State Budgets: Recent Trends and Outlook By Donald J. Boyd

Transcription

1 State Budgets: Recent Trends and Outlook By Donald J. Boyd BUDGET States are recovering from the recent fiscal crisis, but many will need to cut spending further or increase taxes to bring spending and revenue into line. In addition, states must confront fiscal pressures in Medicaid, elementary and secondary education, and other areas, and will face risks from actions to reduce the federal budget deficit. The Fiscal Crisis and How States Have Responded State tax revenue fell 10 percent between fiscal year 2000 and 2003, adjusted for inflation, population growth and legislated changes far more than the relatively mild recession would have suggested, and nearly twice as much as in the crises of the early 1980s and early 1990s. States were better prepared for this recession than the prior one. They buffered much of the initial revenue shock by drawing fund balances down from 10.4 percent of expenditures to 3.2 percent, a drop of 7.2 percentage points compared with only a 3.7 percent drop in the previous recession (when fund balances at the start were lower). States also garnered considerable nonrecurring revenue by issuing bonds that allowed them to convert annual tobacco settlement revenue into a few large payments. Drawing down balances and tapping nonrecurring revenue sources allowed states to push some of the problem off to future years. Elected officials and the public in most states have had little appetite for tax and fee increases. Cumulative increases in response to this crisis have amounted to only 3.5 percent of own-source revenue, down sharply from the 9 percent increases in each of the prior two crises. Spending cuts have been more popular: states have cut real per-capita general fund spending by about 6.4 percent from its 2001 peak, similar to reductions in the 1980s crisis but far deeper than in the early 1990s when states hardly cut aggregate spending at all. Tax revenue fell so far in this crisis that subsequent tax increases and economic growth have not been enough to raise revenue to its prior level. For the nation as a whole, state tax revenue in 2004 was still 6.7 percent below the 2000 pre-crisis peak, adjusted for inflation and population growth. 1 By contrast, four years after the last crisis hit real per-capita state tax revenue in 1994 was 6.8 percent above its 1990 pre-crisis peak (Figure A). Tax revenue has continued to recover in 2005, but assuming states hit their budgeted estimates they will still end the year more than 4 percent below The failure of state tax revenue to recover to precrisis levels despite tax increases and economic growth is widespread, as Figure B shows: 36 states had lower real per capita tax revenue in 2004 than in 2000, and the median for these shortfall states was 8.0 percent below States that are the furthest below 2000 generally rely heavily on income tax revenue or had economies that were hit disproportionately hard by the recession. Wyoming and several other states with large increases in revenue benefited from increases related to oil, natural gas and other natural resources that tend not to follow the national business cycle. Simply put, current state revenue structures cannot support as much spending as before the crisis. To be sure, states have cut spending, although it is difficult to measure quite how much. The earliest available data on state expenditures come from reports state budget offices provide to the National Association of State Budget Officers (NASBO). Unfortunately, these data generally serve the needs of the annual budget process and are not always classified the same way from year to year (or from state to state). In each of the last two recessions, the NASBO data tended to show considerably deeper cuts in state budgets than the more comprehensive and consistent expenditure data reported by the Census Bureau two years later. NASBO data might overstate spending cuts in this crisis as well, but we won t know for nearly two years. NASBO data show that total state general fund expenditures have declined by 3.3 percent between 2000 and 2004, adjusted for inflation and population growth. 2 However, this overstates cuts in recurring spending because it includes capital spending financed by the general fund as well as operating expenditures. States tend to scale general fund capital spending back sharply in crises, either deferring capital projects or financing them from other sources such as bonds and dedicated revenue. Although these cuts help to balance annual budgets, the spending can spring back sharply The Council of State Governments 401

2 Figure A: Real Per Capita State Government Tax Revenue Indexed to Pre-Crisis Peak, 2 Crises (actual revenue, not adjusted for legislation) index relative to prior peak Last crisis This crisis # of years from pre-crisis peak Sources: Taxes: Through 2002, cenfin database (Rockefeller Institute database of Census Bureau data). For 2003, Census state tax collections from their website (2002 tax data from this Census source matches 2002 from other Census sources, giving comfort that the 2002 to 2003 growth rate is appropriate). For 2004, growth rate from Rockefeller Institute Revenue Report tax data (as collected by Nick Jenny) applied to 2003 Census tax data. For 2005: assume that state budget offices forecasted growth rates (from NASBO s Fiscal Survey) for income, sales, and corporate taxes reflect what will happen to taxes as a whole (see below) Population: Through 2002, cenfin database. For 2003, 2004, from same census pop source. For 2005, assumed to grow 1% based on recent prior history the population data were pieced together from various Census Bureau sources and are all on a July 1 (not April 1) basis. Inflation: slgcwpi (state and local government chain-weighted price index) BEA. For 2005 (cy 2004), assumed to be 3 percent based on my earlier analysis of how inflation was running for the year. after the crisis ends. Between 2000 and 2004 state governments cut general fund capital spending by 48 percent in real per-capita terms reductions that probably will not be sustained. Table A removes general fund capital spending, showing just spending on operations. By this measure, spending fell by 2.9 percent between 2000 and 2004 well shy of the 6.7 percent tax revenue decline in the same period. 3 As the table shows, spending on Medicaid increased by 6.4 percent, while all other areas in aggregate were cut back. State support for higher education was cut particularly sharply, leading to double-digit tuition increases in many public universities. In about half of the states general fund spending grew faster than tax revenue between 2000 and 2004, adjusted for inflation and population growth, and by at least 5 percentage points faster in more than a dozen states. The implication is that despite improving revenue collections, many states still will need to raise taxes or cut spending further to keep budgets balanced. This is consistent with reports that approximately half the states faced gaps for FY 2006 at the time governors were preparing proposed budgets. 4 Spending Pressures Medicaid: After a brief slowdown in the late 1990s, Medicaid returned for several years to double-digit 402 The Book of the States 2005

3 Figure B: Percentage Change in Real Per Capita State Tax Revenue, 2000 to 2004 growth rates and now is the single-largest area of state government spending (including spending from state funds and federal funds), ahead of elementary and secondary education. The growth resulted from many factors that are difficult or impossible for states to control, including expensive and rapidly evolving technologies and drugs (which affect privately funded health care as well as public programs), and growth in enrollment of expensive-to-care-for disabled and dual eligible populations (individuals eligible both for Medicare and for Medicaid). In addition, state and federal policy choices to expand Medicaid to cover more low-income children and pregnant women and to reach out to potentially eligible populations and enroll them in Medicaid have contributed to spending increases. 5 Many of these forces will continue to drive Medicaid costs upward in coming years. In addition, the aging of the population will begin to have a significant impact. This is important because the average elderly Medicaid recipient costs more than seven times as much to care for as the average low-income adult or child. Economy.com forecasts the population aged 65 and over will grow by about 8.5 percent between 2005 and 2010, and growth will accelerate after that. By contrast, the under-65 population is expected to grow by 3.8 percent between 2005 and As the population ages, states may find it difficult to finance rapidly increasing demand for Medicaid-financed prescription drugs and expensive longterm care services. Many Southwestern and Mountain states are likely to feel this pressure soonest, with most facing growth in the next 10 years of 45 percent or more 6 (see Table B). The Council of State Governments 403

4 Table A: Real Per Capita General Fund Operating Expenditures Amount per capita (2004 $) Programs FY 2000 FY 2004 Percent change Total $1,821.2 $1, % Elementary and secondary education Medicaid Higher education All other Sources: National Association of State Budget Officers Expediture Report 2001 and 2003 (state expenditures), Bureau of Economic Analysis (state and local government chain-weighted price index), and Bureau of the Census (population). Table B: Projected Growth in Population Aged 65+: States Facing Fastest Growth, 2005 to 2010 State 2005 to to 2015 United States median 8.5% 24.7% Nevada Arizona Alaska Colorado Utah Idaho Georgia Washington Oregon Texas Source: Rockefeller Institute analysis of projections from economy.com. Analysts at the Centers for Medicare and Medicaid Services recently forecasted that state government Medicaid spending will continue to grow faster than the overall economy for the foreseeable future, rising at an average annual rate of 8.6 percent for the nation as a whole over the period from 2006 through percentage points faster annually than the economy is projected to grow, and 5.4 percentage points faster than population growth plus general price inflation. 7 Thus, even without major changes in federal participation Medicaid seems likely to strain state finances. Elementary and secondary education: Elementary and secondary education enrollment growth is slowing in most of the nation, although there will be pockets of rapid growth. Over the next five years, the number of children in the 5 19 age group is forecasted by Economy.com to decline in two-thirds of the states. Most of the significant exceptions are in the southwest or west Nevada, Arizona, Alaska, California and Texas all will see population in this age group increase by 5 percent or more over the next five years. However, the pressures to increase spending per pupil are larger than ever. Even before the No Child Left Behind Act (NCLB), states were raising graduation and learning standards, creating demand for updated textbooks and curricula, smaller class sizes, more highly qualified teachers, more academic intervention services, enhanced summer learning opportunities, and other supports, all of which cost money. NCLB will intensify these demands. In addition, almost every state has had its system of financing education challenged in court and about two-thirds of challenges in the past 15 years have been successful, creating additional pressure to spend more. The costs of meeting higher standards and responding to court challenges cannot be estimated with any confidence, but it is clear they could be very large. One recent study estimated statistically the costs of bringing low-performing school districts in Texas up to the statewide average on certain exams, and concluded that it would take a doubling of state aid to school districts in Texas to accomplish this. 8 The court-appointed referees in a New York lawsuit recently issued a report estimating an increased need of $5.6 billion annually in New York City, a more-than-40 percent increase. 9 Cost studies associated with litigation in other states also have concluded that spending increases would need to be very large. Some researchers argue that higher spending will not lead systematically to higher student achievement, but in the context of the existing education system it seems clear that states, school districts, parents, and courts will seek considerably higher spending. Higher education: Higher education is the thirdlargest spending category for the state-local sector. Public colleges and universities enroll more than 12 million students and account for more than 77 percent of all higher education enrollment. State 404 The Book of the States 2005

5 expenditures on higher education as a share of gross domestic product have fallen almost continuously since 1976, in part reflecting graduation of baby boomers from the higher education system and in part reflecting lower priority for higher education than for other services. State contributions to public higher education institutions were battered in the recent fiscal crisis real state appropriations for public higher education institutions fell by 7.8 percent between FY 2002 and FY 2004, and declined in 36 states, contributing to widespread double-digit increases in tuition. Labor markets are demanding that workers have more higher education the U.S. Department of Labor estimates that occupations in which threequarters or more of workers have at least some college education will constitute 43 percent of the new jobs in the decade from 2002 to 2012, despite accounting for only 29 percent of current jobs. 10 This labor market demand is likely to lead to higher college participation rates among people in the labor force of all ages. In addition, underlying demographic forces will drive up enrollment in some states, as baby boomers children exit high school and enter college. For the nation as a whole, this should place only mild pressure on the higher education system, but in some states the population in the largest college-going age group, year olds, will grow substantially. According to Economy.com, growth will be fastest in the Northeastern states and California and as a result these states may face additional pressure to finance higher education. Other important areas of state and local finance: Medicaid, elementary and secondary education, and higher education are the three largest areas in the typical state budget and all face spending pressure. Some smaller areas will face pressure as well, while others may provide fiscal savings. One notable area that could cause difficulty for some governments is employee pensions: state and local government pension fund earnings more than doubled relative to state and local budgets between 1990 and 2000, allowing governments to scale back contributions (with a lag) by more than 30 percent despite rising pension obligations. That trend has since reversed and many state and local governments now face rapidly rising pension contributions that are sometimes quite significant relative to their budgets. Federal Budget Cuts and Policy Changes Federal deficit-reducing actions will affect states in several important ways, including cuts in grant programs and proposals to restructure the federal tax system. The discussion below is based on the president s proposed budget; the final budget could impose larger cuts than those discussed here, or smaller cuts, but is likely to include significant cuts in any event. Federal grants to state and local governments were $423 billion in FY 2004, accounting for one quarter of the federal budget for domestic programs. Grants account for approximately 30 percent of all state government revenue and 4 percent of local government revenue. 11 Approximately one-third of federal grants are labeled mandatory and the rest are discretionary. Large well-known mandatory grant programs include Medicaid, Temporary Assistance to Needy Families and child nutrition programs. Large well-known discretionary programs include Title I education grants for the disabled, special education grants, and various public housing and community development grants. Cuts in Federal Grants Other than Medicaid The president s budget proposes sharp cuts in grants to state and local governments. In FY 2006, discretionary grants would be cut by 9.2 percent in real per capita terms, and grants for mandatory programs other than Medicaid would be cut by 5.8 percent. 12 Combined, these cuts would be equivalent to about a 2.4 percent reduction in state government tax revenue. The budget does not itemize cuts in grants beyond 2006, but it proposes caps on domestic discretionary spending that would lead to cuts between 2005 and 2010 of 16 percent, adjusted for inflation and population growth. If discretionary grants, which account for about one-third of domestic discretionary budget authority, share proportionately in these cuts and if cuts in non-medicaid mandatory grants are proportionate to cuts in non-medicaid mandatory entitlement programs, the recurring annual cut in these grants by 2010, in real per capita terms, would be the equivalent of about a 4 percent cut in state government tax revenue. Put in perspective, that would be a permanent drop in state government revenue that is almost as large as the cyclical tax revenue drop of the 1990s recession and a little less than half as large as the tax revenue decline in the recent fiscal crisis. These are large enough to get the attention of state governments, particularly since there would be no reason to expect grant revenue to bounce back in later years. The Council of State Governments 405

6 Medicaid Cuts and Restructuring 13 The president has proposed $45 billion in net federal Medicaid savings over the next 10 years, reflecting $60 billion of cuts and $15 billion in new initiatives. Most of the federal savings would result in higher costs to states, but some would result in state savings, for a net cost to states of $34 billion over 10 years. The largest changes that would provide savings to states include reductions in payments Medicaid will make to pharmacies and provisions that would make it harder for people seeking to enter nursing homes to shield assets from Medicaid. The largest changes that would shift costs from the federal government to states include limits on intergovernmental transfers (IGTs can allow states to increase federal reimbursement without increasing expenditures), limits on administrative expenditures, and restrictions on case management expenditures. The president s budget also proposed to increase outreach to and coverage of children, increasing federal and state expenditures. All told, Medicaid changes appear likely to increase state Medicaid expenditures by about 2 3 percent over 10 years. Federal Tax Reform Perhaps the largest risk is the possibility that the federal government will enact a major overhaul of the federal tax system, adopting a retail sales tax, a consumption tax or a value-added tax. Whatever the merits of these changes for the federal tax system and the nation s economy, all of these choices could create major and largely undiscussed problems for state and local government finances. Depending on very important details, these proposals could (a) eliminate the deductibility of state and local income and property taxes, raising the effective cost of state and local services and having dramatically different impacts across states, (b) tread into the traditional state-local terrain of sales taxes, making it difficult for state and local governments to raise revenue from these taxes, (c) make it impractically expensive for states to have their own income taxes if federal tax changes are in place of the existing federal income tax, and/or (d) raise the costs to states of maintaining and improving infrastructure, if municipal bond interest is no longer tax-exempt. Conclusions The recent recession is behind states, and state revenue is recovering. However, tax revenue fell so sharply during the recent fiscal crisis that despite economic recovery and recent tax increases, real per capita revenue remains below its prior peak in 70 percent of the states. States have raised taxes by far less in this crisis than in the prior one, and cut spending by more. They also drew down fund balances by more, and have relied heavily on tobacco bonds and other nonrecurring revenue. The net result is that many states still face budget gaps and are likely to need more spending cuts or tax increases to bring revenue and spending into balance. As states continue to work their way out of this hole, they will confront spending pressures from their own citizens and economies, and fiscal risks from actions to reduce the federal deficit. Medicaid is now the largest state spending area, and restraining price and utilization of health care will remain difficult. In addition, the impending growth in the elderly population also will place pressure on Medicaid over the next decade, and sooner in many Southwestern and Mountain states. States will face pressure to raise spending on elementary and secondary education in an effort to achieve higher standards, and will face labor market and demographic demands for additional spending on higher education. Federal budget cuts will add to fiscal pressures states face. The president s FY 2006 budget proposed cuts in discretionary grants and mandatory grants other than Medicaid that are the equivalent of about a 2.4 percentage point drop in tax revenue in 2006, and could grow to the equivalent of about a 4 percentage-point drop almost as large as the tax revenue drop in the 1990 recession, but presumably permanent. The federal budget also would cut Medicaid, exacerbating fiscal pressure on the states. Finally, if the federal government overhauls the federal tax system by moving toward a consumptionbased tax, it could make it extremely difficult for state and local governments to raise revenue. Debates over federal tax policy have so far paid very little attention to tax reform s impact on state and local governments. While the recovery in tax revenue is welcome news for state governments, they will need this revenue growth and more, or cuts in spending, to keep budgets in balance in coming years. Notes 1 For this purpose, I do not adjust for legislative changes because I am interested in how much states can spend revenue states actually collect. 2 General fund expenditures are a reasonably good indicator of spending supported by taxes and other revenue states raise from their own sources (excluding federal aid). Arguments can be made for alternative measures of state- 406 The Book of the States 2005

7 financed spending, but all have their flaws and I find this measure preferable for the purpose here. 3 Operating expenditures actually increased by 14 percent in nominal terms, but that is not a good measure of underlying pressures because it does not take into account the fact that prices and population have increased since Real per capita expenditures is a better measure. 4 See Elizabeth C. McNichol, State Fiscal Crisis Lingers, Center on Budget and Policy Priorities, Revised February 15, For an analysis of recent Medicaid spending growth, see John Holahan and Ghosh Arunabh, Understanding the Recent Growth in Medicaid Spending, 2000 to 2003, Health Affairs Web Exclusive, January 26, A more meaningful but less intuitive way to look at the data is to examine the change in the elderly population as a share of the total population. This does not alter in any significant way conclusions about which states will face pressures soonest, so I present the simpler approach. 7 Stephen Heffler, Sheila Smith, Sean Keehan, Christine Borger, M. Kent Clemens and Christopher Truffer, U.S. Health Spending Projections for , Health Affairs Web Exclusive, February 23, Andrew Reschovsky and Jennifer Imazeki, Financing Education So That No Child Is Left Behind: Determining the Costs of Improving Student Performance, Developments in School Finance 2003, (National Center for Education Statistics, 2004). 9 John D. Feerick, E. Leo Milonas and William C. Thompson, Report and Recommendations of the Judicial Referees, Supreme Court of the State of New York, Campaign for Fiscal Equity, Inc., et al., vs. The State of New York et al., Index No /93, Honorable Leland DeGrasse, November 30, Daniel E. Hecker, Occupational Employment Projections to 2012, Monthly Labor Review, (U.S. Bureau of Labor Statistics, February 2004). 11 Based on Census Bureau data for FY The Center on Budget and Policy Priorities has issued several reports on the impact of the federal budget on grants and on other domestic programs. This analysis is based on many of the same data sources as those analyses. There are two main reasons for differences in numbers between the analyses: I adjust for population growth, and I compare 2006 and later grants to grants in 2005 rather than to a projected baseline. Sources: Federal budget for FY 2006, unpublished OMB tables underlying federal budget, and Carlitz, Ruth, Domestic Discretionary Funding Levels for 2006 through 2010, Detailed Data, Center on Budget and Policy Priorities, February 28, This section draws heavily on Victoria Wachino, Andy Schneider and Leighton Ku, Medicaid Budget Proposals Would Shift Costs To States And Be Likely To Cause Reductions In Health Coverage, (Center on Budget and Policy Priorities, February 18, 2005). About the Author Donald J. Boyd is the director of fiscal studies at the Rockefeller Institute of Government of the State University of New York. His past positions include director of the economic and revenue staff for New York state s budget office, and director of the tax staff for New York s Assembly Ways and Means Committee. Boyd holds a Ph.D. in managerial economics for Rensselaer Polytechnic Institute. The Council of State Governments 407