Up Front

The Budget Crisis in the States

Tracy Gordon

On February 2, Tracy Gordon, author of a recent article on state and local finances, took questions in a live web chat on budget crises facing the states.

The transcript of this chat follows.

12:30 Seung Min Kim: Welcome everyone and thank you for joining us. We have Tracy Gordon here to answer your questions about state budget crises. Welcome, Tracy.

12:30 Tracy Gordon: Thanks, good to be here.

12:30 [Comment From Carl Osgood: ] The Rockefeller Institute reported, yesterday, that state revenues “are on the rebound,” although not enough to close current budget gaps. This, combined with the rising stock market is suggesting to some that “we’ve turned the corner” on the economic crisis. But the Angelides financial crisis commission concluded that the crisis was avoidable in the first place and that no real measures have been taken to prevent it from happening again. Rather than there being light at the end of the tunnel, doesn’t this mean that states are in for even bigger budget crises when the next Wall Street bubble crashes?

12:32 Tracy Gordon: The Rockefeller report was certainly good news. Revenues are up, although as you point out states are climbing out of a deep hole precipitated by the financial crisis. Only time will tell if we face something else this big in the future.

12:32 [Comment From Eric: ] Should there be a state bankruptcy code?

12:36 Tracy Gordon: The big issue with bankruptcy is sovereignty. Right now, states cannot declare bankruptcy because they are considered sovereign entities under the U.S. Constitution. Municipalities can in some states, but even then judges’ powers are circumscribed compared to under the corporate bankruptcy code. For instance, a judge can’t threaten to liquidate a municipality like a corporation. This significantly reduces leverage over all the parties who have to sign on to a deal. Witness Vallejo, CA which initiated bankruptcy proceedings in 2008 but is only now (maybe) emerging.

12:37 [Comment From George: ] How are pensions going to affect state and local budgets?

12:39 Tracy Gordon: Pensions are certainly a looming challenge. Some estimates suggest state and local governments are in the hole for as much as $4 trillion although this depends on some modeling assumptions. In any event, the key thing to remember is that pensions are a long term issue. The short term issue is projected shortfalls between revenues and spending now as governors craft their 2012 budgets.

12:39 [Comment From Rachel W.: ] Which states are in or headed for the most fiscal trouble? Are state governments doing anything specifically to avoid further budget crises?

12:43 Tracy Gordon: Illinois had the biggest projected budget gap until recently (about half of total spending) but they raised income taxes significantly to address the shortfall. A lot of states are doing very positive things to address future shortfalls. About half all states have commissions to look for efficiency improvements or ways to overhaul their tax codes. Although these actions won’t solve short-term problems, they’re still a good idea.

12:44 [Comment From Brian: ] Are we likely to see more Republicans, traditionally opposed to raising taxes – especially on the business community – turn to broadening the tax base by expanding services that get taxed?

12:45 Tracy Gordon: That’s a great question. Economists have long said that we should broaden sales taxes to cover services (where most consumption now occurs). Unfortunately, it can be very difficult politically. Individual service providers (e.g., lawyers, doctors) will object to being taxed and often the only service that gets hit is the one that’s not there for the negotiations (e.g., tanning salons). That outcome flies in the face of the whole idea of broadening the base and lowering the rate.

12:45 [Comment From Paul McFadden: ] Aren’t the state and federal budgets inextricably combined/ Can we get into a failure spiral here, where the states and the feds keep dragging each other farther down?

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12:49 Tracy Gordon: Yes, they are certainly inter-related. Concerns about negative spillovers to the national economy (and budget) were a main driver for federal policymakers to include payments to states and localities in the stimulus package. But then there is also the worry of moral hazard, or states and localities spending too much because they know they can count on the feds for a bailout. This created serious instability in other countries like Brazil and Argentina. The EU may also be instructive here. On the other hand, the challenges facing states and localities are the same as those facing the federal government — health care costs and aging populations. Maybe the states can be a source of creative solutions.

12:50 [Comment From Ioana Arghir: ] How can states and localities balance their books with minimum harm to national economic recovery? If balancing books implies cutting spending and/or increasing taxes, which effect will this have on economic recovery?

12:53 Tracy Gordon: There are differences of opinion about which is more harmful to a recovery – tax increases or spending cuts. It really depends on what kinds of policies we are talking about. In general, spending cuts can mean layoffs which reverberate more through the economy. Tax increases can also be harmful. But then there are some activities we might like to see less of, so taxes are a good thing (e.g., taxes on fuel or sugary sodas).

12:53 [Comment From Trent W.: ] Governors have been announcing their plans to deal with the crises – New York, California, etc. Who’s doing it well — or badly? Any real innovation out there?

12:55 Tracy Gordon: The best innovation I have seen is more transparency. I thought it was interesting that Gov. Cuomo yesterday presented his proposed cuts to Medicaid and education in terms of absolute dollar amounts as well as relative to a baseline. He also said the era of gimmicks was over, or something to that effect, which would be a good thing.

12:55 [Comment From PeterE: ] Given that most states will continue to depend upon services and programs that may get cut from the federal budget, how can states be preparing alternative options?

1:00 Tracy Gordon: The prospect of federal budget cuts is always scary to states, that tend to rely on the feds for about 20 percent of their revenues. Most of the cuts being talked about these days at the federal level — to discretionary spending and earmarks – would be concentrated in education and transportation. The big ticket item is Medicaid and proposals to block grant the program or make states responsible for managing the costs. This is scarier to state governors given the uncertainty in medical care expenses. Some states have requested Medicaid waivers to experiment with cost containment strategies. This may be one way of preparing. Another would be to get their own fiscal houses in order in terms of improvements to spending programs and the revenue code.

1:01 Seung Min Kim: Thanks for the chat today — a great discussion.