Spotlight on the States: Structural Challenges

Jul 18, 2012

The State Budget Crisis Task Force -- a group of budget experts including the likes of former CBO and OMB director Alice Rivlin, former Federal Reserve chairman Paul Volcker, and former Treasury secretary George Shultz -- released a report yesterday detailing the six biggest threats facing states in terms of long-term fiscal sustainability. They looked at six of the more heavily populated states -- California, Illinois, New Jersey, New York, Texas, and Virginia -- but their prognosis is easily applicable to other states.

Arguably, one of the largest fiscal burdens on states is that of Medicaid. The program is projected to grow faster than the economy or state tax revenue for the foreseeable future, meaning that changes will be needed to prevent the program from crowding out other spending or revenue will have to be raised to pay for it. The report notes that each state has attempted to tackle Medicaid costs in recent years, but there are limits on how much they can do without either violating federal guidelines or hurting providers too much. Coordination between both levels of government on how to control Medicaid costs would be ideal.

Another issue on the spending side is pension and health benefits for retired state employees. These benefits are projected to be underfunded as rising health care costs and aging of the population puts further pressure on these systems. Using conservative estimates, the six states studied have unfunded liabilities totaling over $500 billion. The report notes that pensions often have some level of constitutional protection so they are harder to scale back in a timely manner than other benefits. Beyond reforms to benefits, the report recommends that states more fully and more accurately account for future liabilities.

On the revenue side, the report notes problems of eroding tax bases and increased volatility for income taxes. On the first issue, the sales tax base has eroded due to both state legislative decisions and the growth of (generally) non-taxed Internet sales.  In addition, motor fuels taxes have eroded since the tax rates that are given as cents per gallon rather than as a percent of the sale have not kept up with inflation. Income taxes have become more volatile since they are increasingly made up by revenue from capital gains, which vary based on both the amount of the gains and the decision by investors of whether or not to realize those gains. Revenue from capital gains, as expected, plummeted in the aftermath of the financial crisis. The Task Force urges the federal government to facilitate the collection of taxes on internet sales and urges states to structure their tax system to rely on more stable sources of revenue.

Other Considerations
Two other threats to state fiscal positions come from above and below -- federal and local governments, respectively. With deficit reduction in the cards at the federal level, grants and other forms of aid to states could be reduced; in addition, a tax reform measure may reduce or eliminate, for example, the state and local tax deduction or the municipal bond exclusion, both of which could affect funding streams for states. The Task Force recommends that federal-level body or the CBO quantify the impact of federal legislation on states. In terms of local governments, many of them have been struggling with fiscal problems of their own, and states may have to help them out if the issues become severe. The Task Force advises increased monitoring of local government fiscal status so that they can address problems before they get out of control.

Budget Gimmicks
Finally, the report states that budget gimmicks used to fill short-term gaps have made longer-term fiscal balance harder to achieve. One of the most common gimmicks involves transactions that increase revenue in one year while producing liabilities in the following years. A notorious example of this practice is the Arizona state government's selling and leasing back of many of its own buildings, including the state capitol. Four of the six states studied have pulled forward revenue from a settlement with tobacco companies, one which is intended to compensate for smoking-related health care costs. As state budgets have become more volatile, these gimmicks have become more common, but they have also damaged state fiscal positions down the road. To deal with this, the Task Force recommends that states use accrual budgeting, which would more fully represent the budgetary impact of these gimmicks, and that states strengthen rainy day funds to make volatility less of an issue.

Since many people focus on the longer-term or structural challenges that the federal budget faces, it is appropriate that the Task Force has done the same for states. The report is well worth the read to see the problems that state governments are facing currently and will continue to face in future years.