THE FUTURE OF STATE BUDGETS

DAN WHITE

ECONOMIST MOODY’S ANALYTICS daniel.white@moodys.com

STATES CAN’T KICK PROBLEMS DOWN THE ROAD ANYMORE Policymakers Must Address Near-Term Issues, Long-Term Structural Imbalance

Over the past three fiscal years, state budgets have undergone a period of extraordinary distress. The onset of the Great Recession brought enormous economic uncertainty, highlighted by plummeting state tax revenues. As a result, policymakers were forced to implement tax increases as well as make almost continuous cuts to programs and personnel within even the most sacrosanct areas of state budgets.

These actions, combined with significant assistance from the federal government through the American Recovery and Reinvestment Act of 2009, have been able to at least temporarily stem the tide of rising deficits. Now the national economy and state revenues are in a fragile state of recovery, but instead of breathing a collective sigh of relief, states are bracing themselves for even larger fiscal challenges.

In the near term, states face a shaky revenue picture coupled with the impending expiration of the remaining federal Recovery Act funding initiatives. State revenues will grow throughout the 2011 fiscal year, although at a more moderate pace than most states originally forecast. Then, as the national economic recovery accelerates, so too will growth in tax collections.

However, growth will not be substantial enough to offset the 2012 fiscal year expiration of the remaining Recovery Act assistance programs. Subsequently, most states will see deficits continue into the 2012 and 2013 fiscal years. While the Recovery Act assistance programs were of paramount importance to balancing budgets, they were ultimately intended as a temporary solution, allowing states time to more deliberately and systematically address fiscal deficits without shocking the economy further.

Unfortunately, a majority of states relied too heavily on this assistance and failed to address long-term structural fiscal issues, which the recession amplified. During the 2009 and 2010 fiscal years, aggregate state tax revenues declined approximately $80 billion, according to the Nelson A. Rockefeller Institute of Government. However, during that same time period, states actually closed collective budget deficits in excess of $300 billion, according to a report from the Center on Budget and Policy Priorities.

Portions of the difference can be attributed to declines in nontax forms of state revenue and cyclical enrollment increases within Medicaid and other social assistance programs. However, most of the difference represents growing structural deficits within state budgets from organic growth in the demand for state services to everincreasing pension and retirement obligations.

These challenges, particularly those facing states in the near term, must be addressed with great care and consideration for the fragility of both the local and national economic recoveries. If not, some states run the risk of falling back into recession and taking the broader national economy with them.

The national unemployment rate is already likely to return to double digits in coming months, and a number of states are still in recession or are seeing their recoveries stall. Subsequently, chances of a national double-dip recession over the next 12 months have steadily increased since earlier this year from 1-in-5 to 1-in-3.

Policymakers must simultaneously address these near-term issues as well as long-term structural imbalances that they have kicked down the road for too long. Striking the proper balance between these two priorities will be difficult but imperative to ensuring the future fiscal health of state governments for years to come.