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HOT TOPIC » A Lost Decade

by Ray Scheppach, Executive Director, National Governors Association
The fiscal condition of states deteriorated dramatically over the last two years because of the depth and length of the economic downturn, and state officials do not expect this situation to improve any time soon. Previous downturns have proved that the worst budget years for a state are the two years after the national recession is declared over. States’ recoveries from the current recession, however, may be prolonged, with most economists projecting a slow and potentially jobless national recovery.
Moreover, even when recovery begins, states will continue to struggle because they will need to replenish retiree pension and health care trust funds and finance maintenance, technology and infrastructure investments that were deferred during the crisis. They will also need to rebuild contingency or rainy day funds, and both implement and pay a portion of the Medicaid expansion under national health care reform.
The bottom line is that states will not fully recover from this recession until very late in this decade.

The Current Situationray

The recent economic downturn started in December 2007 and likely ended in August or September 2009, making it one of the deepest and longest since the Great Depression. State revenues were down 4 percent in the last quarter of 2008, and 11.7, 16.6 and 10.9 percent in the first three quarters of 2009. These findings are consistent with the National Governors Association and the National Association of State Budget Officers joint publication, the Fiscal Survey of States, estimate that state revenues declined 7.5 percent in the 2009 fiscal year, which for most states ended June 30, 2009.
Revenues will likely continue down for another one or two quarters before turning up slowly. This precipitous drop in state revenues is consistent with past recessions in which the trough in state revenue generally coincides with the peak in unemployment. Most economists forecast unemployment will continue to increase into the first quarter of 2010.
Similarly, Medicaid spending, which is about 22 percent of state budgets, averaged 7.9 percent growth in the 2009 fiscal year, its highest rate since the end of the last downturn six years ago. Medicaid enrollment is also spiking, with projected growth of 6.6 percent in the 2010 fiscal year compared with 5.4 percent in 2009. The combination of falling revenues, which accompany high unemployment, and an explosion in Medicaid enrollment, which occurs very late in an economic downturn, explain why a recession’s greatest impact on state budgets occurs one to two years after the downturn is over.
States’ budget problems are reflected in the latest Fiscal Survey of States, which shows states closed budget gaps of $72.7 billion in the 2009 fiscal year and $113.1 billion in the 2010 fiscal year. This includes tax and fee increases of $23.8 billion in 2010. Even with cuts and tax increases, states are experiencing new budget shortfalls totaling $14.5 billion for 2010 and $21.9 billion for 2011. However, these projected shortfalls will increase dramatically over the next several months.

The American Recovery and Reinvestment Act

Of the $878 billion in Recovery Act funds, about $246 billion came to or through states in more than 40 programs. Most importantly, the $87 billion in Medicaid funds and the $48 billion in state stabilization funds were flexible and allowed states to offset planned budget cuts and tax increases. The Medicaid funds allowed states to reprogram state funds that were originally to fund Medicaid expansions, while the education money was targeted for elementary, secondary and higher education, which represents about one-third of state spending. If Congress had not made these funds available, state budget cuts and tax increases would have been much more draconian and devastating to state governments, their employees and citizens. States must plan for the serious cliff in revenues they will face when Recovery Act dollars expire.

The Recovery Period

While there is still uncertainty regarding the shape of the recovery, there seems to be a growing consensus that it will be slow. Numerous studies project that state revenues will likely not recover until 2014 or 2015. A recent forecast by Mark Zandi at Moody’s economy.com showed that the national unemployment rate, which straddled 5.5 percent during the 2001 to 2007 period, will not attain that level again until 2014. Similarly, Zandi’s forecast in January indicated state revenues will not return to the 2008 level in real terms until the 2013 fiscal year. Until employment improves, state revenues will continue to struggle. Work by the Nelson A. Rockefeller Institute of Government similarly indicates that per capita real revenues will not reach the 2007 level until 2014. Making matters worse, economist Robert Kuttner indicated that the states’ fiscal shortfalls will be about $350 billion over the next several years.

Deferred Investments

Even when recovery begins in the 2014 to 2015 period, states will be faced with a huge overhang in needs and will have to accelerate payments into their retiree pension and health care trust funds, as well as fund deferred maintenance and technology and infrastructure investments. They will also have to rebuild contingency or rainy day funds. All of these needs were postponed or deferred during the 2009 to 2011 period and will have to be made up toward the end of the decade. According to a recent Pew Center on the States report, states have an outstanding liability of about $3.35 trillion in employee retirement, health and other benefits coming due over the next several decades, of which more than $1 trillion is unfunded.

Medicaid Expansion

In 2014, states would have to expand Medicaid to all individuals below 133 percent of poverty as part of the Senate health care reform bill. For the newly eligible population of about 11 million individuals, the federal government will pay an enhanced match, which will average about 90 percent, if the Senate provisions prevail in the final bill. Unfortunately, the state’s share of this over the next decade is about $25 billion, according to the Congressional Budget Office. Moreover, states will incur other substantial costs as the 3 million to 4 million people currently eligible for—but not enrolled in—Medicaid come onto the rolls. Despite this projected increase in Medicaid participation, states would receive only their normal federal match. Furthermore, if states are forced to increase provider reimbursement rates to maintain access, they will only receive their normal match for this cost.