Recession Could Reshape State Governments in Lasting Ways

For a preview of the future of state government, consider Arizona’s plan to raise desperately needed cash by selling and leasing back the office tower that houses most of its government. Or Hawaii, where more than 500 people chipped in their own money to keep open a public library that the state had planned to close because of budget cuts. Or Maine’s attempt to simplify and lower its income tax rate while broadening its sales tax base to cover services such as ski-lift tickets and dry cleaning.

Around the country, the worst economic downturn since the 1930s forced states to consider new ways of thinking about what could be a slimming down of government lasting several years. Once states get past the immediate crisis of plugging record-high budget gaps, they will confront the likelihood that the recession will impose permanent changes in the size of government and in how states deliver services, who pays for them and which ones take priority in an era of competing interests.

“There is no question that states are going to be considering changes that in some cases could be dramatic,” said Susan K. Urahn, managing director of the Pew Center on the States, which tracks and analyzes issues affecting states’ fiscal health and economic competitiveness. “This recession has cut too deeply.”

States have weathered the ups and downs of 10 economic slumps since World War II, but none with the scope of the Great Recession. Its toll can be measured with a big number: the more than $300 billion in budget gaps states have faced since the start of the recession in December 2007, according to the National Conference of State Legislatures (NCSL). But just as searing are its smaller impacts, such as the impending demise of the Michigan state fair, a symbol of Americana since 1849 that the state no longer can afford.

Raymond Scheppach, an economist who has headed the National Governors Association for 26 years, said the recession marked the start of a “lost decade” in which states are likely to face slow revenue growth, spending cuts, depleted reserves and backlogged needs. Unlike previous recessions, he said, states are heading into “a permanent retrenchment.”

Fiscal distress for years to come

The spending decisions facing lawmakers for the budget year that for most states begins July 1 are the most difficult of the past three years.

Even as the economy slowly heals, history shows that the worst budget crunch for states comes in the year or two after a recession ends and that a full recovery can take years.

Magnifying the problem facing states, the federal stimulus dollars that helped plug almost 40 percent of budget holes will start drying up at the end of 2010.

In addition, economists are forecasting double-digit unemployment through the summer and continued scaling back of consumer spending. Both will siphon precious tax revenue from states and drive up demand for costly social services such as Medicaid health care coverage. The plight of Kentucky is typical: State leaders used the rainy day fund and stimulus dollars last year to escape deep education cuts and mass layoffs of state workers but will have to consider both measures to erase a $1.4 billion shortfall over the next two years.

It will take years for states to return to normal, whatever the new normal will be. In many states, the recession reduced the base for future revenue even as pressure to increase spending grew. Reeling from the Wall Street financial crisis, New Jersey might have to wait five years for revenue to return to 2008 levels. Home of two automaker bankruptcies, Michigan has less revenue this year than it did in 1997. “Think if you were back to your income from 1997,” said Scott Pattison, executive director of the National Association of State Budget Officers. Minnesota economist Tom Stinson predicts that in the next 25 years, revenue will grow at half the rate of the late 1990s. “The issue is a long-run structural one. Short-run solutions will not solve the problem,” he said.

The recession is amplifying pressures on elected officials to make essential long-term changes so states can live within their means yet still educate children, keep people safe and create jobs. But 2010 is an election year, and politicians seeking another term may be loath to tackle such volatile issues as reforming the tax structure or public employee pensions for fear of backlash to higher taxes or reduced retirement benefits. The typical pattern after a recession is to muddle through until the economy recovers, then return to cycles of increased spending when revenue goes up.

But officials in a number of hard-hit states will not have that option this time because of the gravity of the downturn. “Not only has this recession affected states more deeply, it will continue to do so for a longer period of time,” said Sujit CanagaRetna, senior fiscal analyst at the Council of State Governments. “As a result, it will fundamentally alter the relationship that citizens have with their government.”

Already there are signs of how the recession is changing the face of state government.

Altering the size of government

The number of public employees is shrinking in many states, and officials are experimenting with four-day workweeks and virtual meetings.

As governors have slashed thousands of jobs, layoffs and furloughs of public employees have become an increasingly common way for states to save money. They are effective because government’s biggest cost, just as in the private sector, is labor. Thousands were furloughed last year in more than 20 states, including teachers in Hawaii. The Aloha State shaved up to 17 days off the school year, which could be the shortest in the nation. More furloughs are expected in 2010. Overall, the number of state workers fell in 28 states in fiscal year 2009, according to the Bureau of Labor Statistics.

Unpaid furloughs of state workers are affecting the timely delivery of unemployment checks, disability payments and food stamps for millions of Americans, according to federal officials. Citizens in California and other states are coping with the closing of driver’s license bureaus and courts some weekdays, in effect imposing a four-day week for some government services. To save energy costs, Utah’s 17,000 state workers switched to a four-day schedule of 10 hours a day. In Florida, among other states, employees have been asked to conduct more meetings by teleconference to trim travel costs.

What will be the long-term effect of these reductions on states and residents? Many state jobs will not be refilled, which could strain the ability to provide services. Additional layoffs could hit at critical functions of government, namely education, public safety and health care. Because many leaving government are the oldest, most experienced workers, states have fewer experts, a pressure that surfaced last year when Colorado, New Jersey and North Carolina, among other states, did not have enough people to administer and audit the federal stimulus programs. Moreover, the future appeal of working for state government has been weakened by reduced pay and, in some states, benefits. Lawmakers froze salaries in at least 10 states and shrank current or future pension benefits in 10 states. The targeting of state employees is affecting morale; some managers say they will have trouble energizing deflated workers going forward in the mission of state government. Like the private sector, states depend on the ability to recruit, retain and motivate talented workers to provide services at the lowest possible price. 

Streamlining services to save money

States are rethinking how to deliver services in cheaper, more creative ways.

When Washington State was trying to close a budget gap in 2003, state leaders came up with a system called “Priorities of Government” to examine virtually every program and service. They asked such questions as: What are the essential services the state must deliver? And what is the most effective way to accomplish goals with the money available? Variations of these questions are being asked today by state officials from coast to coast as they scour for savings.

Reducing duplication is one target. Massachusetts squished six agencies and 10,000 workers into a single state transportation department last year, saving money by laying off employees who duplicated work. Other states are reforming the way they buy goods and services. New Jersey replaced 17 contracts for buying paper and office supplies with one, shaving costs 20 percent. States such as Indiana are starting to consolidate offices, vacating leased space as contracts expire.

Coinciding with state employee cutbacks, digital government has moved beyond offering citizens a way to renew a driver’s license, pay income taxes and obtain a fishing license. Nebraska ranchers can check a state database of livestock brands to identify animals that stray onto their land. Relatives of Arkansas inmates can deposit money online into a commissary account. Tennessee is claiming $90 million in savings over nine years from digital transactions conducted on state Web sites, including the motor vehicles department, according to Web site contractor NIC Inc.

Partnerships with private companies also are tempting to state officials who cannot afford to complete expensive projects. Last February, Texas transportation officials approved a contract with a private firm to build and operate 14 miles of toll lanes, the second such venture in the Dallas area. The state is putting up about $1 billion, with the private firms contributing $5 billion. California’s office of the courts is planning to retain a private company to design, build, operate and maintain a proposed $300 million Long Beach courthouse. The trend is not limited to infrastructure: Louisiana is looking at privatizing the state’s employee health insurance program.
Public-private deals have had mixed results, though, and states are approaching them guardedly. Although the Dallas area highway projects will move forward, Texas lawmakers in July rejected a request by Governor Rick Perry (R) to allow more privately run toll roads; policy makers were concerned about a proliferation of roadways requiring fees but will take up the issue again in 2011. Indiana Governor Mitch Daniels (R) was forced to end a 10-year, $1.3 billion contract with IBM and other companies to dole out welfare benefits because the computer system made too many mistakes. The state had better luck with the sale of the Indiana Toll Road to a foreign company in 2006.

Still, the pressure to explore new financing options will only increase this decade because of the bleak revenue picture. The sale of assets such as Arizona’s plan to deal its state office building may raise some money in the short term, but specialists question whether this is a lasting trend because states have a limited number of assets that are attractive to investors.

Who pays and how much?

States are turning to cost-shifting to balance their budgets.

In nearly every state, leaders are asking residents to take on a larger share of the cost of government. Depending on where you live, your state may have asked you to shell out higher taxes on your paycheck; pay more for a carton of cigarettes, a six-pack of beer or a tank of gasoline; or fork over higher fees to register a vehicle, rent a car, check into a hotel, adopt a child and obtain a business or fishing license.

Adults on Medicaid in four states in 2009 lost vision and dental benefits, forcing them to absorb the costs or do without. Tuition at public colleges shot up more than 10 percent in 10 states at the start of the 2009-10 academic year. Arizona’s 17 percent increase was the highest, a tipping point that ignited statewide protests. By this fall, tuition at California colleges and universities will jump 32 percent. Florida International University even charged a $5 admission fee for extra tickets to its graduation ceremony. Collegiate or high school sports will be affected in California, Hawaii, Nevada, Ohio, Rhode Island, Virginia and elsewhere, where cuts have led to fewer games, higher or first-time participation fees and even dropped sports.

The costs are not always financial, as in the case of a Mississippi mother who complained in a news account about having to put her daughter on a school bus at 5:40 a.m. and pick her up at 4:30 p.m. because budget cuts forced the consolidation of bus routes.

Much of this cost-shifting is permanent-college tuition likely will not go down, for example. Lawmakers could always rescind some of the tax and fee increases-some approved on a temporary basis anyway-if revenue collections improve, though that seems unlikely given their historical reluctance to do that.

Debate over hiking taxes and fees is overshadowed, though, by the larger, longer-term challenge of fixing tax systems that are outdated or broken to correct the structural inequities that deprive states of revenue, especially during downturns.

In contrast to Maine, where lawmakers revamped the tax system subject to approval from voters in June, a proposal by a tax reform panel in California to simplify personal income tax rates and impose a new business net-receipts tax was widely panned despite support from Governor Arnold Schwarzenegger (R). Arizona, Colorado, Kentucky, Michigan, Nevada, North Carolina and West Virginia have established panels to examine tax and budget reform. One hot topic is whether to expand the sales tax to services, such as car repairs and dry cleaning, instead of only goods. New York, North Carolina and Rhode Island are pioneering laws allowing them to get around legal hurdles to require sales taxes for online purchases.

Michigan House Speaker Andy Dillon (D), who is heading that state’s budget reform effort, said the recession gives states an opening to restructure taxes and budgets early in 2010 before the campaign season heats up. “We have to do what General Motors did to itself,” he said. “It wasn’t until [GM] hit the wall that the real structural changes happened. We have a small window of opportunity to make structural, long-term changes to state government to avoid hitting a similar wall. That time is now.”

Other lawmakers say they are not convinced that radical changes are needed. Arizona State Senator Russell Pearce (R), chairman of the Senate Appropriations Committee, concedes that the state will have to end some programs. But excessive spending is the issue, he said, not taxes. “Agencies are still spending like drunken sailors,” he told The Arizona Daily Star .

With less money to spend, who gets it?

States are reordering their spending priorities, targeting some of the fastest-growing costs.

As state officials enter a decade of limits, looming over all of their decisions are the fastest-growing costs of state government: Medicaid, corrections and public employee pensions. Indiana’s Daniels, a former White House budget director, said the biggest threat to the nation’s economic future is not last year’s $1.4 trillion federal deficit but “the entitlement overhang that sits out beyond that,” particularly Medicaid.

Officials are rethinking how to cut Medicaid, corrections, pension systems and retiree health care without jeopardizing public health, public safety or a stable state workforce.

Reversing years of spending increases, more than half the states clipped corrections costs last year either by closing prisons, pruning inmate rehabilitation programs or, in Colorado and elsewhere, releasing prisoners early. “Corrections departments are tightening their belts with a new round of operating efficiencies that can trim a few percentage points off their budgets,” said Adam Gelb, director of the Public Safety Performance Project at the Pew Center on the States, which helps states advance sentencing and corrections policies that provide a greater return on taxpayers’ dollars. “But these kinds of moves won’t be sufficient for them to weather the fiscal storm. They’re going to have to dig deeper, and that means implementing research-based sentencing and corrections strategies that can lead to less crime at far less cost than prison.”

The next decade also will test states’ ability to finance their public employee retirement benefits-pensions and health care. Because of the Wall Street financial crisis, state and local pension funds lost a median 25 percent in 2008 before the funds started to rebound last year. While officials say they can pay benefits right now, they are not sure whether they will have enough to recover investment losses and meet the increased pension payouts for retirees. More than half the states made changes to their plans in the past two years to shave costs, in many cases asking newly hired state employees to accept reduced retirement benefits. More legislatures are taking up reform this year. (The Pew Center on the States is releasing a report early this year on the bill coming due to states for their public-sector retirement benefit obligations.)

The biggest worry among state budget experts is that Medicaid-whose expenses are split between the federal and state governments and now account for a fourth of overall state spending-will continue to eat up state money needed for everything else. Some states tried to pare Medicaid costs last year; some raised fees or cut optional benefits such as the adult vision and dental coverage. But those actions and $87 billion in federal economic stimulus dollars for Medicaid were offset by the growth in enrollees. New Mexico officials declared a crisis last fall after foreseeing a Medicaid hole of as much as $300 million.

On the horizon is the cost of federal health care legislation. William Pound, executive director of NCSL, said proposals that ask states to shoulder greater costs so that more uninsured can be covered by Medicaid reflect Congress’ lack of understanding of the gravity of state government finances.

After Medicaid, corrections and pensions, states are trying to be more strategic about where to invest scarce dollars. State-financed early education programs are a good example of the anguish confronting state officials: Even though 10 states trimmed their pre-k appropriations for fiscal year 2010, 29 states increased their investment or held funding steady.

Looking for long-term fixes

Against such pressures to control costs while revenue is declining, state officials see years of austere budgets, a striking contrast to the start of the last decade when 21 states were so flush they cut taxes and fees. Whether the recession leads to permanent change in state government will depend not just on whether lawmakers can bridge political divisions but also on whether they can find a way to manage government over the long term instead of simply getting by year to year.

One obstacle to long-term planning is that the legal requirement in most states to balance the budget often demands a rapid response instead of one that is deliberate, especially when revenue drops wildly from month to month. On a single day in October 2009, six states that had balanced fiscal year 2010 budgets reported sharp revenue declines that forced further cuts. Donald J. Boyd, a senior fellow at the Nelson A. Rockefeller Institute of Government in New York, said many states will not have time to consider long-term fixes as they are swamped trying to get by through postponing payments, dipping into reserves, selling state assets or enacting one-time savings such as furloughing employees.

“States need to evolve beyond a short-term perspective,” said Urahn of the Pew Center on the States. “There are actions that states can take that will position them for long-term success coming out of the recession. But they require creativity, collaboration and in some cases political courage.”

Arizona last year failed to find enough short-term solutions to cover its multibillion-dollar budget shortfall, shoving off decisions to 2010. But in a hopeful example for other states, business, civic, education and political leaders launched a long-term government reform effort. They say their goal is to diversify Arizona’s economy and repair dysfunction in government, such as the ballot initiative process that some state officials say can hamstring them by requiring spending on certain programs at the expense of other services.

Colorado business, civic and nonprofit groups have embarked on a similar endeavor to recommend long-term financial solutions. Iowa, Louisiana and Utah officials are meeting to identify government-streamlining recommendations that will go to the legislature. Nevada’s Vision Stakeholder Group has the weighty goal of proposing changes to the state’s antiquated tax structure; four previous groups since 1960 urged major reforms that policy makers ignored. Other states share comparable outcomes. “Efforts like this fail when committees like this are either captured by the special interests or partisan politics,” State Senator Jeff Danielson (D) said at a recent meeting of Iowa’s State Government Reorganization Commission.

Sue Clark-Johnson, executive director of Arizona State University’s Morrison Institute for Public Policy, which is leading one of the efforts, uses the metaphor of the 1969 fire in Ohio’s Cuyahoga River that called attention to the nation’s environmental crisis. “The river is on fire” in Arizona, she said. “This crisis that we’re in is so deep and severe that it is pulling people together to ask questions in a more forceful and vocal way than before. I don’t think this is just an Arizona problem. Many states don’t have a clear-cut vision of what they want their state to be.”