Cities, states begin to feel economic downturn

By Prashant Gopal

updated 1:55 p.m. ET July 1, 2008

State and local governments were flush with tax revenue during the five-year housing boom. They pulled from bulging pools of property, income, and sales tax to expand education, law enforcement, health care, and infrastructure programs without needing to burden residents and corporations with tax hikes.

Those days are over. Home prices are falling, and foreclosures, gas prices, unemployment, and inflation are on the rise. At least 29 states, plus the District of Columbia, reported budget shortfalls that total about $48 billion as they finalized their 2009 fiscal budgets, which typically begin July 1, according to the Center on Budget & Policy Priorities.

States are facing flat or even declining revenues even as costs for salaries, fuel, and construction increase. And revenues will only plunge further as the housing slump and credit crunch begin to reflect more in lower property assessments and sales and income taxes. With fewer homes being sold, homeowners are spending less on new furniture, carpets, bathroom and kitchen fixtures, and other household costs. Americans struggling just to make mortgage payments and fill fuel tanks have less to spend on discretionary purchases. Income tax is down as a result of job losses and shrinking profits for corporations, including those in the construction business.

"The downturn in the housing market is a big factor as to why this has happened," says state representative David Lujan (D-Ariz.). "When one segment of the economy is going down, all other aspects are impacted as well."

Arizona topped the BusinessWeek.com list of the 10 states that took the biggest tax revenue hits, compiled using data from the Nelson A. Rockefeller Institute of Government, the public policy research arm of the State University of New York. Arizona's tax revenue dropped 13.6 percent in the quarter ending March compared with the same period last year. On Thursday the Arizona legislature approved a budget plan for the coming year that eliminated a $2 billion shortfall by cutting spending for college construction projects and expanding revenue by beefing up photo enforcement and the state lottery.

Many of the states with the worst housing markets, including Florida, Nevada, Rhode Island, and California, also topped the revenue shortfall list.

More from BusinessWeeek States with the worst tax shortfalls Ten housing markets: The outlook worsens The home price abyss

Despite the revenue shortfalls, it could be some time before average taxpayers notice their garbage isn't being picked up as often or that their children are sharing a teacher with too many students.

"Governments have ways of muting and stretching out the effects of these things," Donald Boyd, a senior fellow at the Rockefeller Institute, says of the declining state and local tax money. "They take the easiest actions first. They will draw down reserve funds first. They came into this with historically good reserves … You will see spending restraint. But for outright cuts, prisoners released, and teachers laid off, you would have to see something truly significant."

Many states are freezing new hires, borrowing for necessary expenditures and dipping into "rainy day" funds to fill budget gaps and avoid tax increases. But in many cases they're tapping out the reserve funds for the coming budgets and might need to make tougher choices when they put together their 2010 spending plans, especially if the economy worsens.

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