Commentary: It Could Get Worse Before it Gets Better

Last December many states began to see declines in revenues as a result of the slowing economy. The August and September employment reports, which showed losses of 85,000 and 157,000 jobs, respectively, along with an increase in the unemployment rate to 6.1 percent, marked a dramatic acceleration in the downward revenue trend. Until that time, it was primarily decreasing sales and corporate taxes dragging down state coffers. With unemployment increasing, states now must contend with declines in income taxes as well. And given recent trends, the state fiscal situation will likely get even worse.

Loss of liquidity and rising unemployment

The liquidity crisis that peaked in September with the bankruptcy and consolidation of several investment and commercial banks has exacerbated the state fiscal decline in two respects. First, several states such as New Mexico and California were finding it difficult to borrow in the short-term credit market to finance expenditures until their monthly revenues were realized. Where credit was available, the interest rate had jumped-for example, from 1.8 percent to 5.15 percent just last week. In addition, a number of states now are unable to float long-run bonds to finance infrastructure such as highways, bridges and schools. This list includes Florida, Hawaii, Maine, Massachusetts and New Mexico. Second, the liquidity crisis has severely impacted the private sector, particularly small businesses that often need short-run financing to meet payrolls. This lack of credit has forced more layoffs and unemployment, and thus, state income-tax revenues are now declining more rapidly.

Future risks

Now that Congress has passed and President Bush has signed the $700 billion liquidity package, some credit should start flowing again, which should increase states’ access to credit markets. Nevertheless, most economic forecasters believe that the U.S. economy is already in a recession and that it will continue at least through the second quarter of 2009 and possibly longer. The economy could well lose 200,000 jobs per month over the next several months, with unemployment peaking at between 7.5 percent and 8 percent. This means that states will continue to have major fiscal problems for at least two more years.

The first year will be because the economy likely will be in recession for another 9 to 12 months. The second year, we know from experience, will be because states feel the greatest impact on their budgets the year after a recession ends. This is primarily attributable to growth in Medicaid, the state-federal health-care program for the poorest Americans. Medicaid rolls swell as more individuals become unemployed and lose their health insurance. Given that Medicaid is 23 percent of the average state’s budget, these costs are significant. The combination of losses in tax revenue and major increases in Medicaid will require states to make significant cuts in other programs, including elementary and secondary education as well as higher education. It also will lead some states to increase taxes to meet their balanced budget requirements.

As if that weren’t enough, several risks could make the current situation much worse for states:

1. The value of housing still needs to fall nationally another 5 percent to 10 percent to be affordable relative to the average income. This, coupled with the fact that large numbers of subprime mortgages will trigger to higher rates over the next 18 months, will increase the number of defaults and put another major drag on the economy.

2. The $700 billion liquidity package just enacted will help only the residential mortgage problem. It does little to help credit card, automobile, student aid and commercial property bad debt. Thus, Congress will need to take additional action to recapitalize the banking industry. Until that happens, liquidity may continue to be a problem.

3. The world economy is slowing dramatically. Coupled with the increase in the value of the dollar, this slowdown will reduce U.S. exports, which have been one of the bright spots in the U.S. economy lately.

The bottom line is that states are facing a very difficult fiscal outlook over the next two to three years. This economic downturn will likely be longer and more severe than any states have experienced since the downturn of 1982-1983, when unemployment hit double-digit levels. In short, the fiscal situation for states could get really ugly.

Raymond C. Scheppach, Ph.D., is the executive director of the National Governors Association. The views expressed here are those of the author and do not necessarily represent those of the National Governors Association.