(UPDATE: The California House and Senate have both approved a fiscal-year 2010 budget in the wee hours of Saturday, July 25, that Gov. Arnold Schwarzenegger says he will sign. The budget, though, falls $1.1 billion short of being balanced and Schwarzenegger says he will propose yet further cuts. The main reason for the continued shortfall is that the most controversial budget-balancing maneuver — raiding the coffers of local government — was reduced in scope. The state will no longer take municipal governments’ gas tax revenue. Stay tuned.)

By Matthew Blake

Chicago, July 25 — The annual writing of balanced budgets by state governments is not a sexy story. This year, quite unfortunately, is different – most states face an unprecedented economic crisis. In the first three months of 2009, state tax revenue plunged 11.7 percent compared to the first three months of 2008, according to a report released by the Nelson A. Rockefeller Institute of Government at the State University of New York. The fall in revenue, coming after a five-year period of revenue growth in most states, was the most drastic plunge in year-to-year revenue in the 46 years that detailed state revenue statistics have been recorded.

Every state except Montana and North Dakota approached the 2010 fiscal year that began July 1 with a budget shortfall. The 50 states had a combined $121.2 billion deficit, according to the National Conference on State Legislatures. Most states have since balanced their budgets through a painful combination of tax increases and spending cuts, including deep slashes to many social programs.

The main culprit for this fiscal calamity is the recession. But the Obama administration and Congress deserve some blame as well. Given that 46 states are bound by their state constitution to balance budgets, Washington has been,at least, inconsistent given the attention it has paid to the balance sheets of investment banks and auto companies while ignoring the rising debt of states around the country.

But state governments have not shown much foresight, relying on the boom and bust economic cycles that have existed in our national economy for decades.  “No one can blame state leaders for failing to anticipate the worst revenue collapse in half a century or more,” says Robert Ward, deputy director of the Rockefeller Institute. “Still, it’s fair to say that taxpayers and individuals who depend on public services are suffering more now than they might have, if governors and legislators paid more attention to long-term budget problems.”

These self-inflicted wounds are perhaps most prominent in the highly populous states of California and Illinois. These are two states where the essential functions of state government are being thrown into question.

Incapable in Illinois

Illinois kicked off 2009 with the Democratic-controlled General Assembly voting to remove fellow Democrat Rod Blagojevich as Governor. The bad times continued when Blagojevich’s replacement, ex-Lt. Gov. Pat Quinn, said in his first address to the General Assembly that Illinois faced an $11.6 billion deficit over the next two years. There was a $4.3 billion shortfall for fiscal year 2009 and a $7.3 billion gap for fiscal year 2010. Those accustomed to reading articles about the $1.8 trillion dollar federal deficit might think those numbers hardly deserve a second look. But the $11.6 billion deficit is almost twenty percent of what Quinn and the General Assembly had planned to spend on state programs over the next two years.

How could Quinn have inherited such a deficit? It was in part the recession – Illinois has a 10.5 percent unemployment rate, and people are making less money and spending less money, so income and sales tax revenues are down. But even during the housing boom, Illinois was balancing its budget on the back of Wall Street bonds, deferring payments to the pension fund for public employees and delaying payments to state vendors.  “Before the current economic crisis we had a structural deficit in our state,” notes Doug Schenkleberg, associate director of policy and advocacy at the Heartland Alliance, a non-profit Chicago social services group.

So Quinn made a bold proposal – a 50 percent increase of the state’s flat-rate income tax,  from three percent to 4.5 percent. While Chicago Tribune and Sun-Times tabloid headlines screaming “Rookie Gov Wants  50 Percent Tax Increase” did not make great politics, a tax hike in a recession seemed a necessary evil. According to the Center for Tax and Budget Accountability, of the six states with a flat rate income tax (most states have a progressive tax), Illinois’ three percent rate is the lowest. By comparison, the highest rate is Massachusetts at 5.3 percent. Illinois residents only have the 41st highest tax burden among states even as the state government has in recent years borrowed to balance its budget. “We’ve needed an income tax increase for more than ten years,” laments Charles Barron, communications director of the Illinois Education Association, an advocacy group for public education employees. “We have limped along without a significant revenue increase even as we have continued to add programs.”

The state Senate approved a version of Quinn’s tax proposal in May. But members of the House, who are elected every two years, were nervous about voting for a tax increase during the recession. And House Speaker Mike Madigan – in that position since 1983 and chairman of the Illinois Democratic Party since 1994 – was cool to the idea. When Illinois could not reach a budget agreement at the end of its spring legislative session, Quinn quietly took the tax hike off the table. “The governor suddenly announced in May he was no longer for pushing income tax right away,” says Barron.  “He favored this temporary solution that involved borrowed money and cutting programs.”

But even with the most politically explosive piece of the budget debate off the table, Quinn and the General Assembly still could not agree on a budget by July 1st. They waited until July 15th – the day paychecks had to be mailed to state employees – to pass a balanced budget that is neither balanced nor budgets for social services. To close the $7.3 billion fiscal year 2010 budget deficit, the state will – brace yourself – carry over $3.2 billion from the fiscal year 2009 budget deficit to the fiscal year 2011 budget deficit. This $3.2 billion is itemized as delayed payments to state vendors, which apparently means that this years and next years payments to state contractors will go on the next budget.  The state will also route $2.2 billion from the sale of pension obligation bonds toward fiscal year 2010 spending. But these pension notes may be worth less if Moody’s downgrades the state’s credit rating. “We are concerned about how the state will move from here to return to balanced financial operations," Ted Hampton, who writes Moody’s investor services reports, told the Chicago Tribune. "The state has essentially kicked the can down the road in terms of making decisions.”

Perhaps the most egregious example of delayed decision making, though, is the final $2 billion in fiscal year 2010 cuts needed to close the $7.3 billion gap and produce an at least nominally balanced budget. How these cuts are distributed is to be decided entirely by Quinn and Illinois state social service agencies – the General Assembly punted on outlining specific cuts to popular social service programs. “Given a choice between a tax increase and spending cuts, the General Assembly chose neither,” says Larry Joseph, policy analyst for Voices for Illinois Children, a non-profit group that analyzes state children’s services policy. “They don’t want their fingerprints on painful cuts. They want to be able to blame the governor.”

As a result, social service providers remain in limbo. Already the delay in passing a budget has resulted in 1,900 laid off social service workers and 14,300 impacted clients, according to the state political news Web site, Progress Illinois. The Illinois Board of Education, though, did announce its cuts Wednesday, which come to $475 million taken out of a $7.5 billion annual budget. Of this, $123 million is cut from early childhood education, effectively preventing 30,000 low-income children from enrolling in pre-school. Other cuts include millions subtracted from mental health intervention services for troubled youth, and a program to provide alternative schooling for students who drop out or are expelled. The state’s health service agencies will soon announce their budget cuts, expected to eviscerate child care and health care programs for low-income families not covered by federal-state Medicaid. “The legislature reneged on its responsibilities,” says Schenkleberg of Heartland Alliance. “The funding is unable to deal with the most vulnerable.”

California Falls Into The Ocean

California is home to 1/8 of the country’s population, 1/7 of its economy – and the biggest fiscal disaster among the 50 states. As of July 24th,, the state Senate had finally approved – but the state House had still not agreed on (UPDATE: they have as of July 25th) – a fiscal year 2010 budget that was announced this Monday by Republican Gov. Arnold Schwarzenegger, Democratic Speaker of the House Karen Bass, and Democratic Senate leader Darrell Steinberg. The budget is similar to the one Schwarzenegger proposed in June, a spending plan that Jennifer Steinhauer of the New York Times reported “would turn California into a place that in some ways would be unrecognizable in modern America.” 

As in Illinois, California has decided against tax increases to close a massive deficit – 26.3 billion in fiscal year 2010 alone, or about 30 percent of the state’s annual general revenue spending. Instead, as Boyd of the Rockefeller Institute says, “California is making major cuts in programs that are part of each state’s fundamental responsibilities – things such as providing education, and caring for the helpless.”  For example, there will be a freeze in the enrollment of the state healthy families program, with the result being that thousands of low-income seniors and children will soon not have state-provided medical care. The plan will cut home health care service visits to most of the elderly. Those seniors who still qualify will be fingerprinted by the state to make sure they do not game the system. Welfare benefits will be cut for thousands, including care for the children of welfare recipients.

Prisoners, though, fare a little better – a $1.2 billion cut in the prison system will set 20,000 inmates free before their sentences ends. The budget maneuver, though, that may yet be the sticking point for the state House, is a plan to take $2 billion in property taxes collected by local governments and transfer it to state coffers. The budget would also raid $1 billion in municipal government transportation money (UPDATE: the House rejected this funding stream) and 1.7 billion from local redevelopment agencies and re-route it to the state government. Local governments – not exactly flush with revenues– are appalled. The Los Angeles County Board of Supervisors voted on Tuesday to sue the state (their specific claim is that snatching cash from local redevelopment agencies violates the state constitution).

What became of California? First, the state was ambushed by the recession. There is an 11.5 percent unemployment rate and its revenue collection is at a record low. Personal income tax collection plummeted 27 percent in the first three months of 2009 compared to the first three months of 2008 and, overall, the state lost $4.1 billion in revenue in the first three months of this year alone.

Also, California political leaders must deal with what New America Foundation senior fellow Joe Matthews called in a Washington Post op-ed “our terrible state constitution.” Matthews noted that the constitution requires 2/3 approval by the state legislature both to pass the annual budget and also to approve any type of tax increase. “In a state of such size and diversity, that’s a recipe for gridlock and dysfunction,” Matthews argued. “It’s next to impossible to get two-thirds of Californians to agree on anything, especially the unpalatable cuts or tax increases needed to balance our budget.” Post columnist Harold Meyerson went further, declaring that it was specifically the “malign initiative” of Proposition 13 that has paralyzed California politics. Prop 13,a ballot initiative that California voters passed in 1978, capped property taxes and also mandated a two-thirds majority vote in the legislature to raise taxes.  Prop 13 was the first of several ballot initiatives where Californians cast their votes for less revenue. Indeed, this May, voters rejected a set of ballot initiatives that would essentially have heralded a broad-based tax increase. It was a ringing no-confidence vote for any lawmaker tempted to push for a tax hike to close the deficit.

But while these flaws in the democratic process are a vital part of the problem, short-sighted California governance during and before the Schwarzenegger administration is probably more at fault. “They have taken what would be a bad situation and made it much, much worse,” says Daniel Schnur, director of the Jesse E. Unruh Institute of Politics at the University of Southern California, and the former media spokesman for California Republican Governor Pete Wilson. “If you have a small deficit it requires small difficult decisions to balance but by rolling over that into future years you’re making that problem larger and less manageable.” Ward of the Rockefeller Institute notes that, “California has self-inflicted budget problems in part because they have enacted big spending increases in the good years, and ignored the consequences for the future years when revenue growth will slow, disappear entirely or even shift into reverse.”

Daniel Mitchell, a professor emeritus in political science at UCLA, says that these self-inflicted wounds have been a fact of life in California for the last 30 years. “After Prop 13 what you saw was a series of economic bubbles that temporarily cover up the problem of declining revenue,” Mitchell says. “In the eighties, military spending goes up and California has a booming aerospace industry. When that ends, California has a budget crisis – but then comes the dot.com boom and then dot.com bust and then housing boom and bust. There was never the political leadership to change this cycle.”  What is different now, Mitchell argues, is not the fiscal problem at hand or the political obstacles toward solving it, but the sheer scale of fiscal woes for a state that now issues residents and businesses IOU’s. “We’ve had the requirement of 2/3 approval for the budget going back to the great depression,” he notes (only the 2/3 approval needed for a tax increase was the result of Prop 13).  “But as long as we were sort of booming along it didn’t prove to be an insurmountable constraint. Then, we could live within our means.”

Parental Supervision from Washington

Some states — like Massachusetts, which passed a legitimately balanced budget before the July 1st deadline and is exploring long-term ways to reduce health-care costs – have handled the recession much better than Illinois and California. But, for the most part, states big and small – New York, Texas, Ohio, Alaska, South Carolina – have found the recession too much to handle. Despite this and the Obama administration record of bailouts for financial firms and other pillars of the national economy, there is not much talk of a bailout for states. The $787 billion American Reinvestment and Recovery Act, better known as the stimulus bill, certainly helped state budgets, particularly with the federal government agreeing to pay a greater percentage of Medicaid costs.  The stimulus package has covered about 40 percent of state gaps between revenue and projected spending, according to the Center for Budget and Policy Priorities.

But absent another stimulus package or direct aid to states, California, Illinois and other state, and local governments, may default on bonds or see their credit rating downgraded. Given the size of California, this could trigger a national crisis. “Eventually Obama is going to be pulled into this,” says Mitchell. “Local governments in California could default on their bonds and it could undermine the municipal bond market.” Another reason states’ problems could hit the national scene is that at a time when the federal government, unencumbered by balanced budget requirements, has increased spending, states have cut back. In other words, as James Surowiecki of the New Yorker recently pointed out, the whole idea behind Washington’s economic recovery plan – more government spending and lower taxes producing more jobs and more consumer spending – is being undermined by the states. When the George W. Bush and Obama administrations rescued AIG and Citigroup and General Motors, the idea was that these companies were too big to fail.  That trumped the moral hazard of bailing out myopic and mismanaged firms. The same logic may work for a $26 billion bailout for California or an $8 billion bailout for Illinois. The decline of these states may not ruin the financial sector. But it has jeopardized government assistance that millions desperately need.

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