Understanding States' Fiscal Health During and After the 2001 Recession

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Abstract

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.

Introduction

Every state except Vermont operates under some sort of balanced budget requirement (National Conference of State Legislators 1999). 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. That requirement can cause states substantial fiscal stress. Often, states will experience revenue declines (absent offsetting tax or fee increases) as they experience rising eligibility for state services such as unemployment insurance and Medicaid (Mattoon 2003). Thus, to provide even the same services available before a recession, states will have to increase spending to account for the larger, newly eligible population. Also, if costs rise from a particular part of the budget—for example, healthcare—level spending will still mean real cuts in services the state provides.

Typically, state tax policy increases during economic downturns fully offset revenue declines from slowed economic activity (Dye and McGuire 1999). State tax reactions to the recession in the early 2000s differed markedly. Rather than reacting quickly to increase revenue when it declined by increasing broad-based taxes, states enacted relatively few tax increases—and concentrated those increases on narrowly targeted tobacco taxes (Maag and Merriman 2003). Despite dramatic declines in revenues, McGuire and Merriman (2006) observe that social spending on two core programs—Medicaid and TANF—increased during the most recent economic downturn—even more than in downturns before welfare reform. Conversely, McGuire and Merriman find that other parts of the budget became more procyclical in the post-welfare-reform era, experiencing substantial cuts.

This report examines the extent to which rainy day and general fund savings were a significant factor in helping states cope with fiscal stress, a possible explanation for the lower than expected legislated tax increases and social welfare cuts. We begin by reviewing previous literature on the effectiveness of rainy day funds. We describe the data used for that analysis and define critical terms. We then summarize state resources during and after the 2001 recession. We ask whether states with relatively high levels of savings entering the fiscal downturn were able to weather it with fewer spending cuts than those with a smaller cushion. Further, we explore whether the size of the fiscal shock that a state suffered in 2002 reverberated beyond the recession into 2004 and 2005.

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The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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