U.S. states face a "lost decade," says Raymond Scheppach, head of the National Governors Association. The problem is a broken fiscal model exposed by the recession, and likely to extend the pain beyond the downturn's official conclusion.
GM's eventual bankruptcy was rooted largely in the award of ever-more-generous employee benefits, all paid for by cyclical car sales. States have similarly expanded the scope of services beyond their revenue-raising abilities. Some 55% of state revenue, before federal transfers, comes from personal- and corporate-income tax and sales tax, according to Donald Boyd at the Nelson A. Rockefeller Institute of Government. All three get killed in a downturn, and the first three quarters of 2009 were the worst for state tax receipts since at least 1963.
Expenditures are harder to rein in. States projected a collective $145.9 billion budget gap for fiscal year 2010, which began in July, equivalent to 9.2% of the previous year's total state expenditures. Apart from voter backlash against cuts, the economic cycle raises spending as the newly unemployed turn to government programs like Medicaid for help. The result is a lagged effect on state finances, with tax revenues usually taking as long as five years to reattain prior peaks, according to Mr. Boyd.
Since states can't run general funding deficits, closing gaps mean raising taxes, cutting services and resorting to one-time measures. No prizes for guessing which option politicians prefer. A big one is $246 billion of stimulus transfers from Washington. More than half of this pot will have been spent by the end of this year. And while states had estimated rainy-day funds of $36.5 billion in fiscal year 2009, it is likely they have since drawn them down significantly.
Besides the near-term crisis, the other similarity states have with the old GM is an overhang of debt. Between 2000 and 2008, state debts—distinct from other municipal debts—almost doubled to about $1 trillion, according to the Census Bureau. However, that is only 7% of gross domestic product, and low rates mean interest charges have been manageable, reaching $47 billion, or 3.7% of total expenditures, in 2008.
The bigger issue is retirement obligations. Like GM, many localities have struck generous deals with public-sector workers. In part, this reflected a desire to appease unions with promises for tomorrow that didn't have to be paid for until well after the next election. In a new study, the Pew Center on the States estimates there was a $1 trillion funding gap on $3.35 trillion of state health-care and retirement obligations as of fiscal year 2008.
Overhaul of these, as well as the out-of-date, volatile revenue-raising mechanisms that fund them, is long overdue. Just don't expect it to happen quickly: 37 governors' seats are up for election this year.
In the meantime, states will scrimp as much as they can, and raise fees and taxes to balance budgets. State defaults remain unlikely, but as their ability to help localities is constrained, holders of bonds issued by cities, public projects and other smaller entities should beware.
The wider issue is the drag on economic growth. Median household income was stagnant in the last economic up-cycle, a big reason why so many borrowed against their homes to maintain living standards.
That option is now severely constrained, and higher taxes and reduced government services will serve to erode disposable income and living standards further. Consumers, and the cyclical stocks that take their cue from them, face an extended period of Capitol punishment.
—Liam Denning
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