The summer of 2019 ushered in sunny fiscal conditions for states. On July 1, the U.S. economic expansion tied the record for the longest in history—a decade after the Great Recession ended in June 2009.
At the same time, surging tax collections, low unemployment, favorable interest rates, rising equity portfolios, and stable real estate markets combined to improve state finances. Most states ended the budget year June 30 with year-over-year increases in revenue and spending, and higher amounts set aside in reserves. Many even finished with a surplus, some for the second year in a row, which did not seem possible in the past 10 years.
When top legislative fiscal directors from 34 states gathered for a meeting in Nashville in August, an official from the National Conference of State Legislatures asked them to hold up an emoji poster characterizing their states’ fiscal outlook. All but one chose the smiling image. “Lots of happy faces,” said the NCSL official, Mandy Rafool, as she looked around the room.
But research this year by The Pew Charitable Trusts showed that the outlook is not as rosy as it may appear in several states. In fact, Pew’s analysis of 10 years of fiscal data concluded that many states still were facing lingering effects from the recession. The research by Pew’s Fiscal 50 team was inspired by economist Ray Scheppach’s prediction during the 2007-09 recession that states would face a “Lost Decade” before they would recover from the severe revenue losses, spending cuts, and deferred investments. “Lost Decade” became the title of Pew’s report.
“We found that, heading into 2019 legislative sessions, state finances still had not fully emerged from the Lost Decade,” says Barbara Rosewicz, who directed the research. “There were still budget cuts and deferred investments that haven’t been fully restored, and other costs that rose in the wake of the recession and have remained higher.”
As a new decade of state finances began with the July 1 start of the fiscal year, the findings magnified a concern that some states may not be sufficiently prepared for another downturn. Among the reasons for the uneasiness is the question of whether some of the spending cuts made during the Lost Decade, such as those to higher education, will ever be restored to pre-recession levels. “These cuts could be cemented in place if the funding isn’t restored before the next recession,” Rosewicz says.
Moreover, policymakers worry that states will not pick up the costs they shifted onto others during the recession, including local governments and higher education shortchanged by reduced state aid. Pew’s research showed that as the recession took hold, strained states missed out on collecting at least $283 billion in tax revenue that in healthier times could have mitigated those trickle-down cost effects as well as spending reductions in virtually every program or service. To cover the budget gaps after revenue plunged, states variously cut spending, put off public pension and infrastructure investments, increased taxes, tapped rainy day funds, and spent one-time federal stimulus money.
As fiscal year 2019 began, nine states still were taking in fewer tax dollars, adjusted for inflation, than they did at their peak before or during the recession. The decline in tax dollars—states’ largest source of revenue—was the catalyst for spending reductions. General fund spending has recovered nationally, surpassing levels reached before the recession, after accounting for inflation. However, Pew’s analysis showed that 15 states still reported lower estimated general fund spending in fiscal 2019 than in fiscal 2008.
Many legislatures approved budgets for fiscal 2019 and fiscal 2020 that added money to programs and services that had been cut, including K-12 instruction and teacher pay raises. Nevertheless, the historic size of the revenue loss during the recession and the long, slow recovery exposed persistent consequences states have yet to surmount.
Nowhere is that more true than in cuts to higher education, the third-largest budget expense after K-12 education and Medicaid. Forty states reported lower per-student funding in fiscal 2018 than 10 years earlier, after adjusting for inflation. As a result, public higher education in 26 states relied more on tuition and fees from students than on state support—the most widespread, lingering impact of the Lost Decade, according to Pew’s analysis. Tuition at public four-year colleges doubled in Louisiana since the recession and rose by more than half in 11 other states.
“This new norm is here to stay,” says Robert E. Anderson, president of the State Higher Education Executive Officers Association. “With that said, states have the capacity to chart a new path by establishing an appropriate balance between state and student investment in higher education and how this balance can be maintained.”
Other important spending areas also lagged pre-recession levels in many states, the analysis said. State investment in roads, bridges, water and sewer systems, school buildings, ports and airports, parks, and other infrastructure was at its lowest level as a share of the economy in more than 50 years, according to the most recent data (from 2017). State aid to local governments, many of which were struggling with budget problems of their own, was lower in 26 states.
The effects of the recession were not only fiscal; the number of state workers in fields other than education was 4.7 percent lower in 2018 than at its peak in 2008. That could make it more difficult in the next downturn for policymakers to turn to workforce reductions for budget savings—not to mention the loss of many experienced, knowledgeable employees.
States also wrestled with growing fixed costs, which are harder to contain than other spending. Medicaid is a mandatory cost that usually rises during recessions when the demand for benefits goes up as people lose their jobs and health care coverage. The program, funded jointly by the federal government and states, was using up a greater share of revenue in 48 states than before the recession.
During the depths of the downturn, states were temporarily shielded from a spike in Medicaid enrollment and costs by federal stimulus dollars from the American Recovery and Reinvestment Act of 2009. Once that money ran out in 2011, state Medicaid spending rose and has remained higher as a share of revenue even as the economy has improved. The optional expansion of Medicaid under the Affordable Care Act also had little impact on state spending
initially because, until 2017, the federal government picked up the full tab for enrolling newly eligible low-income adults.
Another fixed cost—public pension system funding—was already rising before the recession, but shortfalls grew after pension systems experienced investment losses during the downturn and tight budgets made it hard for many states to pay their annual retirement contributions. Unfunded pension liabilities went up in nearly every state, collectively totaling $1.28 trillion by fiscal 2017, the most recent figure.
Other Pew research released since the Lost Decade analysis showed that although every state pension system experienced investment losses, some states rebounded better than others during the recovery. South Dakota, Tennessee, and Wisconsin had almost all the assets they needed to fully fund their liabilities in 2007 and in 2017, Pew found. The three states with the biggest shortfalls —Illinois, Kentucky, and New Jersey—ended the decade with fewer assets than at the start of the downturn.
“Policy choices drive differences in state pension funding levels,” says Greg Mennis, who directs Pew’s public retirement system research. “Well-funded states successfully coped with the adverse effects of the recession by consistently making their actuarially determined contributions in good times and bad. States with poorly funded plans have had to substantially increase their contributions to try to catch up.”
Policy choices to rebuild reserves during a recovery—after spending them down to balance recession-era budgets—also vary by state. The good news: Pew’s Lost Decade analysis found that, taken together, states made substantial progress refilling their rainy day funds in the 10-year period. By the end of fiscal 2019, rainy day funds were estimated to hold more money than in any year on record.
A better measure than dollars, though, is how far that money would go in covering day-to-day operating expenses, expressed by the number of days a state could run on its reserves alone. Using that measure, at least 13 states still had smaller rainy day funds—as a share of operating costs—by the end of fiscal 2019 than they did the year before the recession began. Six—Illinois, Kansas, Kentucky, Montana, New Jersey, and Pennsylvania—expected to have less than a week’s worth of operating costs.
Although government fiscal analysts do not recommend a specific percentage of general funds that states should set aside in reserves, one measure of states’ progress in building their savings is a comparison with pre-recession levels. For many states, even pre-recession levels were not large enough to plug the budget gaps during the downturn.
That is why, out of caution, many states are refilling their reserves in preparation for the next downturn, enacting rules about when to put money in and take it out. Policymakers in states with budget surpluses in fiscal 2019 set aside a portion of the extra revenue to stockpile reserves. Utah lawmakers, for example, used surplus revenue to boost the rainy day fund to its targeted levels—on top of the fund’s automatic required deposits.
The buildup in reserves comes as economists debate the timing of the next downturn, especially after a key recession predictor, the bond market’s inverted yield curve, reared its head in mid-August. Uncertainty over the timing is a big worry among state fiscal policymakers after such a long expansion. “We’ve had a 10-year recovery. To me, it’s like, when does the next downturn happen?” says Bob Lang, director of the Wisconsin Legislative Fiscal Bureau.
“There’s probably a recession coming,” Dan White, an economist at Moody’s Analytics, warned state lawmakers at the August legislative meeting in Nashville. “It’s going to be more stressful for you than previous recessions, but probably not as stressful as the Great Recession. There won’t be much help from the federal government, so you’re on your own.”
Because of the experience gained in the Lost Decade, White added, states may be in a better position to fend for themselves this time. Still, they will confront a host of challenges. Interviews with policymakers at the Nashville meeting brought up lingering issues from the Lost Decade—and new ones.
Utah legislative fiscal analyst Jonathan Ball worries that the state’s tax system is not capturing revenue it should from taxes on services such as Uber and Lyft. West Virginia Senate budget director Chris DeWitte says his state needs to retool its economy in the face of a declining coal industry and falling population. Arizona and New Mexico officials say they are under pressure from courts and educators to adequately fund K-12 education. And Alaska legislative finance division director David Teal says, “I don’t think anyone wants to be where we are”—with an unprecedented budget deficit that has resulted in deep cuts, especially to the University of Alaska.
Even officials in relatively stable states are not sanguine. Virginia finished fiscal 2019 with a $778 million surplus. But Senate Minority Leader Richard Saslaw says the state will need to find additional revenue in the next decade to finance K-12 education, higher education, and transportation. “I don’t know how we’re going to do it,” Saslaw says, “but sooner or later, we’re going to have to raise revenue.”
And what does the economist who first came up with the Lost Decade prediction say? Ray Scheppach, who headed the National Governors Association until 2011 and now teaches at the University of Virginia, worries that the spending reductions made to public investments such as education and infrastructure during the recession will harm productivity, which in turn will lead to slower economic growth in the coming years.
He points out that growth of the labor force—the number of people working or looking for work—is a key factor in the expansion of state economies, but that growth is projected to continue slowing because of the decline in population growth and the aging of Americans. In addition, Scheppach says, although the economy has shifted from goods to services, elected officials in most states have not changed their sales tax structure to capture revenue from that transition because it could lead to politically sensitive new charges on previously tax-free services.
Somewhat reassuringly, Scheppach says he doesn’t think the next recession will lead to another Lost Decade. “It won’t be eight to nine years of no growth,” he says, “but there will be substantially lower growth relative to the boom periods in the decades before 2008. States will continue to struggle fiscally throughout the next decade. This will be the ‘New Normal’ decade.”
Stephen Fehr reported and edited state government coverage at The Kansas City Star, The Washington Post, and Stateline before becoming a member of The Pew Charitable Trusts’ state fiscal health team.
Despite almost 10 years of national economic recovery, strains from the 2007-09 downturn still linger in many states