The weak economy has precipitated another state budget crisis. State tax revenues have dropped sharply, while their costs continue to rise. To maintain budget balance, states are cutting employment and services while raising fees and taxes. These actions delay economic recovery and offset the economic stimulus coming from monetary policy and the federal budget. Since state budget reductions fall heavily on programs that serve the low-income population, state budget crises tend to hit the most vulnerable when they are already feeling the impact of a weak economy. In an effort to keep up with the rising cost of state services, states have increasingly relied on income taxes. Income tax revenues grow faster than relatively sluggish sales tax revenues, but the more rapid growth comes at the price of greater volatility over the business cycle.
This brief describes the state fiscal problem and suggests some solutions. The federal government could provide immediate fiscal relief to the states, and adopt a longer run program to mitigate cyclical swings in the state revenues. States could build more adequate reserves in good times. They could work together to modernize and harmonize their tax systems and share some jointly collected revenues.