COMMENTARY: Silver Lining in State Fiscal Crisis?

This past year governors across America watched their state’s fiscal health deteriorate. For the first time since World War II, state revenue growth was negative and budget shortfalls were the worst since the downturn of the early 1980’s.

The state budget process became a bitter, protracted battle in many states. Governors and state legislatures went back to the drawing board once, twice and some even three times trying to balance their budgets. Many of them are back at it again and preparing for another very difficult year making tough decisions on what to cut and how to raise the revenues necessary to fund important state programs.

However, the most recent recession was one of the mildest in terms of declines in gross domestic product, which is the broadest measure of economic activity in this country. So why is the fiscal situation so desperate in the states?

The underlying reason for this dichotomy is the state fiscal problem was only partly due to the cyclical downturn in the economy. Two longstanding structural problems an eroding tax base and the explosion in health care costs were the major cause. Both of these problems were camouflaged by the phenomenal economic growth in the second half of the 1990’s. The recession unmasked the problemsbut it was not the reason for the swift and steep decline in the state fiscal situation.

Unfortunately, state tax systems were developed for the manufacturing economy of the 1950’s not for the service-oriented, high technology, international economy of the 21st century. Sales tax revenues are being eroded by the change in the “mix” of products purchased by consumers and the growth in electronic commerce, which is largely tax exempt. Most states do not tax services which have grown from 41 percent of household consumption in 1960 to 58 percent in 2002. This is a major cause of erosion. States are also losing revenues due to their inability to require out-of-state sellers to collect state sales and use taxes. Finally, corporate profit taxes have been eroding for years partly due to an increase in tax credits enacted by states, and also because corporations have become more sophisticated in minimizing their tax liability. Since sales and corporate taxes represent about 45 percent of state revenues, the erosion over time has been dramatic.

Health care represents 27 percent of the average state budget. Medicaid alone represents 20 percent of this cost. Total health care costs are growing at 13 percent this year, which follows an 11 percent increase last year. This health care cost crisis is a national problem. But there are few policy options available to states to control costs–particularly given the difficult political environment in reducing benefits and eligibility within the Medicaid program. Few Americans understand that Medicaid is now larger than Medicare in terms of the number of people covered 44 million vs. 40 million, and in total spending $230 billion vs. $215 billion. Medicaid eligibility is growing twice as fast as Medicare. The cost of long-term care, such as nursing homes, as well as the low-income individuals who are both Medicaid and Medicare eligible, “dual eligibles,” are expensive and probably should not be a state responsibility.

However, there may be a silver lining in the dark clouds that have been hovering over state budgets. A growing awareness of the significance of these structural problems in both Washington, D.C. and state capitals is increasing interest on the part of our elected officials in reforming both state tax systems and the federal-state Medicaid program.

There are recent signs that Medicaid reform is moving up on the national agenda. For example, NGA recommended creating a high level Medicaid Commission to spearhead reform and the Senate adopted a resolution on a commission earlier this year. Furthermore, Senator John Breaux, chairman of the Aging Committee, is advocating long-term care reform. Perhaps most important is a bill recently passed by the U.S. House of Representatives that would have the federal government pay for drug benefits of the dual eligibles, saving states more than $45 billion over the next 10 years. While actual Medicaid reform may be three to five years away, momentum for change is growing.

Next November is a big election year for the nation’s governors with 36 states facing elections. Given term limits and governors who have chosen not to run, there will be at least 21 new governors in office by next year (including Guam). Some new governors who anticipate being in office for eight years will decide that the only way to avoid a continuing fiscal crisis will be to enact tax reform. History shows that making this move during the first year in office makes the most political sense.

For state sales taxes, reform could mean lowering the rate on goods and increasing the rate on services. One of the basic tenets of good tax policy is to have a low rate on a broad base so that taxes do not bias market decisions. With respect to electronic and other remote sales, states are currently developing a simplified system whereby all states will adopt common classifications and definitions while maintaining their different rates. The hope is that Congress will pass legislation requiring out-of-state sellers to collect use taxes. Reforms of corporate taxes may mean phasing them out altogether, eliminating most tax credits, or replacing them with a proxy for a value added tax.

Fixing either one of these structural problems takes the kind of bold and progressive public policy action that is often so difficult for elected officials. But the desperate fiscal situation in states has perhaps provided the impetus in both Congress and statehouses to take on the challenge. If so, states will be put on solid long term fiscal footing so they can stabilize spending, focus on education, the efficiency of state programs and be the innovators of public policy. Now that really would be a silver lining.

Ray Scheppach is the Executive Director of the National Governors Association (NGA). The views expressed are his own and do not represent the views or the policy of the NGA.