The fiscal crisis in the States: how the states went from boom to bust

Business Economics, July, 2003 by Nicholas W. Jenny

State budget deficits are larger than they have been in at least a generation. For the most part, this was due to the revenue crash of 2001-2002, which was more severe than that of recent recessions and out of proportion to the severity of the 2001-2002 recession. Much of the crash was due to the same factors that created a revenue boom in the 1990s: capital gains, wages for top executives, some taxed stock options, bonuses, and other kinds of income that were related to investment. Because the economy and stock market are recovering slowly and because high levels of personal consumption cannot be sustained, it is likely that the states face a painful fiscal future for some time to come.

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As of 2003, just about every state has been struggling to close gaps between projected revenue and projected expenditures in their budgets. In some states, these gaps are huge. This has created great pressure on states to either increase taxes or cut spending, both of which would create a drag on the economy and present challenges for their residents.

These budget gaps are the largest that have been seen in at least a generation and come after some of the best times ever for state budgets. In the late 1990s, states tax revenue grew very quickly, building up surpluses that allowed states to cut taxes, increase spending, and build up budget reserves. In this paper, I will try to show that many of the factors that went into creating this boom are also responsible for the current bust.

The Revenue Surge of the Late 1990s

Figure 1 shows that the states experienced a steady increase in their general fund tax revenues through the ten-year period from 1991 through 2000. Revenue growth recovered from the recession at the beginning of the 1990s and soon settled into growth rates ranging from about four percent up to about ten percent year-over-year. The median growth rate in the 1991-2000 period was 6.35 percent, and there was a noticeable upward trend in revenue growth as the decade progressed.

[FIGURE 1 OMITTED]

Figure 2 shows that if we adjust for the effects of inflation and legislated tax changes the picture changes somewhat. We can see that growth in the early 1990s was supported by tax increases. New enactments increased state revenues by over $30 billion for fiscal years 1991 through 1994. (National Governors Association and National Association of State Budget Officers, 2002). Without these increases, real state tax collections would have declined until the end of fiscal 1992.

[FIGURE 2 OMITTED]

By fiscal 1995, states had begun to cut taxes. However, these cuts--eventually adding up to nearly $30 billion in the other direction--only slightly moderated the strong growth in state revenues. Inflation contributed fairly little to state revenue growth in this period, never running much over three percent from 1992 onwards.

The Revenue Crash of 2001-2002

As fiscal year 2001 progressed some weakness in state tax revenue growth began to appear. This was initially most noticeable in the Great Lakes, Plains, and Southeastern states and seemed to be related to a serious decline in the manufacturing sector of the economy. It was not immediately obvious what this slowing meant: it might have been a localized and temporary effect, or it might have been the beginning of a broader trend. State revenue growth in fiscal year 2001 was half of what had been the average over the previous six fiscal years. (See Table 1.) What was most noticeable in the affected states was a serious slowing in sales tax growth. However, personal income tax growth also slowed and corporate income tax collections--the most volatile of the major taxes--actually declined.

It turned out that the slowing of fiscal 2001 was in fact the beginning of a recession, which was in full progress nationwide by mid-2001. The recession, intensified in some ways by the terrorist attacks on September 11, caused a sharp decline in state revenues in fiscal year 2002. Total state tax revenues declined by 6.3 percent. Table 2 shows the regional pattern of declines, with the worst affected areas being the Far West, New England, and the Mid-Atlantic states. Much of this decline was due to a very large decline in personal income tax collections. Meanwhile, the sales tax was nearly flat; and the decline in the corporate income tax accelerated.

Figure 3 illustrates an important feature of this recent downturn in state revenue. The decline in state tax revenue in fiscal 2002 was much greater than the downturns seen in either the recession in the early 1990s or the recession in the early 1980s, and well out of proportion to the magnitude of the current recession.

Causes of the Surge and the Crash

The most obvious cause of the change in the revenue fortunes of the states is the change in the performance of the economy. State taxes are all related--directly or indirectly--to economic activity: as this activity slows, then state tax collections slow. Some taxes respond more strongly to economic trends, for instance the personal income tax will grow faster than personal income when times are good and decline more sharply when times are bad. However, even considering this, the revenue downturn in fiscal year 2002 was much worse than the setback in the economy would have suggested.