State Budget Outlook: The Worst Isn’t Over

Last year, to the surprise of many people in Maryland, the state ended the fiscal year with a $344 million surplus. State revenues, beaten down by the recession, had begun to increase again — and they’ve continued to rise ever since. After three revenue-draining years, it seems, the long-awaited economic recovery has begun.

That’s the good news. The bad news is that the uptick won’t be anywhere near enough to save Maryland from what will likely be the worst year yet of its current budget crisis. Even with the recent revenue growth, Maryland faces a budget shortfall for the coming fiscal year of somewhere between $1.3 billion and $1.6 billion. As a result, this year may be the first time in the current economic downturn that Maryland cuts K-12 education spending to a lower amount than it was the year before. Also for the first time, major layoffs of state workers may be coming

“This budget is going to feel a lot more painful than the last few,” Governor Martin O’Malley said in December.

In most states around the country, it’s hard to imagine how the budget situation could get any worse. Over the past four years, states already have had to close more than $400 billion in budget gaps through budget cuts, tax hikes, tapping rainy day funds or borrowing.

Yet as the nation’s governors and legislatures prepare to write budgets for fiscal year 2012, which for most of them begins July 1, they are bracing themselves for what is likely to be the hardest year yet in what already has been the most difficult budget period in modern history.

That’s because revenues — while up a bit now — plunged so deeply in 2008 and 2009 that it will take years for many states to return to levels they saw before the recession. Now, with the federal stimulus program expiring and the cost of paying for existing commitments such as health care increasing, states will have to make more budget cuts on top of the deep cuts that already have been made.

Those dynamics have state leaders contemplating actions that were once considered unthinkable, including dramatic cuts to core services like Medicaid and education. What’s not clear yet is whether these fiscal circumstances will prompt a desperate scramble to balance budgets now regardless of the long-term consequences or whether they’ll prompt a thoughtful reassessment of what government should do and how it should do it. State lawmakers are sure to scrounge for one-time money wherever they can find it, but more of them are starting to acknowledge that long-term changes will be necessary to get their budgets back on sound footing, even after the recession recedes into history.

Growth hides grim situation

As in Maryland, the budget news in most states has started to get better — at least superficially. More than half of all states are reporting year-over-year revenue growth. Overall, state tax revenue has increased, compared to what it was a year before,  for three consecutive quarters, according to the Nelson A. Rockefeller Institute of Government. With most economists expecting national economic growth in the 3 to 4 percent range in 2011, the revenue recovery should accelerate somewhat in the months ahead.

Scott Pattison, executive director of the National Association of State Budget Officers, says those numbers hide the reality states are wrestling with. “You might have some ridiculously high-sounding revenue growth … but that’s because the base is so low,” Pattison says. “I’ve been telling a lot of people, ‘Compare the budget totals to pre-recession levels, because that’s a better measure. Don’t assume happy days are here again.’ “

Those comparisons aren’t pretty: In the third quarter of 2010, overall state revenues were down 7 percent compared to two years earlier. That drop has come at a time when the slow economy is putting increasing demands on safety-net services that states administer, such as Medicaid. The state-run health program for people with low incomes has eclipsed K-12 education as the most expensive portion of overall state budgets.

Then, there’s the end of the stimulus. States have received about $165 billion from the federal government to offset their budget shortfalls, mostly in the form of increased funding for Medicaid and education. Almost all of that money will be gone by the upcoming fiscal year. Republican leaders in Congress say they’re not interested in providing new aid to states.

Big budget gaps again

Add it all up and, despite the nominally good revenue news, states face budget shortfalls of at least $82.1 billion, according to the National Conference of State Legislatures. The final shortfall numbers are likely to be tens of billions of dollars higher.

As a result, elected officials are making some unpleasant choices. In California, where there is a $25 billion budget gap, Governor Jerry Brown is pushing for the same broad-based tax increases that just two years ago voters overwhelmingly rejected at the polls. New York Governor Andrew Cuomo is attempting to scale back his state’s Medicaid program, even though trying to do that has crippled the political standing of multiple governors in the past. South Carolina will stop paying for hospice care for the poor next month. In Georgia, there’s serious talk of applying the sales tax to groceries, even though legislation to repeal the grocery tax passed the Georgia House 15 years ago on a vote of 171 to 2.

Oregon is contemplating cuts to pension benefits for current and future public employees, even as a landmark 2003 deal to cut benefits remains fresh in the minds of many workers. Despite implementing a major income tax increase just last year, Oregon still faces a budget shortfall in the upcoming biennium of $3.5 billion, which represents a 20 percent gap. “All the states are probably at the point where they’re cutting into things that in the past wouldn’t have even been on the table,” says George Naughton, Oregon’s budget director.

Reckoning in Annapolis

Maryland also finds itself in trouble despite having made a tough decision to raise taxes. In 2008, Governor O’Malley pushed for and passed a tax package highlighted by a one percentage-point increase in the sales tax.

Then the worst of the recession hit. Personal income tax revenue declined in both fiscal year 2009 and 2010. As consumers pulled back on purchases, sales tax revenue slid, too — leaving aside the additional revenue that came in from the sales tax hike.

Those back-to-back drops in the state’s two major sources of revenue were unprecedented in modern Maryland history. In that context, the steps the state took to balance the budget actually seem relatively mild. Maryland slashed the amount of money provided to local governments for road repairs and what it paid hospitals under Medicaid. It furloughed state workers and eliminated some state positions. It raised college tuition by 3 percent after years of freezes. But there was no cataclysmic reordering of Maryland state government.

That’s because Maryland leaned heavily on one-time revenue sources. The stimulus money was there to use. So was money intended for environmental programs, which Maryland redirected to the general fund. And the state borrowed from reserves that are used to distribute income tax revenue to local governments.

Warren Deschenaux, the Maryland Legislature’s top fiscal analyst, says that the state’s one-time options now are more limited than before. “This is the year the bullet must be bitten,” Deschenaux says. That’s true even in a state with a AAA bond rating and where the unemployment rate has remained a couple of points below the national average.

What’s more, Maryland’s leaders are finding themselves constrained politically. Having already presided over one major tax increase, O’Malley is in no mood to do it again. While some legislators still want to find ways to raise more revenue, higher broad-based taxes look unlikely.

In this way, Maryland is similar to most other states. With a few notable exceptions, states generally fall into one of two categories. There are states that already have raised taxes and where, consequently, the political will for tax increases is close to exhausted. And there are states where governors, many of them new in office, have ruled out tax increases. Some states fall into both cateogries. The result of this tax-averse mood will be deeper cuts, like the layoffs and education funding reductions Maryland is contemplating.

Long lasting impact

When will the budget situation for states return to normal? Not in the foreseeable future. Although NASBO’s Pattison thinks fiscal year 2013 will look better than 2012 for most states, there are signs that the road to recovery is going to be a long one.

A big reason why is the nation’s stubbornly high unemployment rate. Joblessness remains a drag on personal income tax revenue and sales tax revenues — states’ two biggest revenue sources. That’s not likely to change soon. The Federal Reserve projects that unemployment will remain around 8 percent by the end of 2012.

“Jobs have been extraordinarily slow to recover,” says Donald Boyd, senior fellow at the Rockefeller Institute of Government. “You can’t get much income tax growth without job and wage growth. People can’t open up their pocket books if they don’t have money to spend.”

For states to get back to where they expected to be prior to the recession, they’d need much faster growth than is expected. In Oregon, the latest long-range budget forecast shows that even after a decade, revenues won’t get back to where they were projected to be before the recession.

Tim Nesbitt, who served as chief of staff to former Oregon Governor Ted Kulongoski, compares the situation to a plane that rises slowly, then drops suddenly, then rises again at the rate it had been. “You never regain your old flight path,” Nesbitt says. “You’re farther beyond. What we’re seeing is a reversion to a lesser mean — a new normal.”

Take that analogy to Maryland, and revenue growth would have to average 6.6 percent per year for 20 years in order to get the state back to the line it was on before the recession. That level of growth seems unlikely to David Roose, director of the Maryland Bureau of Revenue Estimates. After all, previous previous growth averaged just 5.4 percent annually. Plus, Roose notes that even if the state were to reach the old line in 20 years, in the meantime it would have tens of billions of dollars less to spend than if the recession hadn’t occurred.

Clearly, the budgetary effects of the Great Recession will be felt by states for decades.