The State Budget Squeeze

Low revenues and high costs plunge states into crisis
As America’s economic recovery crawls forward, its states suffer from depleted revenues and large spending commitments. Experts project between $30 billion and $40 billion in combined state budget deficits for fiscal year 2012. Though the federal government runs deficits during recessions to fund expansionary policies, many states are constrained by constitutional balanced budget requirements. They must close deficits by cutting spending and raising taxes, choking recovery with behaviors that compound macroeconomic problems.
Policymakers should not seek to eliminate balanced budget amendments, an important federalist measure to prevent states from amassing enormous debts. Rather, the federal government should offer short-term deficit relief to states and enable them to better project revenues and outlays, as well as making rising pension costs more transparent.
Balanced Budgets and Pro-Cyclical Policies
While every state but Vermont has a balanced budget requirement, deficits still occur because the regulations usually only cover operating budgets, comprising about half of state spending. Compounding the problem, this requirement applies only to projected budgets, where states foresee higher revenues and smaller expenditures than reality might suggest. As Harvard Law School professor Howell Jackson told the HPR, states “formally comply with balanced budget rules but do not fulfill the spirit of the amendments.”
As a result of their evasions, many states stand in dire fiscal condition. Periodic deficits are manageable, but Brookings Institute’s Tracy Gordon explains that states have been running deficits for the past five years because of the recession. Now states seek to cut spending, but Gordon adds, “If states run out of money, there are a lot of people who are hurt, and these are often the most disadvantaged people in our society.” The Obama administration, recognizing the threat presented by state statutes, offered fiscal relief in the 2009 economic stimulus. This money prevented some layoffs and spending cuts, but now funds are drying up. Gordon points out, “State governments are continuing to lay off about 30,000 employees per month. This is not only bad for the macroeconomy; it also means a lower quality of services that state and local governments are able to provide.”
As Gordon’s example illustrates, aid proposals such as the American Jobs Act are important steps toward alleviating state budget crises. With spending cuts continuing, the federal government should continue to offer aid to the states. Harvard Kennedy School Professor Daniel Shoag asserts, “State spending can be a real driver” for the economy. Thus, Jackson says, “A revenue- sharing mechanism [between the federal and state governments] can be appropriate.” Devising that mechanism to disperse aid to states remains complicated, because aiding states with the worst fiscal crises merely increases the moral hazard that states will spend frivolously. Awarded assistance based on other measures, like the unemployment rate, might prove a better bet.
Short-Term Crisis
When states make emergency cuts, they often proceed without carefully considering the long-term consequences. Most budget yearly, which, when coupled with balanced budget requirements, offers little incentive for long-term focus. Gordon points out, “There is a lot of push now to improve forecasting on the state level and engage in longer- term planning.” Additionally, state revenues vary considerably between years and work poorly under short-term restrictions. The income and capital gains taxes prove substantially cyclical, plunging states into deficits during recessions. Thus, to prevent shortsighted emergency policies, states should project both revenues and outlays over longer periods. As Elizabeth McNichol of the Center for Budget and Policy Priorities maintains, “Long-term, multi-year forecasting on both the spending and revenue sides… gives the states the opportunity to figure out the impact…on spending programs or tax systems for the long-term balance of their budget.”
One particularly effective mechanism may be the pay-as- you-go rule. This method, which the federal government followed from 1991-2000, would require every spending increase or tax cut to be financed by a tax increase or spending cut of equal size within five years. This policy helped create budget surpluses during the 1990s, and should be pursued as a structural fix to prevent budget crises from reemerging, at both the state and local level.
Unsustainable Costs
Even when the current crisis ends, however, states will still face the prospect of disaster in their pension funds. Pensions for public employees are funded by collecting taxes from workers and investing them in diversified portfolios. Shoag states, “It’s sort of like borrowing from the workers to invest in the stock market.” While these funds have typically earned high returns, approximately eight percent annually, the investments are highly susceptible to downturns, and have suffered greatly recently. Yet states continue to discount their obligations to pension funds without taking risk into consideration.
Funds’ behavior exposes taxpayers to substantial liabilities. Economists Joshua Rauh and Robert Novy-Marx estimate that state pensions are currently underfunded by about $3.23 trillion, assuming the eight percent discount rate. Considering that pension obligations are, as Jackson states, “very difficult to adjust due to legal and contractual arrangements,” many question whether pension obligations should be calculated at such high, risky rates. Given the volatility of pension funds, taxpayers will likely have to bail out public pensions, unless they are reformed.
Experts suggest various solutions. Shoag offers, “Pension obligations probably should fall under a balanced budget amendment.” This would prevent states from underfunding pensions, and would specify how exposed taxpayers actually are. Still, the underfunding itself is not an immediate crisis for the states. According to McNichol, 40 states have taken action recently to either reduce benefits or increase employee contributions. She adds, “It is important to separate out the immediate problems that the states are facing as a result of the impact of the recession on their budgets…from some of the longer-term issues, like pensions, which they don’t have to resolve tomorrow.”
Nevertheless, given the growing burden of pension obligations, especially health benefits, states should not take these problems lightly. Jeff Miron, Harvard economics professor, offers some structural solutions, which include creating defined contribution plans similar to 401Ks found throughout the private sector. Miron claims the benefit as that “[States] don’t have to do the fancy accounting and make those projections because… the employer is never on the hook.” Further, Miron believes the federal government should offer block grants to states for Medicaid expenses, rather than reimbursing states for half of all health care costs. According to Miron, “[States] would be forced to allocate [Medicaid funds] in ways that were affordable.”
In this weak economy, states should not drastically adjust pension or health care benefits. Over the longer term, they should still make the necessary projection and accounting changes. Ultimately, there are no easy answers, and states face complex constraints, often misunderstood in public discourse. But the solutions outlined can, with the right political will, mitigate the current situation and protect against future crises.
Daniel Backman ’15 is a Staff Writer.
Photo Credit: kenteegardin, Flickr