Citation URL: http://www.urban.org/DavidMerriman

Every state except Vermont operates under some sort of balanced budget requirement. That means that to serve the increased need of distressed populations during recessions, states must either increase revenue or reallocate resources dedicated to other programs. Similarly, when revenue declines, states must raise taxes or reallocate resources. This report examines the extent to which rainy day and general fund savings were a significant factor in helping states cope with fiscal stress during and after the 2001 recession, a possible explanation for the lower than expected legislated tax increases and social welfare cuts.

The states experienced rapid and dramatic nominal revenue declines following the 2001 recession, but spending did not follow suit. The chart in this article shows general fund revenues and spending from 2000 to 2006 (not adjusted for inflation) and savings as a percent of prior-year expenditures. Spending over the 2001-2003 period was essentially flat in the face of lower revenues, and a drop in savings made up some of the shortfall.

This analysis of seven states (California, Colorado, Florida, Michigan, Mississippi, New Jersey, and Washington) shows that the severity of the current revenue crisis far exceeds that of the recession that triggered it because states cut taxes and expanded programs based on unsustainable revenue growth during the late 1990s. All of the states studied responded to revenue declines with short-term solutions -- using reserves, transferring other funds to the general fund, refinancing debt, and shifting expenditures or revenues across fiscal years. All but New Jersey and Washington cut spending. Only New Jersey relied heavily on tax increases. The authors suggest that states should be realistic about the sustainability of future revenue trends and should not count on federal help. States should also build up reserves and be able to draw on them when needed, and should make tax policies symmetrical rather than place special barriers against tax increases.

We compare state tax policy responses to the recessions that began in July 1990 and April 2001. Tax revenue declined more in the 2001 recession even though the output shock was smaller. In the early 1990s, states quickly altered tax policy to replace a large share of lost tax revenue. In the recent recession, states have made few tax policy changes to enhance revenue except for increasing tobacco taxes. We present some reasons for this behavior and argue that states are on the verge of missing an opportunity to improve their tax systems.

State tax revenues were $32 billion lower in 2002 than in 2001, the first year over year revenue decline in recent history.1 Since then, budget conditions have deteriorated further, with an aggregate budget gap of $49 billion in 2003, according to the National Conference of State Legislators. The last time most states faced severe budget problems was in the recession of the early 1990s. States typically legislate tax increases during economic downturns and tax cuts during booms. During the 1990 recession, policymakers raised taxes. Tax increases continued in 1993 and 1994, but were followed by tax cuts from 1995 to 2001.

Large funding differences reflect the realities of the old welfare system and unfairly disadvantage many states.

The diversity of state programs makes comparison of fiscal activities across states and over time difficult. This paper compares ongoing surveys that provide data about state revenues and expenditures from the Census Bureau, National Association of State Budget Officers, National Conference of State Legislatures, and the Nelson Rockefeller Institute of Government. The strengths and weaknesses of each source are discussed and differences in the estimates of recent state budget growth by each source are analyzed.

While real per capita state expenditures increased an average of 29 percent from 1988 to 1997, the brief finds that states' expenditures for public welfare increased by 71 percent. Payments to vendors for medical services - most under the Medicaid program - increased by 111 percent and accounted for 80 percent of the growth in public welfare spending. Significant increases in state spending also occurred in health and hospitals (28 percent), elementary and secondary education (24 percent), and corrections (54 percent). Substantial growth in three sources of revenue accounted for most of the additional revenue states needed to pay for these increased expenditures: federal payments (57 percent), individual income tax (28 percent), and sales tax (20 percent).

States responded to economic recessions by legislating increased sales and income taxes. When the economy improved, states rolled back much of the income tax increases while leaving the sales tax increases in place. Despite this pattern, sales tax revenues grew less than income tax revenues because of long-term declines in the sales tax base resulting from, among other things, increased Internet and catalog sales. In the future, pressure on the income tax may increase, since the importance of sales tax is diminishing as a source of revenue and sales tax rates are already high.

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