States’ Budgets: You Don’t Know the Worst

It’s pretty common knowledge by now that many states are drowning in red ink. Most notably, the weak economy has created operating gaps ranging from the hundreds of millions of dollars in Arizona to the tens of billions in California, Illinois, and New Jersey.

Deep cuts in public spending have become the order of the day, some executed with more care than others, and although political rhetoric presents an obstacle, some leaders are contemplating whether to raise taxes, as Illinois did recently.

And yet, that’s just part of the deficits problem. Bad as this situation is, this year’s difficulties are arguably one of the lesser aspects of a longer-term, public finance crisis in the states that actually won’t improve, like the short-term one will, as the economy recovers.

How is that? A new report recently released by my group at Brookings Mountain West, working in partnership with the University of Tennessee economist Matt Murray and Morrison Institute of Public Policy at Arizona State University, lays out the problem, focusing on California and in the Intermountain West.

On the one hand, the large “cyclical” deficits most states are grappling with represent the temporary fallout of the Great Recession These shortfalls are daunting but will pass once the picks up. In that sense, these gaps of hundreds of billions of dollars are the easier part the problem.

The hard part; because they are more entrenched, are what we call “structural” deficits — the more or less permanent imbalances of revenues and expenditures arising from flaws in a state’s fiscal structure, fundamental changes in the regional economy or the state’s demographics, or, especially, imprudent or shortsighted policy choices.

In Arizona, this sort of structural shortfall now adds up to a cool $2.1 billion — a chilling 21 percent of stable general fund expenditures. In California, the figure is about $9.2 billion — about 9 percent of stable expenditures. And these figures leave aside such other long-term challenges like pension obligations and retiree health insurance.

How do these structural problems arise and what needs to be done about them? The contrasting messes in California and Arizona — two of the Western states we studied in our report–display in extreme versions the kinds of rashness and imprudence that have gotten so many states in trouble.

California’s budget problems show how overly-optimistic spending, combined with voter mandates and institutional constraints (with none of it linked together), can lead to calamity. There, a proposition directing half of all new revenue to schools has combined with multiple state and local voter-approved limits on taxing and revenue raising to produce a train-wreck.

Arizona’s fiscal problems demonstrate, meanwhile, how a single-minded emphasis on tax-cutting combined with California-style voter mandates and institutional constraints can also lead to a crack up. Arizona basically gave away the store in better times by handing out an inflation-adjusted $2.9 billion in ill-advised tax cuts over some 15 years unaccompanied by spending cuts. Major new education and Medicaid expansions in the last decade added to the problem, but for the most part a fiscal disaster resulted from the combination of massive tax cuts, voter mandates and a super-majority requirement for any revenue increase.

The long-predicted result: The Arizona general fund is now short some $3.4 billion, or a full 33 percent of the needed total, for FY 2011 with fully two-thirds of that amount associated with the state’s permanent structural gap.

The bottom line: Arizona and California, notwithstanding their contrasting political tilts, each ran into the ditch by combining rash, basically optimistic spending and tax decisions in good times with rigidity and narrowness all along. In each place, moreover, the basic need to constantly compare spending and revenue-raising broke down thanks to ideological fixity, a loss of consensus, and the recourse to voter mandates.

So what should these and similarly afflicted other states like Illinois and New Jersey do? States need to break with business-as-usual in three fundamental ways.

First, they will need to take unprecedented steps to close gaps–and the sooner the better. Austere states will need to add revenue increases to the mix while profligate ones will need to discipline spending.

Second, states need to broaden, balance, and diversify their revenue bases while looking to the long-haul balance of taxing and spending. Over-reliance on narrow bases won’t cut it now.

And third, states need to improve the information sharing and budgeting processes.

And yet, to achieve any of this, there is one other requirement: States are going to need to reject conventional dynamics. They need to reconstruct the integrity of their budget process, make it harder for interest groups to pass budget-blowing measures that undermine sound fiscal policy, and get beyond ideological warfare to foster more collaboration.

The choice couldn’t be more clear. States need to make the sound policy decisions necessary to putting their fiscal house back in order, or prolong over many years a world of hurt.