The State Fiscal Crisis

Peter R. Orszag
Peter R. Orszag Vice Chairman of Investment Banking, Managing Director, and Global Co-Head of Healthcare - Lazard

August 1, 2003

To view the full paper visit the Tax Policy Center

State governments play a critical role in the nation’s fiscal and economic system. They collect revenues on the order of 6 percent of GDP, or roughly a third as much as the federal government. They have long been responsible for key government functions that affect long-term economic growth as well as everyday life—notably, education and law enforcement. What’s more, over the past two decades, devolution has given them expanded responsibilities in core areas like health care and welfare.

The ability of state governments to meet their obligations is now threatened by yawning budget deficits. According to the National Conference on State Legislatures, projected deficits total $80 billion—about 15 percent of expenditures—for the fiscal year that began in July in most states. And after two years of budget nips and tucks, states have largely run out of easy options. They are now cutting health care for the poor, slashing higher education spending, releasing prisoners early and even unscrewing light bulbs to save on utility bills. These actions are harmful not only from a social perspective, but from a macroeconomic one. They are a sort of “anti-stimulus,” reducing demand for goods and services just when the economy has capacity to burn.

The states’ responses to this most-recent fiscal crisis differ from past efforts to close budget gaps. In the early 1990s, for example, states aggressively raised taxes to mop up the red ink. This time around, however, they have relied much more on spending reductions—with troubling implications for the ability of state governments to deliver crucial services like higher education. The $20 billion in emergency relief that was part of the recently enacted federal tax cut package will close only a modest portion of the states’ fiscal gap.

The proximate cause of the state budget crisis is easy to pinpoint. The sluggish performance of the economy, combined with the bursting of the stock market bubble, significantly reduced state government revenue even as state outlays for Medicaid soared. But that is not the whole story. The states failed in their duty to accumulate adequate reserves during the boom of the 1990s, and Washington has no general countercyclical revenuesharing program to help the states help themselves. Because of both what it has done and what it hasn’t, Congress has shifted more costs to states—notably, through the Medicaid program.