FRBSF ECONOMIC LETTER

2010-20 June 28, 2010

 

Fiscal Crises of the States: Causes and

Consequences
BY JEREMY GERST AND DANIEL WILSON

The recession that began in late 2007 severely reduced state tax revenue and increased
demand for many public services. In the near term, institutional and political factors limit the
options states have for cutting spending and raising taxes. Aid to states in the federal economic
program is winding down next year and the situation is likely to get worse before it gets better.
Painful budgetary choices lie ahead for many states, though the drag on the national economy
should be modest.

In recent months, state lawmakers have been gathering in capitals around the country to try once again
to hammer out balanced budgets for the fiscal year that in most states starts in July. Faced with the
longest, deepest and broadest recession since the Great Depression, states have seen tax receipts
plummet and demand for government safety-net programs soar. The result has been large and growing
fiscal imbalances that are likely to persist for some time. Recent data from the Center on Budget and
Policy Priorities show that the combined budget gap states faced heading into fiscal year 2009 was $110
billion, or around 15% of total state general fund budgets (see McNichol and Johnson 2010). The gap
heading into fiscal 2010 was even larger, $200 billion, or roughly 30% of general funds.

This Economic Letter examines the fiscal crises faced by state governments, focusing on three key
questions: What caused these crises? When are they likely to end? And what might be their broader
impact going forward?

What caused the states’ fiscal crises?

The causes and severity of fiscal crises vary, but two primary circumstances have affected every state to a
greater or lesser extent. The most obvious is the profound macroeconomic shock that hit all states. The
recent recession was one of the sharpest economic contractions in U.S. history. Real GDP fell by 3.8%
while nonfarm employment fell by 6.1%, or about 8.4 million jobs, from peaks registered around the
start of the recession until they bottomed out. Moreover, the unemployment rate essentially doubled,
going from 5% at the beginning of the recession to a peak of 10.1% in October 2009. The economic
distress was not uniform across states. Many, especially those in the West which had greater exposure to
the housing downturn, suffered more dramatic declines. Other states fared better than the nation
overall. Still, no state escaped the effects of the downturn.

The deep recession placed a severe strain on state tax revenue. Figure 1 shows real state and local tax
receipts growth and real GDP growth from 1970 through 2009. As GDP declined sharply, state and local
tax revenue essentially collapsed. In fact, at the worst point in the recession, real state and local tax

 
FRBSF Economic Letter 2010-20 June 28, 2010
 
receipts fell over 10% on a year-over-year basis. While tax revenue always declines or grows more slowly
during recessions, the fall during the latest recession was the most severe since at least 1947, when these
data began to be collected. Furthermore, reports from states on April tax collections, the largest tax
revenue month for most of them, paint a gloomy picture for 2010. Many states report that tax receipts
fell short of forecasts, further widening budget gaps.

States have not met these revenue Figure 1

losses with corresponding spending As GDP fell, revenue plummeted
cuts. Figure 2 shows real state and
%
local tax receipt growth and real state 12
and local government consumption 9
expenditures from 1970 through 2009.
6
Government consumption
expenditures exclude interest 3

payments on debt and mandated social 0

transfers to individuals, and are the -3
Real GDP
best measure available of state and State and local
-6 tax receipts
local government discretionary
spending. Although states have made -9

some efforts to rein in spending, the -12

drop in state and local government 70 73 76 79 82 85 88 91 94 97 00 03 06 09
revenue has dwarfed declines in
Sources: Bureau of Economic Analysis and authors’ calculations.
expenditures.

The institutional arrangements that

Figure 2
limit the ability of state governments
Spending adjustments failed to match revenue
to respond to economic shocks are a
losses
second cause of fiscal troubles. State
%
governments are constrained in at 12
State and local
least three ways. First, nearly all states 9 expenditures
have balanced budget requirements.
6
The details of these vary, but in general
they prevent states from engaging in 3

deficit spending—that is, allowing 0

planned general fund spending to
-3
exceed anticipated revenue in an State and local
-6 tax receipts
upcoming budget year. Second, many
states came into this recession with -9
modest or nonexistent savings or -12
“rainy-day” funds. State governments 70 73 76 79 82 85 88 91 94 97 00 03 06 09
are politically, and in many cases
Sources: Bureau of Economic Analysis and authors’ calculations.
legally, limited in how much they can
put aside in rainy-day funds. Third,
states have important checks on their ability to reduce spending during recessions. For one thing,
demand for many of the services state governments provide increases during downturns. For example,
claims for unemployment insurance benefits inevitably rise as a state’s unemployment rate climbs.
Moreover, many state programs are tied to federal matching funds, which makes it very costly for states

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FRBSF Economic Letter 2010-20 June 28, 2010
 
to reduce spending in these areas. For instance, states typically receive reimbursement from the federal
government for between 50 and 80% of their Medicaid expenses. The federal stimulus package, the
American Recovery and Reinvestment Act of 2009, increased each state’s matching percentage by 6.2
percentage points. This means that, if a state cuts Medicaid expenses by one dollar, it will net savings of
only between 12 and 44 cents, while denying its residents a dollar’s worth of Medicaid services.

Variations in the severity of the economic shock and differences in institutional factors affecting fiscal
policy help explain why some states are in much deeper budgetary holes than others. Consider the cases
of California and Oregon. Leading up to fiscal year 2009, which began on July 1, 2009, California had a
budget gap of 37%, while Oregon’s gap was just 7%, according to the Center on Budget and Policy
Priorities. What explains the difference? To gauge the severity of the economic shock state by state, we
ask what would each state’s 2009 gap have been if they had kept per capita expenditures constant from
2007 onward as revenue fell. It turns out that Oregon’s and California’s budget gaps would have been
roughly the same, around 20%. However, Oregon in 2008 curtailed expenditure growth, enacted some
notable tax increases, and tapped into its rainy-day fund to reduce its budget gap. On the other hand,
California saw expenditure growth barely slow at all, enacted only limited tax increases, and had nothing
in its rainy-day fund coming into the recession. Much of California’s limited policy response reflected
institutional constraints on the ability of lawmakers to change fiscal policy. For instance, tax increases in
California must be approved by a two-thirds majority of the legislature, and voter propositions approved
in the past greatly limit the legislature’s ability to curtail spending growth in many areas.

When are the crises likely to end?

All indications are that states will be struggling to move their budgets toward balance for quite some
time. Recovery of state finances historically lags recovery of the national economy. Forecasters expect
the national economy to recover gradually (see Weidner and Williams 2010). Thus, it will take quite a
while before states see considerable improvement in their fiscal health. Indeed, estimates from the
Center on Budget and Policy Priorities show significant state budget gaps persisting through at least
2012. And a recent Rockefeller Institute report noted that most states are uncertain when revenue will
return to prerecession levels, indicating the problem could continue well beyond 2012 (see Boyd and
Dadayan 2010).

In many respects, fiscal conditions are likely to get worse before they get better. Federal stimulus plan
grants to state governments have helped states close budget gaps. However, federal stimulus funds are
set to diminish in 2011 and all but disappear in 2012, leaving states to deal with their budget gaps
without this federal support. Another factor that could worsen state budget problems is the depletion of
rainy-day funds. At this point, even states that had rainy-day funds going into the recession have fully
tapped them. Finally, some states have used accounting tricks to in effect kick the fiscal adjustment can
down the road. Now these have largely been exhausted and the end of the road is in sight.

Broader implications

State budget crises are already having and will continue to have very real and significant effects on
residents and businesses. Cuts to public services, public safety, and education are severe and could
potentially have lasting long-term consequences. And large tax increases appear inevitable in many
states, which will take an economic toll. These effects will undoubtedly be painful to individuals who
experience higher tax bills or reduced access to health care, education, and other services. However, the
impact of state fiscal crises on the overall economy will likely be more modest. Projected 2010 state

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FRBSF Economic Letter 2010-20 June 28, 2010

 
budget gaps account for only about 1% of national GDP. The combined state budget gaps from 2009
through 2012, as calculated by the Center on Budget and Policy Priorities, total less than the estimated
cost of the 2009 federal stimulus package. Most importantly, even though the shock to state finances
has been unprecedentedly large, it was predictable given the severity of the recession. As such, Federal
Reserve and private forecasters generally incorporated the negative impact of state and local budgets
into their macroeconomic models. Many forecasters are projecting moderate GDP growth over the
next few years. These forecasts have already built in a modest drag on growth arising from state and
local fiscal strains.

Conclusion

The current fiscal crises that most states are facing are generally the result of a severe macroeconomic
downturn combined with a limited ability of the states to respond to such shocks. States are facing
increased demand for public services at the same time revenue is falling. Federal stimulus support for
state budgets is winding down over the next two years. Rainy-day funds are all but exhausted. Thus,
state fiscal crises aren’t likely to go away soon and will probably get worse before they get better. The
solutions states employ to close projected budget gaps will have painful effects on state residents and
businesses but pose a more modest risk to the national recovery. Historically, the health of the national
economy determines the health of state finances, not the other way around. Sustained improvement in
the national economy is essential for states to grow their way out of their current problems and
improve their fiscal conditions.

Jeremy Gerst is an economic analyst at the Federal Reserve Bank of San Francisco.
Daniel Wilson is a senior economist at the Federal Reserve Bank of San Francisco.

References

B0yd, Donald J., and Lucy Dadayan. 2010. “Revenue Declines Less Severe, But States’ Fiscal Crisis Is Far from
Over.” State Revenue Report 79 (April), The Nelson A. Rockefeller Institute of Government.
http://www.rockinst.org/pdf/government_finance/state_revenue_report/2010-04-16-SRR_79.pdf
McNichol, Elizabeth, and Nicholas Johnson. 2010. “Recession Continues to Batter State Budgets; State Responses
Could Slow Recovery.” Center on Budget and Policy Priorities (May 27). http://www.cbpp.org/files/9-8-
08sfp.pdf
Weidner, Justin, and John C. Williams. 2010. “The Shape of Things to Come.” FRBSF Economic Letter 2010-15
May 17. http://www.frbsf.org/publications/economics/letter/2010/el2010-15.html

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