States' budget woes may mean tax hikes

updated 10:25 a.m. ET March 13, 2009

Even after $135 billion in federal aid gets spent, many states will be staring down budgetary black holes unless they initiate dramatic spending cuts or tax increases, or both.

In the short-term, the massive stimulus will help balance budgets and keep key services, such as Medicaid, going. But economists agree the money will not quickly eradicate high unemployment, low consumer spending or distress in the housing market — the triple threats behind a nationwide tax-collection shortfall that is expected to drag on even after the economy begins to rebound.

Without higher taxes, bigger cuts to government services — or yet more federal funding — states face budget gaps that could reach $120 billion nationwide in their 2011 budgets, according to an analyst at the Rockefeller Institute, a think tank in Albany, N.Y. James Diffley, managing director of Global Insight's U.S. Regional Services Group, says it's unlikely budget gaps will close before 2013.

"States' budget problems lag the economy," Diffley said. "What we see in budgets will get worse for at least another year."

Federal Reserve Chairman Ben Bernanke recently told Congress that the recession might end this year if the government is able to prop up the shaky banking system.

States simply are not taking in enough money to cover expenses that are rising with the recession. So far, neither the spending cuts nor the tax and fee increases being discussed appear large enough to address the impending revenue shortfall, economists said.

Spending increases were easier to cover in flush times earlier this decade, when tax collections jumped 40 percent over five years. Then the bubble burst. Inflated housing wealth collapsed, consumers hunkered down, businesses slashed jobs and tax collections plunged.

Sales and income taxes can provide around two-thirds of tax revenue. Other revenue streams, like the real estate fund transfer tax, continue to take hits, too, as the housing market scrapes bottom.

States' combined deficits have already climbed to around $50 billion in their 2009 budgets and are expected to grow in the following budget cycle, leaving governors and lawmakers with more painful choices over the likes of education cuts and layoffs.

"They're going to have to cut their budgets significantly," said Mark Vitner, senior economist and managing director at Wachovia.

Exhibit A for state budget messes is California, where lawmakers struggled to reach a deal to raise taxes, borrow money and cut services to close a multiyear $42 billion deficit. The state was hit as hard as any by the housing collapse, and residents like Tanya Duarte in Fresno illustrate the challenge California and other states face to turn things around.

When the housing bubble burst, work dried up for Duarte's husband, a house painter, and they could not afford the $2,215-a-month mortgage payment on their home. They have since struck a deal with the bank to avoid foreclosure, but have had to cut back on everything to piano lessons for their 13-year-old son to cable TV.

"We're just doing the best we can," she said, "we're hanging in there."

Duarte was fortunate enough to avoid foreclosure in a state plagued with them. And her husband now has a job, but roughly 1.7 million Californians don't — showing how deep and interconnected the revenue problems are for states.

Fewer jobs mean less income tax. Even wealthy people with steady work are earning less taxable income because investment income is down. Losses for high earners add up fast due to progressive tax rates — a loss of $1 million in capital gains can hurt a state treasury more than dozens of workers losing $40,000-a-year jobs.

New York and other states dependent on finance will be hardest hit, but many states will feel the pinch, said Scott Pattison, executive director of the National Association of State Budget Officers. Virginia Gov. Tim Kaine recently warned that losses in investment income could expand the state's shortfall.

The reduction in Wall Street bonuses alone will cost New York nearly $1 billion in personal income tax revenues, state comptroller Thomas DiNapoli said.

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