State Fiscal Crises: Lessons For The Future

Leslie McGranahan, in Unprepared for Boom or Bust: Understanding the Current State Fiscal Crisis, highlights the problems that are inherent in state policy when dealing with the cyclical behavior of the economy. The article released in the 2002 3rd quarter edition of Economic Perspectives, a publication of the Federal Reserve Bank of Chicago, identifies the common problem of states cutting taxes and increasing expenditures during boom times only to be faced with revenue shortfalls during recessions.

When revenues are reduced, states are forced to cut government services when they are needed most and increase taxes when taxpayers are the poorest. McGranahan identifies various reasons for the increased revenues during the boom period of the 1990s, including increased sales tax revenue from increased consumer spending, increase in revenue from taxes on capital gains and dividends, the influx of tobacco settlement money and decreases in spending on welfare programs as they have been restructured among various other reasons for enhanced revenues. While revenues were increasing, state spending was growing as well. State governments' tendency to increase spending and decrease tax rates creates a fiscal crisis when the inevitable cyclical downturn occurs.

McGranahan outlines five areas in which state governments can institute policy changes that can help prepare states for lean times during economic downturns.

• The size of rainy day funds should be increased (some are statutorily restricted to a few percent of total state budget.) By increasing the levels of funds during periods of boom, states will be better prepared for less fortunate times.
• States should enact tax cuts that do not require legislation to be reversed. Particularly, states should consider tax rebates and refunds rather than reductions in rates.
• State expenditures patterns must be closely examined. One of the arguments against larger rainy day funds is that governments will see these balances and find wasteful ways to spend them. Leaders are more inclined to return money to taxpayers than to leave the temptation for governments to spend this money. States should look at the across the board cuts that are enacted during lean times and see how agencies react to identify where fat actually does exist in the budget.
• States should not rely on the federal government to bail them out during tough times. Funding from the federal government will not come quick enough to alleviate current problems.
• Balanced budgets restrictions should be reevaluated even though this would be extremely unpopular politically.

The author hopes that two economic downturns in the past decade or so will help states understand how to have better foresight into preparing for future downturns. The complete article can be found at: http://www.chicagofed.org/publications/economicperspectives/2002/3qepart1.pdf