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State Fiscal and Economic Outlook

Presentation at the 2010 National Association Of Governmental Labor Officials (NAGLO)  Annual Meeting, Richmond, Virginia, July 26, 2010
click here to view the slides (2.75 MB file)

Sujit CanagaRetna, Senior Fiscal Analyst

Southern Legislative Conference of
The Council of State Governments

It is a great honor to be here and I thank Commissioner Sviggum and the National Association of Governmental Labor Officials for extending this invitation to me and to The Council of State Governments.  The Council, established in 1933, serves all three branches of state government by fostering the exchange of insights and ideas.  While I work for The Council’s Southern Office, the Southern Legislative Conference in Atlanta, the Council is headquartered in Lexington, Kentucky with regional offices in California, Illinois, New York and Washington, D.C.

My presentation this afternoon will cover five broad areas.   Part I highlights key national economic trends and the fiscal position of states while Part II highlights some of the strategies being deployed by states to balance budgets.  Part III identifies several structural flaws in state tax systems that will continue to plague state finances going forward while Part IV explores some of the major expenditure categories looming on the state fiscal horizon.  Finally, Part V hones in on some of the “green shoots of growth” and the promising economic development projects that will contribute toward reviving state economies.

Part I: Key National Economic Trends and the Fiscal Position of States

The U.S. economy continues to warily recover from the Great Recession, the longest, broadest and most severe downturn since the Great Depression.  Even though the recession might have technically ended, the devastation caused by the Great Recession continues to linger and will continue to do so for a number of years.  What was most disconcerting about the Great Recession was that the U.S. economy had to face concurrent crises on multiple fronts: output declines, revenue shortfalls, credit freezes and confidence drops.  While any one of these negative developments has the potential to stall the economy, the fact that they all occurred concurrently completely destabilized it.  It was almost as if Hydra, the multi-headed monster bore down on the U.S. economy.

As grim as the current economic situation is, particularly for the nearly 15 million unemployed Americans, there a number of signs that the U.S. economy is moving in the right direction.  In terms of output, U.S. gross domestic product, GDP, after barely registering growth in 2008 (0.4 percent), plunged into negative territory in 2009 (-2.4 percent) and confirmed that the U.S. economy had fallen into a recession.  Thankfully, in the first quarter of 2010, GDP grew again by 2.7 percent and the Federal Reserve Bank forecasts real GDP growth of 3 to 3.5 percent in 2010, and roughly 3.5 to 4.5 percent in 2011 and 2012.  The national unemployment rate, after soaring to a high of 10.1 percent in October 2009, the highest rate since April 1983, has started a slow descent (it was 9.5 percent in June 2010) though it remains stubbornly high.  In fact, when you factor in the number of underemployed and those discouraged job seekers, the unemployment rate is even higher.

The housing sector, one of the primary causes for the disintegration of the economy, continues to struggle but when compared to last year, there is room for optimism based on a review of foreclosure filings, housing starts and building permits.  In June 2010, foreclosure filings, i.e., default notices, auction sale notices and bank repossessions, declined by nearly 3 percent compared to May 2010 and by nearly 7 percent compared to June 2009.  Housing starts, an important signpost of the housing sector, after rising from the slumps of last year, hit their lowest level in eight months in June 2010, further evidence of the challenges confronting the economy.  But, a rise in building permits in June 2010 offered hope that homebuilding was poised to pick up.

The stock market, reflected in the Dow Jones Industrial Average, has also recovered substantially from the lows reached in March 2009.  Corporate profits, an important reflection of the vitality of our economy, remain in very good shape and are on an upward swing after falling for several years.  Since companies slashed costs aggressively during the recession, they are now reaping the benefits with experts forecasting double-digit profit increases in 2010.

In addition, the Federal Reserve recently reported that America's 500 largest nonfinancial companies have accumulated a staggering $1.8 trillion of cash on their balance sheets, a quarter more than they had at the beginning of the recession.  When these corporations channel these funds towards new plants, equipment and workers, the pace of the U.S. economy’s recovery will speed up considerably.

The highly-regarded Consumer Confidence Index (CCI), after plunging to historic lows through most of 2009, has climbed notably this year though it did decline in June 2010.  Given the fact that about 70 percent of the U.S. economy is driven by consumer spending, the CCI’s growth remains critical for the recovery of the U.S. economy.  In fact, real consumer spending appears to have expanded at about a 2.5 percent annual rate in the first half of this year reflecting rising demand from households and businesses.  In sum, there are multiple positive developments that offer promise that the U.S. economy is poised to forge forward though there are many obstacles ahead or as Chairman Bernanke noted last week, that we face an “unusually uncertain economic outlook.”

Even before the extreme economic turbulence of fall 2008, states were looking at a very depressed financial picture and they continue to experience steep revenue losses even though the rate of decline has slowed.  Given that state revenues lag the national economic recovery by at least 12-18 months, states are already forecasting grim fiscal times as far ahead as fiscal year 2012.

State and local government revenue data released by the Rockefeller Institute recently indicates that state tax revenues grew by 2.5 percent in the first quarter of 2010, the first time that states reported growth in collections on a year-over-year basis since the third quarter of 2008.  The Rockefeller Institute emphasized that this growth in state tax revenues should not be interpreted as a broad state fiscal recovery but one that was largely driven by legislated changes in two states — California and New York.  Importantly, not only are state tax revenues still below prerecession levels, preliminary estimates indicate that the second quarter of 2010 will be weaker than the first quarter, with collections so far showing an uptick of less than 1 percent.

In the past few years, while state revenues plunged to unprecedented levels, simultaneously, the demand for such safety net services such as Medicaid and unemployment insurance skyrocketed, resulting in the yawning budget gaps in many states.

In fiscal years 2009 and 2010, states closed budget gaps that totaled $310 billion while the cumulative shortfall for fiscal years, 2011 and 2012, is estimated to total another $300 billion.  While 46 states face budget shortfalls in fiscal year 2011, 31 of these states are staring at double-digit gaps as a percent of their FY 2010 budgets.  Alarmingly, 16 of these states have gaps projected to exceed 20 percent of their FY 2010 budgets with Nevada (57 percent) ranking at the top.

A review of the pre- and post-recessionary spending levels in the states, fiscal years 2008 and 2011, demonstrates how the Great Recession has fundamentally altered the relationship between state governments and citizens.  Specifically, state expenditures during this 4-year period declined by an average of 7 percent with 37 states experiencing a percentage decline, 2 states remaining static and only 11 states experiencing an increase.  Of the 37 states that experienced a decline, 22 experienced double-digit percentage declines.  Therefore, the Great Recession has forced states to enact a Great Transformation, a fundamental shift in the relationship between state governments and citizens brought on by the drastic reduction in the size of government.  Despite larger state populations and higher levels of need for services between fiscal years 2008 and 2011, state spending has declined.

The perilous condition of state economies is further highlighted in a quick review of key economic data.  For instance, state unemployment rates have soared to heights not seen in decades.  According to the latest unemployment data (June 2010), there were 15 states with double-digit unemployment rates led by Nevada (14.2 percent) and Michigan (13.2 percent).  Another disturbing statistic: the steep drop in per capita income; specifically, in 2009, for the first time since 1954, per capita income in the United States declined by 2.6 percent compared to 2008.   Foreclosure filings are another troublesome element in many states and according to the June 2010 Realty Trac information, the filings in a number of states—Nevada, Arizona, Florida, California and Utah—remain particularly challenging.  Experts forecast that more than 1 million American households are likely to lose their homes to foreclosure this year, a record number, and that even though the foreclosure rate has shown signs of leveling off in recent months, it continues to act as a crippling drag on the housing market.

Part II: Strategies Being Deployed By States to Balance Budgets

Given the constitutional requirement in 49 of the 50 states to balance their budgets, states have adopted a number of strategies to meet this condition.  Prior to describing some of these strategies, it is important to mention that raising taxes continues to be a politically radioactive move, an option policymakers at every level are loath to pursue.  Consequently, policymakers would rather adopt any other approach to balance their budgets, particularly in an election year.

1. Slashing Spending
   As indicated earlier, states have enacted significant spending reductions to meet their balanced budget requirements.  Since the onset of the recession, 30 states have reduced healthcare spending; 25 states have slashed programs for the elderly and disabled; 30 states have reduced K-12 education spending; 41 states have cut aid to colleges and universities; and 42 states have shrunk their workforces.  Since August 2008, states, localities, and school districts have eliminated 231,000 jobs.
2. Tapping ‘Rainy Day’ Funds
   States have aggressively tapped their rainy day funds to balance budgets.  In the aftermath of the 2001 recession, most states worked proactively to build up their rainy day funds but in fiscal year 2011, 13 states will completely exhaust their rainy day funds.
3. Expanding Gaming
   Responding to the drop in gaming revenue last year —5 percent to 14 percent in taxes collected from lotteries, horse racing and casinos—at least 18 states have increased or are working on increasing the number of gaming options.  In New York, Governor Patterson wants to bring slot machines to the Aqueduct.  In New Hampshire, Governor Lynch has proposed a casino in the southern part of the state while in Florida, the federal government authorized Governor Crist’s gambling deal with the Seminole Indian tribe.
4. Increasing Borrowing
   State net tax-supported debt increased by 10.3 percent from $417 billion in 2008 to $460 billion in 2009.  While there were a number of factors accounting for this sharp increase, the low interest rate environment was one of them.  Of note, median net tax-supported debt on a per capita basis in the U.S. increased from $865 in 2008 to $936 in 2009, or 8.1 percent.
5. Raiding State Funds
   Cobbling together one-time patches of money by raiding an assortment of trust funds scattered across state government was another tactic deployed to balance state budgets.  The Legislature and Governor in Louisiana, for instance, corralled together $182 million from more than 40 dedicated funds to balance its fiscal year 2011 budget.  In Florida, House lawmakers proposed sweeping $798 million and Senate lawmakers proposed sweeping $295 million from an assortment of trust funds.  In Hawaii, lawmakers sought to raid city transit funds to balance the state budget.
6. Raising Taxes and Fees
   Despite its extreme political toxicity, policymakers were forced to raise taxes and fees in recent years given their dire revenue position.  In fiscal year 2010, states raised a record $24 billion in taxes and fees even though a bulk of that revenue involved tax increases in California and New York.  For the current fiscal year, 2011, there are fewer tax increases in the works ($3.1 billion) given the fact that it is an election year.  Along with the sales and income tax hikes that went into effect in several states (Kansas, New Mexico, Arizona, Oregon), states have also raised cigarette taxes aggressively.  Since 2002, 47 states have increased their cigarette tax rates more than 100 times.  Washington, Colorado and Maine all enacted a soda tax to raise revenue, curb obesity rates and lower healthcare costs.

Part III: Structural Flaws in State Tax Systems

While the adverse effects of the Great Recession remain very severe, the unfortunate conclusion is that even when the economy begins to tick, states will continue to face significant challenges on account of structural flaws in their tax systems.  These structural flaws currently pose, and will continue to pose, even more serious fiscal challenges in the future.   As a result, citizens will have to decide on what kind of state government services they want and whether they want to create adequate revenue streams to finance these state government operations or fundamentally reconfigure their expectations of state government.  There are three aspects to this conundrum:

• Over the past few decades, the role played by services in the economy has grown tremendously.  The service sector is critically important because it accounts for about 80 percent of U.S. jobs and the consumption of services, at about $6.1 trillion a year, accounts for about two-thirds of total consumer spending.  Yet, the sales tax in most states do not cover a wide range of services.
  When state sales taxes were first introduced some 75 years ago, the service sector occupied a miniscule share of the overall economy with manufacturing and agriculture holding sway.  The following example drives home this point: in 1955, the top company on the Fortune 500 list was General Motors, a manufacturing company; some 55 years later in 2010, the top company on this list was Wal-Mart, a service company.  Despite this rapid movement towards a service-driven economy, the traditional state sales tax is applied to an increasingly shrinking proportion of economic activity.  In other words, states currently have 20^th century tax systems in a 21^st century economy.
  According to a 2008 Federation of Tax Administrators report, there are 168 different services taxed in the states across eight broad categories.   Only Hawaii, New Mexico and Washington have broad-based sales taxes that include a bulk of the services (160 and 158, respectively) while South Dakota (146), Delaware (143) and West Virginia (105) also have tax systems that cover most services.  Beyond these 6 states that tax more than 100 services, 19 states tax between 50 and 100 services and 25 states tax fewer than 50 services.  Utility services are taxed in most all states while admissions and repair services are taxed in many states.  On the other hand, fewer states tax personal and business services.  Professional services (doctors, lawyers, accountants, engineers) are taxed in only 7 states.
  Recently, in order to update their tax systems and account for the structural transformation in the economy, a number of states have moved towards broadening the sales tax to include services and mitigate the long-term decline of sales tax revenues.  In most of these instances, this effort has involved lowering the tax rate and then broadening the base of services captured by the sales tax.  Maine, North Carolina, Kentucky, California, Pennsylvania and Michigan are some of those states.
• The explosive growth in e-Commerce transactions has profound impacts on many aspects of the contemporary economy.  U.S. retail e-Commerce sales exploded from a mere $8.3 billion in the first quarter of 2001 to an estimated $38.7 billion, in the first quarter of 2010, a remarkable increase.  Of note, the share of e-Commerce sales as a percent of total sales has also risen steadily: from 1.1 percent in the first quarter of 2001 to 4 percent in the first quarter of 2010.  Yet, due to U.S. Supreme Court rulings and federal inaction, state and local governments continue to lose sales and use tax revenues because of their inability to collect taxes that are due.
  Recent research by the University of Tennessee indicates that states and local governments lost and continue to lose billions of dollars as a result of this restriction.  Specifically, for the six-year period 2007 to 2012, the University of Tennessee study estimates that total state and local sales and use tax revenue losses from e-Commerce sales amount to an immense $52.1 billion.  In 2012 alone, the aggregate losses are estimated to be around $11.4 billion.  The nation’s larger states, California ($8.7 billion), Texas and New York ($3.9 billion) and Florida ($3.7 billion) all have staggering actual numbers but other states, Louisiana (5.91 percent), Illinois (5.5 percent) and Nevada (5 percent), are estimated to have the highest revenue losses in 2012 as a percent of their 2007 sales and use tax collections.
• Given their dire fiscal positions, a number of states from Florida to Texas to Colorado to Georgia to Idaho to Kansas to Wisconsin to South Carolina to Washington, have recently initiated measures to first review and then consider eliminating some of the multitude of sales tax exemptions embedded in state tax codes.  While the presence of these sales tax exemptions underscores the influence of special interests, even a partial repeal could result in billions of dollars in new revenue for the states.
  In sum, these important, fundamental shifts in the structure of our economy are affecting state fiscal systems and transforming them radically, a development that demands the attention of state policymakers and citizens alike in figuring out the specific services and programs they expect from their state governments and how they are going to pay for these programs and services.

Part IV: Looming Major Expenditure Categories

My presentation so far assessed the fiscal position of states and provided some details on the structural flaws that will continue to erode state finances even when the national economic recovery is more pronounced.  Unfortunately, there is more grim news.  What makes the state fiscal outlook quite daunting is that the current revenue shortfalls and huge budget gaps masks a number of enormous fiscal challenges looming in such areas as healthcare, education, public pensions, emergency management,  infrastructure, transportation and unemployment insurance.  At this point, state policymakers have kicked the can down the road but they will inevitably have to devise solutions to these challenges too.

If I may briefly touch on three of these expenditure categories:

1. Public Pensions
   This is an area I have done an extensive amount of research and it is quite apparent that our entire retirement architecture faces significant challenges.  Every element of our retirement architecture—Social Security and Medicare; Corporate Pension Plans; Public Pension Plans; Personal Savings—all face unenviable choices.  In terms of public pension plans, in February 2010, the Pew Center on the States documented that there is a $1 trillion gap between what states have promised their current and retired workers in pension, health care and other retirement benefits and what they have on hand to pay for them.
2. Infrastructure
   For some years now, experts, particularly those with the American Society of Civil Engineers (ASCE), have been emphasizing that policymakers at all levels of government need to urgently devote resources and attention to upgrade the nation’s crumbling and aging infrastructure network.  The 2009 ASCE report noted that America’s infrastructure rates a cumulative grade of D and estimated that $2.2 trillion needs to be invested over five years to improve the nation’s infrastructure.
3. Unemployment Insurance
   As a result of the severity of the Great Recession, the doggedly high unemployment rates in so many states and the actions taken by states (such as expanding benefits and cutting taxes), the UI funds in a majority of the states are in perilous shape.  The funds are being attacked at both ends: more people are tapping benefits while a fewer number of companies are paying taxes to replenish the funds.  The federal government forecasted in December 2009 that an estimated 40 state programs will be broke within two years and projected that these programs will need an estimated $90 billion in federal government loans to keep issuing unemployment checks.

Part V: “Green Shoots of Growth”

In the midst of all this gloom and doom, both in terms of the national economy and in terms of state finances, there are a number of encouraging economic development trends emerging in the states.  This is a strong reflection of the resiliency and vibrancy of the American economy and the astounding ability of the disparate elements within the U.S. economy to innovate, invent and improvise a way out of dire economic times.  It is also evidence of the entrepreneurialism that has always been at the core of America, think Benjamin Franklin, Alexander Graham Bell and Henry Ford, in prior centuries and Sergey Brin, Andy Grove and Steve Jobs in the current era.  Consequently, documenting that it is not all gloom and doom is important and here are a fraction of the bright sparks and promising economic development projects from across the country:

Solar

• In Tipton, Indiana, a facility abandoned by the auto industry, will soon be the site of a solar panel manufacturing facility expected to generate 850 new jobs;
• In Dublin, Georgia, a German company will set up its U.S. headquarters and manufacturing facility for solar modules and create 350 new jobs in the next five years;
• In Oregon, the department of transportation will open the world’s largest “solar highway” with the installation of thousands of photovoltaic solar panels to power freeway lights by night;
• In Senatobia, Mississippi, a solar panel manufacturing facility will open and create 512 jobs with a company investment of more than $175 million; and
• Tennessee has emerged as a dominant player in solar industry manufacturing with three major facilities (in Clinton, in Clarksville and in Cleveland) in the last 18 months, totaling nearly $2.5 billion dollars in plant investments.

Wind

• In Greenville, South Carolina, GE Energy has retooled its production facilities to manufacture wind turbine generators and has already shipped over 10,000 units;
• In Akron, Ohio, the Karder Machine Company plans to build a $30 million plant to manufacture and assemble giant three-bladed wind turbines that will create 400 jobs initially and an additional 800 to 1,200 jobs after 18 months;
• In Oregon, GE announced that it will supply wind turbines to what will be the nation’s largest wind farm, a $2 billion project that will employ 400 during construction;
• In Fort Smith, Arkansas, Mitsubishi will construct a $100 million wind turbine manufacturing facility that will be operational by 2012 and employ about 400 workers; and
• In Iowa, wind energy now accounts for up to 20 percent of the state’s total electricity production, a fact that allows the state’s power costs to rank among the lowest in the nation.

Bio Tech

• In Kannapolis, North Carolina, at the site of the former Pillowtex factory which closed down after 100 years of operation in 2003, the N.C. Research Campus (NCRC), a $1.5 billion private-public venture sprang up designed to further knowledge in biotechnology, nutrition, agriculture, and healthcare;
• In College Station, Texas, public and private resources are being channeled towards accelerating Texas A & M University and its private partners’ abilities to speedily create vaccines for the nation’s next pandemic threat; and
• In Norcross, Georgia, a blood-testing center will hire 125 scientists, technicians and support staff for a laboratory while in Union City, a $70 million cancer-fighting lab will open hiring 300.

Auto Industry
The “drive to move South,” i.e., the location of a number of foreign automobile manufacturers and an array of parts suppliers in nearly a dozen Southern states remains a major economic boost.  After the hiccups caused by the Great Recession, the auto industry in the South stands poised to take off again:

• Nissan is spending nearly $2 billion to build a lithium-ion battery plant in Smyrna, Tennessee that will power the new mass-market electric car, the Leaf, which also be produced at the plant;
• In June 2010, Toyota announced that it would resume construction at its $1.3 billion plant in Blue Springs, Mississippi, building compact cars and eventually hiring 2,000 direct employees;
• In Charlotte, North Carolina, Celgard, the lithium-ion battery manufacturer for automobiles, continues to flourish and a recent expansion will lead to 200 new direct jobs and more than 1,000 jobs among contractors and suppliers; and
• In La Grange, Georgia, an automotive parts supplier announced a nearly $9 million investment that will result in 173 new jobs related to the Kia plant.  The new Kia plant in West Point, Georgia will create some 3,000 direct jobs.

Information Technology and High-Tech

• Dayton, Ohio’s Tech Town is taking shape at a former GM manufacturing site that will transform the beleaguered city’s economy into a center of aerospace, remote sensing and advanced materials expertise, cultivating both startups and industry veterans;
• In Austin, Texas, Samsung recently announced a $3.6 billion chip plant expansion, adding 500 new jobs;
• In North Charleston, South Carolina, Boeing announced that it would build a new assembly plant to manufacture the 787 Dreamliner catapulting the state as an aerospace powerhouse, generating 3,800 direct and thousands of spinoff jobs;
• Atlanta, Georgia is quickly becoming one of the nation’s hottest hubs for digital entertainment design and development, i.e., video games.  Video game sales now surpass movie sales and Georgia is home to more than 60 game companies and more than 2,000 college students enrolled in classes teaching video game design and development;
• In Columbia, Missouri, IBM announced that it would establish a new technology service delivery center and create 800 new direct jobs, the third such new IBM center in the last 18 months, with the centers in Dubuque, Iowa and Lansing, Michigan; and
• Impressively, in the first three months of 2010, Google added about 800 new jobs, Amazon added 1,800 and Intel plans to hire as much as 2,000 employees this year.  Even on Wall Street, the place which led the economy into recession, hiring is picking up underscoring the recovery of the big banks and brokerage firms.  Since employment bottomed out in February 2010, New York securities firms have added 2,000 jobs.

Exports

• U.S. exports totaled nearly $740 billion during the January-through-May period of 2010, up nearly 18 percent from the same period in 2009.  The May export figure is the strongest year-to-date, as well as the strongest monthly performance since September 2008;
• What are some of these exports?  NUTS.  In 2010, China will rank as the number one foreign buyer of American almonds, mostly from California, more than doubling its purchases from two years ago.  Last year, China was the top foreign buyer of American walnuts, and in 2007, became the leading export market for pecans.  USDA documents that in 2009 China bought $737 million in tree nuts from the United States, a rise from a mere $89 million five years earlier.
• All this activity export activity has resulted in generating a tremendous amount of business at the nation’s ports.  Container traffic at Georgia’s ports, for instance, is up 25 percent in the first five months of the year compared to the same period last year.

Conclusion

In closing, as foreboding as the severity of the Great Recession has been on both the national and state economies, there is a glimmer of optimism that we are moving in the right direction.  Undoubtedly, there is more anguish on the horizon given the depths to which the economy plunged, particularly for those facing foreclosure and those still unemployed and underemployed.  Policymakers at every level of government must remain vigilant to ensure that the ongoing recovery evolves into a self-sustaining expansion.  At the state level, policymakers have to heed the structural flaws corroding contemporary state fiscal systems and devise adequate responses based on what programs citizens expect from their state governments and how they are going to pay for them.  Redirecting the energies of our economy — beginning at the local and state levels along with engaging the federal government as a partner — will eventually generate broad-based, sustained economic growth in all sectors of the country.  Thank you for your attention.