State Budgets Under Pressure: Is this the New Normal?

As Congress debates the future of the ACA and Medicaid funding, one question looms large: What will proposed changes mean to state budgets that are already under significant pressure?

On July 6th, after protracted wrangling, Illinois enacted its first budget in two years. Maine and New Jersey experienced brief shut downs and Washington narrowly avoided one. As of July 7th, six states still had no approved budgets even as July 1st marked the start of a new fiscal year in most states.[1] These “down to the wire” budget negotiations create unnecessary expenses for state programs (as contingency plans are made) and uncertainty for individuals who rely on these services. Is this the new normal?

Overall, the projected increase in state general fund revenues in FY18 is only one percent – the smallest increase since 2010 in the depths of the recent recession.[2] State revenue from personal income and corporate taxes are generally down, although there is wide variation across the states. In times of tough state budgets, federal funding takes on added significance. In 2014, federal funds represented almost 31 percent of states’ revenues, nationally.[3] And threats to these funds will have serious implications for states.

Even under the best of circumstances, the state budget process is a challenging one for governors and legislatures. While not always recognized as such, the budget is inherently a state’s most important policy legislation, reflecting the priorities and values of the governor and lawmakers. Because most states must balance their budgets,[4] these policy debates play out within the context of economic constraints and competing demands. It seems that the budget process has grown more difficult in recent years, with state policymakers working harder than ever to come to consensus on a blueprint for the right balance between revenues and expenditures.

There are myriad factors that influence state budgets but a primary constraint is revenue. The revenue source over which states have the most control are state taxes and fees (income taxes, sales taxes, licensing fees, and so on), but that revenue picture has been relatively soft for the past few years. States relying on natural resources extraction like North Dakota, Oklahoma, West Virginia, and Wyoming have seen a good deal of volatility in their tax revenues. But other states not dependent on natural resources have also experienced considerable declines; those declines are primarily attributable to changes in income tax rates.

Although the economy is generally recovering from the recession, state treasuries continue to feel the effect of that downturn. Over the course of CY2016, total state tax revenue from personal income tax fell, in real terms, 1.1 percent year over year. Again, there is variability across the country with some states like South Carolina seeing marked increases and others such as North Dakota seeing large declines.[5] Sales tax revenue is usually a stable revenue source, but even those dollars increased overall by less than one percent in 2016 as compared to the year before, with large fluctuations from state to state. The largest declines were seen in resource-dependent states. States with upward trends in sales tax had instituted rate increases or broadened the base of sales tax to boost revenue collections. Corporate tax revenues are notoriously volatile. Still, nationally, state corporate tax revenues declined 9.3 percent last year as compared to 2015, with 77 percent of the 44 states having broad based corporate taxes reporting real declines in that revenue.[6]

Revenue performance in the current year remains sluggish. According to survey data collected by the National Association of State Budget Officers, mediocre revenue performance led to midyear budget reductions across states of about $5 billion last year – again, the highest mid-year correction since 2010 – with all states reporting general fund revenues falling below forecasted levels.[7] In the current fiscal year (FY17), 33 states are reporting seeing general fund collections from all sources (income taxes, sales and other taxes, as well as fee income) falling short of forecast again.

The still-soft revenue picture, combined with increasing spending pressures and uncertainty about the direction of the federal government ‘s spending priorities (including major initiatives like health care and tax reform) led governors to be quite cautious in their budget proposals this year. Overall, governors’ budgets proposed a one percent increase in general fund spending for FY18 over FY17 – the lowest increase since FY10.[8] Many proposed budgets and many enacted budgets included “revenue enhancers” like tax increases intended to help close the states’ budget gaps and rebuild rainy day funds.

Some of the problems states are experiencing are a result of the hangover the country is still feeling from the Great Recession – even though we are seeing improved economic performance, revenues haven’t yet caught up. Some states, 11 of them since 2011[9], enacted substantial tax cuts – oftentimes phased in over a number of years— in an effort to stimulate their economies. Now, however, significant, projected budget gaps are threatening not only the future of those tax cuts, but also a range of state programs that are facing large funding shortfalls.

States are also grappling with the difficult problem of long-term commitments. Apart from debts for infrastructure and other similar investments, states are grappling with the issue of unfunded liabilities for both state employee pensions and for state retiree health benefits. Pew reports that in 2013, states owed almost $970 billion in unfunded pension liabilities – just about six percent of total state income in the US. Retiree health liabilities in the same year were reported to be $587 billion.[10] Outstanding debt came in third, at $518 billion. Importantly, bond debt is used to finance projects that will return value and service to the public for some time in the future. Unfunded liabilities, in contrast, are obligations related to services provided in the past, with no true future value.

The unfunded liabilities along with sustained deficits caused by changes in tax policy, a soft economy and rising costs, lead to “structural gaps” in state budgets. Forty-nine out of 50 states must balance their budgets, leading to an obvious but vexing problem – either spending must be cut or revenues must be increased in order to fill that gap. Importantly, structural gaps – long standing deficit issues that are tough to resolve – have real implications.

Leading rating agencies have warned about the consequences of fiscal instability. One of the major rating agencies recently noted publicly that it would consider downgrading Illinois’ bond rating to junk status if a reasonable solution to the state’s long standing budget crises could not be found. [11] Uncertainty about a state’s total revenue picture – including the outlook for state tax and fee revenue, the level of federal funding coming into the state, projected growth in expenditures, and so on – can cloud a rating agency’s view of the state’s ability to take on additional debt and remain able to satisfy all of its debts, leading to a downgrade in bond ratings. Although most states have constitutional or statutory obligations to pay bond debt first, budget issues and fiscal instability can easily have a negative impact on a state’s bond rating. Downgrading a rating is something every lawmaker and every governor wishes to avoid – since it results in higher borrowing costs for the state, further exacerbating budgetary problems.

Congressional proposals would significantly lower federal Medicaid funds available to states and the President’s budget outline contemplates even further reductions in federal spending. Proposed cuts to Medicaid and public health programs will have repercussions at the state level. And cuts to federal funding for infrastructure, education, environment and other programs will leave state lawmakers with even larger budget gaps to fill, if they want to maintain current programs. If enacted as proposed, these reductions in federal funds will have the effect of shifting more of the fiscal burden to state budgets, creating even greater tensions at the state level over budget development and negotiations, and potentially threatening bond ratings and borrowing capacity. The conditions within the states that lead to brinksmanship budgeting – lower than forecasted revenues, structural gaps, unfunded liabilities, concern about bond ratings, competing priorities on spending and revenue- will be further exacerbated by reductions in, or uncertainty about, federal revenues. Indeed, if the Congress significantly reduces Federal investments in states, the budget challenges states are experiencing could be long term and even more challenging.

[1] http://www.ncsl.org/research/fiscal-policy/fy-2018-budget-status.aspx, accessed June 27, 2017.

[2] http://www.nasbo.org/reports-data/fiscal-survey-of-states, accessed June 25, 2017.

[3] Stauffer A, Theal J. Federal Funds Supply 30.8 Cents of Each State Revenue Dollar. The Pew Charitable Trusts. July 28, 2016. Accessed online on July 10, 2017 at: http://www.pewtrusts.org/en/research-and-analysis/analysis/2016/07/28/federal-funds-supply-308-cents-of-each-state-revenue-dollar

[4] 45 states have a Constitutional obligation to balance budgets and four have a statutory obligation to do so. Only Vermont has no such requirement.

[5] http://apps.urban.org/features/state-economic-monitor/

[6] Ibid.

[7] It is important to note that mid-year budget reductions are not always made as a result of falling revenue; to be fair, some reductions are made to reflect lower than expected costs.

[8] The Fiscal Survey of States: Spring 2017. The National Association of State Budget Officers. Accessed online July 3, 2017 at: https://www.nasbo.org/mainsite/reports-data/fiscal-survey-of-states

[9] https://www.washingtonpost.com/national/its-not-just-new-jersey-and-illinois–many-states-are-facing-budget-trouble/2017/07/07/220061dc-6196-11e7-a4f7-af34fc1d9d39_story.html?utm_term=.6b288c680a0d

[10] Fiscal 50: State Trends and Analysis. Pew Charitable Trusts. June 26, 2017. Accessed online: http://www.pewtrusts.org/en/multimedia/data-visualizations/2014/fiscal-50#ind4

[11] http://thehill.com/blogs/blog-briefing-room/news/339340-illinois-credit-rating-could-be-downgraded-to-junk