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The Worst May Be Over, But Big Challenges Remain For State Budgets

May 03, 2010

Spending on Medicaid, along with the cost of health insurance for state and local retirees and current employees, will continue to grow faster than the gross domestic product.

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With an improving economy and help from the federal government, the worst of the fiscal bloodbath for state governments seems to be over. But the next couple of years still will be challenging and the long-run outlook for state budgets is shaping up to be even tougher.

The pickup in consumer and business activity has been stronger than most state officials assumed when they were planning their budgets for fiscal 2010, which ends June 30 for most states. The U.S. economy grew at a solid 3.2 percent annual rate in the first quarter, according to the Commerce Department’s latest report, with help from a 3.6 percent advance in consumer spending that was the strongest quarterly showing in three years. Although quarterly growth was slightly less than some economists predicted, the annualized rate over the past three quarters is 3.7 percent, more than twice the pace they expected at this time last year.

State and local tax receipts began to turn up in the third quarter of 2009 as a result and have increased at an estimated 5.5 percent annual rate through this year’s first quarter, based on the Commerce Department’s accounting. Unlike individual state data, the Department’s numbers are seasonally adjusted, which allows quarter-to-quarter comparisons. Tax revenues peaked in the second quarter of 2008 and plunged a record 8.8 percent over the next four quarters, triggering dire projections for state coffers and some of the sharpest and most widespread cutbacks in services ever seen. Along with new revenues and about $140 billion in federal grants paid out over a two-and-a-half-year period as part of Washington’s stimulus package, that belt tightening, which included closing schools and state parks and highway rest areas, among other things, helped stabilize the states’ overall fiscal situation—for now.

But governors aren’t breathing any easier about the future, and they shouldn’t be. Budget pressures remain especially intense in states beset by the housing slump and high unemployment. Despite growth on the national level, as of March, economic activity was still declining in 10 states compared to the previous three months, according to a state-by-state analysis by the Federal Reserve Bank of Philadelphia. The Philly Fed’s data, which goes back to 1979, shows that at the same time last year all 50 states were mired in recession, something that has never happened, even in the severe 1973-75 and 1981-82 economic downturns.

If the effects of the recession and its aftermath haven’t been bad enough, a recent assessment by the General Accounting Office concludes that even after the economy regains its pre-recession losses, the pressure on state budgets will continue to grow over the long term. State and local governments face a structural budget headache that, much like the federal problem, is hard-wired into future state finances.

The culprit is health care costs. Spending on Medicaid, the joint federal-state program that finances health care for low-income individuals, along with the cost of health insurance for state and local retirees and current employees, will continue to grow faster than the gross domestic product. Over the next 15 years, the GAO projects health-related outlays of state and local governments, as currently mandated, will rise to 5 percent of GDP, from 3.5 percent in 2010.

Based on the GAO projections, JPMorgan Chase analysts say, even if taxes stay close to historical norms and non-health care spending declines as a share of GDP, state and local deficits will still widen over time. To achieve fiscal balance, the GAO estimates that governments would have to cut expenditures by 12.3 percent beginning this year and in every year going forward, or raise taxes by the same amount, or implement some mix of the two. Almost all states have some kind of balanced-budget law.

States are starting to look at projections for the next fiscal year, beginning for most on July 1, and they don’t like what they see. Funding will take a big hit as help from the federal Recovery Act fades. During calendar 2009, according to Commerce Department data, the increase in federal grants-in-aid more than accounted for all of the $73.6 billion increase in the total receipts of state and local governments.

Those federal funds are scheduled to decline by about $45 billion in the federal government’s fiscal year beginning Oct. 1, 2010, an amount equal to 3.5 percent of state and local tax receipts, according to calculations by economists at JPMorgan Chase. That loss will offset much of the gains from the economic recovery and previous spending cuts. Moreover, states already have tapped their emergency reserves, while delaying new projects and deferring needed maintenance on roads, bridges, and buildings.

Many budget cuts planned for the next fiscal year go even further than those already enacted, according to a state budget update last month (April) from the Center for Budget and Policy Priorities, a liberal-leaning think-tank.

The CBPP says governors from California to Connecticut and Michigan to Mississippi are putting forth plans for additional cuts in education, health and other human services, as well as further reductions in state payrolls.

The bottom line is clear and ominous: State budgets will continue to be under pressure for as far as the eye can see and more cuts are likely in the offing.

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