New Jersey, North Carolina and Oregon.

Another important factor that makes the state fiscal outlook quite daunting is that the current revenue shortfalls and huge budget gaps masks a number of enormous fiscal challenges states will have to grapple with in such areas as healthcare, education, public pensions, emergency management,  infrastructure, unemployment insurance and transportation.  States will have to contend with these significant challenges once the current crisis abates.

Now, on to a quick overview of the results of a fiscal survey we sent out to the SLC states.  We received responses from 12 of the 16 SLC states and our sincere thanks to all those who participated at a terribly busy time.  Copies of the survey responses are in front of you.

Question 1 sought to determine the extent of the FY 2009 budget shortfalls in dollar terms and as a percent of general fund.  South Carolina’s $1.1 billion and Virginia’s $2.4 billion shortfalls (16.3 percent and 13.9 percent of their respective general funds) ranked high.  Texas did not have a shortfall in FY 2009 while Oklahoma enjoyed a $290 million surplus, as of April 2009.

Question 2 inquired about steps enacted to address FY 2009 shortfalls and 9 of the 12 reporting states indicated budget cuts of various degrees.  For instance, South Carolina will impose $1.1 billion in cuts while Georgia will impose cuts of between 8 percent and 10 percent at most agencies.

Question 3 queried expected shortfalls in FY 2010 and 2011.  Georgia estimates a $2.6 billion shortfall in FY 2010 (12.3 percent of general fund) while Maryland estimates a shortfall of $716 million (5 percent of general fund) in FY 2010 and $1.2 billion (8 percent of general fund) in FY 2011.

In terms of addressing these FY 2010 shortfalls, Question 4 determined that the governor in Alabama has sought 10 percent in cuts at all agencies and that Oklahoma agencies are looking at reductions between 3 percent and 10 percent.  All South Carolina agencies, with the exception of K-12, Higher Education and Public Safety, will see a reduction of 13.8 percent.

Question 5 sought to determine whether state budgets are expected to shrink between FY 2009 and FY 2010 and several states (Kentucky, Maryland, North Carolina, Oklahoma, South Carolina and West Virginia) reported that such a decline was possible.

Question 6 involved revenue generating measures and several states indicated hiking cigarette taxes (Arkansas, Kentucky and Oklahoma) while South Carolina and Oklahoma indicated fee increases.  Additional states (Alabama, Arkansas, Maryland, Texas and West Virginia) noted either the possibility or enactment of expanded gaming.

Question 7 dealt with sizable expenditure categories (healthcare, education, pensions, transportation) looming on the horizon and plans to address these items.  Several states reported that efforts to fund these expenditures will not see progress in FY 2010 (Maryland, Oklahoma, Texas, Virginia) while Arkansas and West Virginia noted recent pension fund losses and difficulties faced by their unemployment insurance funds.

Question 8 inquired about SLC states deploying federal stimulus funds to mitigate the impact of budget shortfalls.  Ten of the 12 responding states indicated that they have either deployed or intend to deploy federal stimulus funds to offset their shortfalls.  Mississippi and West Virginia, the two remaining states, will grapple with this issue when they conclude their 2009 legislative sessions shortly.  The South Carolina General Assembly is embroiled in a battle with Governor Sanford over the use of federal stimulus funds.

The final question, Question 9, sought information on any economic bright sparks and 8 of the 12 reporting states indicated they did not have such projects.  Arkansas noted that the state had not been impacted by the recession as much as other states and that the presence of Wal-Mart ($400 billion in annual sales) headquartered in the state and the discovery and development of the Fayetteville natural gas shale in northern Arkansas was estimated to generate 4,500 jobs and a $2.3 billion economic impact.

Now, to address the “green shoots of growth,” a phrase coined by Fed Chairman Ben Bernanke.  In the past few weeks, there have been a series of economic indicators demonstrating that the nation’s outlook is not completely suffocating from the weight of dour economic news.  In fact, recent data suggests that the pace of contraction in a number of sectors may be slowing.  Specifically, the following leads me to conclude that the economy is close to bottoming out and that we can now begin the long and bumpy road to more balanced growth.  Nevertheless, it is important to emphasize the following: any state economic recovery is likely to lag the national economic recovery; consequently, state revenues will continue to struggle well into fiscal year 2010 even after the national recovery is in progress.  Among the glimmers of hope are the following:

  • The Federal Reserve Bank statement in late April that “the pace of economic contraction was somewhat slower” and Chairman Bernanke’s statement earlier this week that the economy appeared to be stabilizing on many fronts even though he cautioned that a recovery was still months away.  In addition, the Fed’s latest Beige Book reports indicated that while overall economic activity contracted further or remained weak, 5 of the 12 Fed Districts noted a moderation in the pace of decline, and several saw signs that activity in some sectors was stabilizing at a low level.
  • Several positive nuggets from the housing sector indicating that the rate of decline in this sector may be slowing.  First, even though the latest S&P/Case-Shiller Index of National Home Prices indicated a drop by nearly 19 percent in February 2009, it was the first time in 16 months that the slide in housing prices did not accelerate.  Second, according to the National Association of Realtors, while existing home sales declined 3 percent in March compared to the previous month (better than expected), first-time buyers responded strongly to low mortgage rates, plentiful inventory and tax credits; they accounted for 53 percent of all transactions.  Third, the National Association of Realtors also reported earlier this week that the number of homes with signed contracts that had not yet closed increased 3.2 percent in March from a month earlier, slightly higher than a year earlier.  In particular, the Pending Home Sales Index in the South in March was 7.7 percent above a year ago.
  • The U.S. Commerce Department reported earlier this week that construction spending rose unexpectedly in March after five straight declines, the best showing since a rise last September.
  • Orders for durable goods, big-ticket manufactured goods, dropped by 0.8 percent in March 2009, about half the decline that economists expected.  In February 2009, orders increased by 2.1 percent; that was the first gain after six straight monthly declines.
  • State and local government credit markets have loosened up.  Municipal debt raised in the first quarter of 2009 totaled $84.4 billion, almost on par with the first quarter of 2008.  Leading the charge was the $6.85 billion bond issue by the state of California in late April that will jump-start 5,000 public works projects.  An SLC state, Georgia, sold $315 million in tax exempt bonds this week, following a $613 million bond sale in February 2009.
  • Consumer spending grew by 2.2 percent for the first quarter of 2009, after two consecutive quarters of declines (though it dropped by 0.2 percent in March 2009).  Consumer spending accounts for 70 percent of all U.S. economic activity.
  • According to the Institute for Supply Management, U.S. manufacturing activity ticked up in April for the third straight month.  Although the overall industry still remains in contraction, the pace of contraction was slower than at any time since September 2008.
  • Consumer confidence rose in April 2009 to 39.2, its highest level in 2009 while a McKinsey survey of global executives in late April 2009 indicated that they were slightly more positive about the economic picture than they were just six weeks ago.
  • Finally, even though I do not consider it a substantial measure of the economy’s health, April 2009 was Wall Street’s best month in 9 years.  U.S. stocks gained nearly $1 trillion in value, on paper.  The S & P 500 Index climbed 9.4 percent in April, its best performance since March 2000, and the nearly 19 percent gain in March-April is its best two month rise since 1975.  Indicating the global nature of this market recovery, The Economist magazine noted that two-thirds of the 42 global stock markets it tracked had also risen by 20 percent between mid-March and end April.

In closing, as foreboding as the severity of the ongoing recession has been and will be on both the national and state economies, there is a glimmer of optimism that there are nascent signs that we might be nearing the bottom.  Undoubtedly, there is more anguish on the horizon given the depths to which the economy has plunged and we will continue to see more foreclosures, more job losses, more hurdles in accessing credit, weak business investment and wrenching economic pressures in a number of other areas.   Nevertheless, it is not all gloom and doom and there are a number of bright sparks and promising economic development efforts in many states.  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 country.  Thank you for your attention.

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