State Fiscal Crises

Causes, Consequences, & Solutions

April 3, 2003

The Urban-Brookings Tax Policy Center, the Kellogg School of Management and the Institute for Policy Research at Northwestern University, in conjunction with The National Tax Association hosted a conference examining the current state fiscal crises.

The conference was divided into three sessions: Overview and Causes, Consequences and Solutions, and Special Analyses, followed by a roundtable discussion. Links to papers and presentations from each session are listed below.

Session One: Overview and Causes

Moderator: Therese McGuire, Professor, Kellogg School of Management and Faculty Fellow, Institute for Policy Research, Northwestern University

• A Summary of What We Know — And Don't — About State Fiscal Crises
  Therese J. McGuire (Northwestern University), C. Eugene Steuerle (The Urban Institute)
  
  Seemingly every day the media chronicles the dire fiscal straights facing virtually every state government. For many states, the deficits they face are unprecedented in size and persistence. And yet it seems we have been here before. At least once a decade in the past 30 or so years, the economy has taken a downturn, and state revenues have failed to keep pace with state expenditures. Despite the creation of "rainy day funds" in most states, policymakers continue to be caught unprepared each time the economy falters.
• Problems and Prospects for State and Local Governments
  Brian Knight (Brown University), Andrea Kusko (Federal Reserve Board), Laura Rubin (Federal Reserve Board)
  
  Using data from the National Income and Product Accounts, this paper analyzes the recent budget crisis in the state and local sector. Two factors primarily external to the sector-the economic slowdown and the decline in capital gains realizations-explain roughly one-third of the swing from surplus to deficit between 1998 and 2002 and two thirds of the swing between 2000 and 2002. However, policy and other factors, including tax reductions enacted by state governments and the recent acceleration in Medicaid spending, also have played an important role. In a historical comparison, we find that macroeconomic factors have played a less important role in the current crisis that they did in the crises of the early 1980s and early 1990s. [View conference presentation]
• Cyclical Variability in State Government Revenue: Can Tax Reform Reduce It?
  Russell Sobel (West Virginia University), Gary Wagner (Duquesne University)
  
  Slowdowns in economic activity tend to significantly reduce state tax revenue growth, making it difficult to fund existing programs. This paper outlines tax reforms that policymakers may pursue to ease periods of fiscal stress. States can reduce the variability of revenue from the two most important sources, sales taxes and income taxes, by eliminating exemptions for food purchases and relying on a less progressive income tax. In addition, expenditures that are difficult to cut during downturns should be financed with stable revenue sources, while more variable revenue sources should be used to finance programs that can be cut more easily. [View conference presentation]
• Three Characteristics of the Tax Structures have Contributed to the Current State Fiscal Crises
  William Fox (University of Tennessee)
  
  State tax revenue growth slowed in 2001 and nominal tax revenue actually declined in 2002, the first decline in at least 30 years. The personal and corporate income tax and the sales tax all yielded lower revenues in 2002 than in the previous year. Three characteristics of the tax structure have been important factors in the revenue decline. First, the corporate income and sales tax bases are eroding, and this process accelerated during the past several years. Second, state tax structures are pro-cyclical. Third, except for the personal income tax, state taxes are inelastic. States could have lessened the impacts of the significant revenue slowdowns by building larger rainy day funds in the 1990s, when revenues were growing faster than personal income. [View conference presentation]

Commentator: Raymond Scheppach, Executive Director, National Governors Association

Session Two: Consequences and Solutions

Moderator: Noah Berger, Executive Director, Massachusetts Budget and Policy Center

• State Rainy Day Funds and the State Budget Crisis of 2002-?
  Christian Gonzalez (The World Bank), Arik Levinson (Georgetown University)
  
  U.S. states entered the 2001 recession better prepared than for any recession in recent decades. Forty-seven states had established "rainy day" funds, which when added to general fund balances amounted to over 12 percent of annual expenditures. Despite this, the National Governors Association has said that "states face the most dire fiscal situation since World War II" (NGA, 2002a). We consider five potential explanations for this discrepancy: (1) state budget crises are exaggerated, (2) state tax bases have changed, (3) state rainy day savings replace existing savings, (4) state savings are dwarfed by state budget cycles, and (5) a late-1990s tax revenue bubble. [View conference presentation]
• Rainy Day Funds and Value at Risk
  Gary Cornia (Brigham Young University and the Lincoln Institute of Land Policy), Ray Nelson (Brigham Young University)
  
  The state fiscal challenges created by revenue shortfalls during the most recent economic slowdown have revealed the inadequacy of rainy day funds. The revenue declines in states whose fund creation employs heuristically derived rules-of-thumb have painfully revealed the need for more formal methodology that can prescribe the size of rainy day funds. Well-developed methodologies exist for similar managerial problems encountered in private enterprise. If decisionmakers see rainy day funds as forecaster indemnity insurance policies, then the risk literature provides a rich menu of accepted methodologies that help gauge the size of revenue risks and their commensurate insurance coverage. Subsequent reviews of the value at risk and insurance funding literatures give methodologies applicable for determining the optimal rainy day fund size. These methodologies are finally illustrated using current state fiscal situations. [View conference presentation]
• Tax Policy Responses to Revenue Shortfalls
  Elaine Maag (The Urban Institute), David Merriman (Loyola University, Chicago)
  
  We compare state tax policy responses to the recessions that began in July 1990 and April 2001. Tax revenue declined more in the 2001 recession even though the output shock was smaller. In the early 1990s, states quickly altered tax policy to replace a large share of lost tax revenue. In the recent recession, states have made few tax policy changes to enhance revenue except for increasing tobacco taxes. We present some reasons for this behavior and argue that states are on the verge of missing an opportunity to improve their tax systems. [View conference presentation]

Commentator: Iris Lav, Deputy Director, Center on Budget and Policy Priorities

Session Three: Special Analyses

Moderator: David Brunori, Contributing Editor, State Tax Notes

• The Impact of Pension Funding on State Government Finances
  Fred Giertz (University of Illinois, Urbana and the National Tax Association)
  
  Pension funding issues have an important, but often hidden impact on the finances of state governments. If pension systems are underfunded, governments must address this problem sooner or later through additional contributions to the systems.
  
  Capital gains have had a dramatic impact on state tax revenues in the last decade. However, the indirect effects of capital gains on state finances through state pension fund growth and decline have had an even greater, but overlooked effect on the long-term fiscal health of states.
  
  The last ten years has seen the rapid growth of state pension asset followed by two years of decline. Changes in pension fund asset/liability relationships have generated problems for states that are much larger than the current state budget shortfalls.
  
  Pension funding issues do not have the immediacy of the state budget shortfalls, but they must be considered when states address long term structural imbalance problems. [View conference presentation]
• The Implications of State Fiscal Stress for Local Governments
  Andrew Reschovsky (University of Wisconsin-Madison)
  
  Recent reports suggest that between now and the end of fiscal year 2004 state governments' budgetary shortfalls will exceed $100 billion. To balance their budgets, states are planning large cuts in state spending. This paper explores the likely fiscal impacts of these budget cuts on local governments and school districts. Limited evidence suggests that states will enact substantial cuts in state aid and will shift responsibilities to local governments without transferring adequate resources. The paper also explores how local governments and school districts are likely to respond to sharp reduction in state resources. [View conference presentation]
• Capital Gains: Its Recent, Varied, and Growing (?) Impact on State Revenues
  David Sjoquist (Georgia State University), Sally Wallace (Georgia State University)
  
  State governments derive their revenue from a number of sources, with the individual income tax being one of the most important. Fluctuations in economic activity, particularly in the level of wages and capital income, will influence the level of revenue generated from the income tax. This paper analyzes the impact of recent trends in capital gains realizations on state income taxes. We look at the growth of capital gains relative to the overall tax base and find that the significant growth in capital gains in the 1990s has added to the fiscal pressure that states now face. [View conference presentation]

Commentator: James Nowlan, former President of the Taxpayers' Federation of Illinois