Not All Deficits Created Equal

Imagine your monthly paycheck is $300 less than your rent. Every month, your money doesn’t cover your expenses. That’s the predicament many states with “structural deficits” face – their incoming revenues don’t cover essential state services.

And during a recession that dramatically shrinks state tax revenues, states with structural deficits are particularly hard hit.

Experts say most states have structural deficits that vary in size. These states have to decide whether to raise revenues or cut services to fill the built-in gap they face going into a new budget, said Elizabeth McNichol, a senior fellow specializing in state fiscal issues at the Center on Budget and Policy Priorities, a Washington D.C., group that focuses on policies that affect the poor.

“That means it’s harder for the state to look beyond that to see what needs of the state are not being met,” she said. The center described structural deficits as “faulty foundations” in a 2005 report .

California’s chronic billion-dollar budget deficits – currently pegged at $40 billion over two years – are probably the best known, but many other states likewise have tax systems that are structured so that the revenue doesn’t cover services.

“Structural deficits suggest something that is long-lasting, if not permanent, as opposed to a short-term, imbalance, a short-term blip,” explained Robert B. Ward deputy director of the Nelson Rockefeller Institute of Government , the public policy research arm of the State University of New York.

New York, for example, typically has a deficit of $3 billion to $5 billion in a normal year, but with the current downturn, the state is projecting a $12 billion to $14 billion shortfall, Ward said. The meltdown on Wall Street hit New York particulary hard as the state gets 20 percent of its revenue from the financial sector.

In California, Republican Gov. Arnold Schwarzenegger Dec. 11 warned the state faced “financial Armageddon” unless lawmakers take decisive action to tackle the state’s chronic budget problems. “Because of our dysfunctional budget system, spending goes up no matter what,” Schwarzenegger said earlier in the year when he unveiled his plan to overhaul the state tax and budget structure. “On top of that, we don’t have a rainy-day fund to soften the blow in down years like this one.”

One reason states have structural deficits is that their tax systems haven’t kept up with the times, said Sujit CanagaRetna, senior fiscal analyst for the Council of State Governments. The U.S. economy has shifted from producing goods, like cars and appliances, which most states have taxed since the 1930s, to producing services, which most states do not tax. Consumers also are buying more online and often avoiding paying state sale taxes.

As part of separate packages to stop the red ink in their states, Schwarzenegger and New York Gov. David Paterson, a Democrat, both have proposed extending their state sales taxes to certain services, ranging from furniture repair to veterinarian services in California to haircuts and movie tickets in New York.

Slapping taxes on services, however, is not without controversy. Maryland, for example, rescinded a new tax on computer services this year to quell industry opposition and replaced it with a new three-year surcharge on millionaires.

Not only are states collecting less revenue under an antiquated system, the demands put on states are actually increasing, especially on the health-care front.

“Growth in health-related costs serves as the primary driver of the fiscal challenges facing the state and local sector over the longer term,” the General Accountability Office said in a recent report.

Some states also are hamstrung by citizens’ ballot measures that lock in a certain amount of money for particular projects. “Because of the initiative process out there [in California], they really have tons of spending on auto pilot and as a result they do have a big problem,” said Scott Pattison, executive director of the National Association of State Budget Officers.

The initiative process also is aggressively used by voters in states such as Arizona, Colorado, Oregon and Washington – all of which face budget gaps.

Some Republican lawmakers in California, for example, want to dig the state out of its deficit by asking voters there to revise ballot measures approved in previous elections that set aside money to fund mental health services for homeless adults and a tobacco tax that is used to pay for health care and education programs for children.

California Democrats, however, have their own plan to tackle the deficit that includes a package of tax increases and program cuts that they say is “revenue neutral” and would thus avoid the state’s constitutional requirement that two-thirds of the legislature approve a tax increase.

California is one of 15 states that have “supermajority” requirements that make it harder for legislators to raise taxes or modernize their tax code because they need more than a simple majority of lawmakers approve such a move, according to the National Conference of State Legislatures. Most require a two-thirds vote, but Arkansas and Oklahoma require three-fourths approval to increase any taxes while Delaware, Kentucky and Mississippi require three-fifths, according to NCSL.

Patrick Fleenor, chief economist for the Tax Foundation , a Washington, D.C. tax research group, also faulted states for not being realistic in their budgeting. “The housing boom of the last seven years obviously wasn’t going to go on forever, but states and localities acted like it would,” he said. Downturns, he said are “quite predictable.”

Experts say structural deficits are political – not economic – problems because politicians, fearing voter-retaliation, are reluctant to change the tax code, particularly during an economic downturn. “States are already on shaky ground. Do you really want to inject another level of uncertainty,” CanagaRetna of the Council of State Governments said. “It’s almost counter-intuitive to overhaul the tax system during a crisis,” he said.

McNichol of the Center on Budget and Policy Priorities said she hopes states will use the downturn to take a serious look at their tax structures. “The services that states provide are important to people – education, health care – so it’s really important that they have an adequate revenue structure,” she said.