Mess in Illinois Only the Beginning of States' Budget Woes

When Illinois legislators voted this week to raise state income taxes by 66 percent, they weren't sending a signal of tax-and-spend. It was tax-and-survive.

The millions of job losses, real-estate market implosion and relentless economic malaise wrought by the 2008-09 recession left Illinois' and other states' treasuries barren and their budgets deep in the red.

Budget shortfalls are expected to be bad again this year and next, leaving state governments around the country with no choice but to painfully cut social services, education funds and other spending, or raise taxes, or in most cases both.

"The wolf is at the door," Illinois state Rep. Greg Harris, a Chicago Democrat, said early Wednesday as the House approved a tax increase that was seconded by the state Senate hours later and that Gov. Pat Quinn promised to soon sign into law.

For Illinois, the increase in personal income tax to 5 percent from 3 percent and a rise in corporate rates to 7 percent from 4.8 percent are expected to increase state revenue by $6.8 billion over four years.

But Illinois is facing a budget deficit this year of $15 billion, roughly half its general fund. And Democrats in the legislature weren't able to muster support in the bill for plans to borrow the $8.7 billion the state already owes to businesses and payments for social services agencies and other bills.

With the tax increases come new limits on spending, and the state is still expected to need drastic cuts across the spectrum of services the state has promised to its residents.

Slash and Burn

Illinois is far from alone.

The worst recession since the Great Depression roughly eight decades ago slashed state tax revenue more than any time in American history, and inflation-adjusted state tax collections are down 12 percent from pre-recession-levels, as calculated by the Washington-based Center on Budget and Policy Priorities.

At least 46 states have struggled to close budget shortfalls for the current fiscal year, which for many states began in July and for the federal government began in October. And this comes after all but two states suffered large shortfalls last year and in 2009.

The exceptions include Montana, North Dakota and Alaska, whose mineral resources -- amid high oil prices -- provided enough revenue to help them ride out hard times that slammed other states. The fourth exception is Arkansas, where Democratic Gov. Mike Beebe and a Republican-dominated legislature have managed to work together to balance the state budget, though Beebe this week said more spending cuts will be needed for the 2012 budget.

Those 46 other states must find a way to deal with $130 billion in shortfalls, or 20 percent of their combined 2011 budgets, the budget center estimates. That total is expected to grow as the year progresses, while most states predict they'll face significant fiscal problems in 2012 as well.

Since few legislatures are politically positioned to enact the kind of tax increases now set for residents of Illinois, the states -- which, with the exception of Vermont, have laws requiring balanced budgets -- will have to make massive cuts.

And that could worsen their economic woes.

"When states cut spending, they lay off employees, cancel contracts with vendors, eliminate or lower payments to businesses and nonprofit organizations that provide direct services, and cut benefit payments to individuals," the center's Elizabeth McNichol, Phil Oliff and Nicholas Johnson wrote in a recent study of the recession's impact on the states.

"In all of these circumstances, the companies and organizations that would have received government payments have less money to spend on salaries and supplies, and individuals who would have received salaries or benefits have less money for consumption," they said. "This directly removes demand from the economy."

Taming the (Fiscally) Wild West

California, the poster child of fiscally challenged states, faces what new Gov. Jerry Brown projects to be a $25.4 billion deficit over the next 18 months.

This week, he unveiled a budget that aims to extend some current emergency taxes by five years -- a move voters in that state will get to accept or reject. But his budget also proposes deep cuts across the board, affecting university students, the mentally ill, low-income Californians needing medical care and county governments across the state who would inherit a host of fire, security and emergency responsibilities.

"It's going to take sacrifice from every sector of California," Brown said. "It's better to take our medicine now and get the state on a balanced footing."

It was that lack of budget medicine for a decade or more that's partly responsible for the current trouble, according to a study of fiscal problems in four Western states released last week by the Brookings Institution.

The study, led by Mark Muro, in part blames "cyclical" economic downturns likes the recession and its aftermath for the decline of taxable activity that has wreaked havoc on state finances.

But another big factor has been structural deficits caused by the kind of political unwillingness among state officials to live within reasonable means that has led to such huge federal budget deficits.

Muro described these as "harder" to fix because they are more entrenched. Structural deficits are "the more or less permanent imbalances of revenues and expenditures that can arise from flaws in a state's fiscal structure, fundamental changes in the regional economy or the state's demographics or, especially, imprudent or shortsighted policy choices," he said.

In Arizona that structural shortfall currently comes to $2.1 billion, or 21 percent of that state's general fund, which, as a percentage, is twice that of California's.

California created too many spending increases during the dot-com boom even as it left in place rigid limits on taxes that originated in the 1970s, while Arizona "basically gave away the store in better times" with a series of tax cuts that weren't accompanied by reductions in spending, Muro argued.

And Nevada hasn't adjusted a budget dependent on real estate taxes to the "new normal" of a persistently ailing housing market, he added.

The "train wreck" noted in Western states, Muro said, "should be duly noted as cautionary tales elsewhere."

No Help From Washington

Making matters worse this year and next is that much of the aid states received from the stimulus package President Barack Obama pushed through Congress in 2009 has been used up.

Peter Brown, of the Quinnipiac University Polling Institute, noted for example that the stimulus package sent nearly $6 billion to Ohio, which was included in Gov. Ted Strickland's 2009 budget.

"The money was used to keep public employees on the payroll, prisons open and Medicaid money flowing, among other things," Brown wrote in a blog post at the Wall Street Journal. "But now, Ohio faces a projected $8 billion shortfall in its roughly $51 billion budget that incoming Republican Gov. John Kasich and a GOP legislature must fill."

Also disappearing are the stimulus package's subsidies for the municipal bond market states use to borrow operating funds for many projects. Without the subsidies, and with fears of a potential state bankruptcy growing with the red ink, interest rates for states are significantly higher.

Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, on Monday went so far
as to compare the budget problems of the states to the credit problems of some European Union members, which have shaken credit markets around the globe.

Lockhart noted that such problems on both sides of the Atlantic pose "a downside risk to an improving economy."

And with Washington already struggling to deal with the federal government's own mammoth deficits, the states will most likely have to fend for themselves.

"We have no expectation or intention to get involved in state and local finance," Federal Reserve Chairman Ben Bernanke told the Senate Budget Committee last week. The states, he said, "should not expect loans from the Fed."