Fate of the States: The New Geography of American Prosperity

by Meredith Whitney

  That’s the idea, anyway. Because forty-nine states have constitutional requirements to balance their budgets every year or two, whenever tax revenues fall short of expectations, states are supposed to either hike tax rates or attack expenses by cutting spending and programs. Thirty-six states have already raised taxes, layering on special levies or one-time taxes, causing a brief uptick in tax receipts.2 But receipts have since leveled off, and in many states they’re trending down. The outcome is inevitable: more budget cuts. Since 2008 Nevada has cut $80 million from mental-health programs. New York State has cut $1 billion from its state college and university system. And Washington State has cut $2.6 billion from K-12 funding.3

  The reality is that over the past decade, states haven’t had the money to pay for all of their programs, projects, and promises, forcing them to seek significant spending cuts. Over the past five years, states have cut over a quarter of a trillion dollars out of their budgets—the equivalent of 13 percent of 2010 total spending and 17 percent of 2010 tax receipts.4 Education and public safety have been frequent targets for cutbacks at the state level, but state aid to cities and counties has suffered most. Local governments traditionally rely on state transfers for over 40 percent of their funding, but with state budgets now being slashed, there is less money trickling down.5 After decades of expanding social services, refurbishing schools, doling out generous raises to cops and teachers, and building new parks and sporting venues, the local-government machine has had to pull back dramatically and begin a long and seemingly endless series of cuts to programs and services.

  % Change in State Expenditures from 2000 to 2010

  SOURCES: BEA, U.S. CENSUS, AND MWAG

  From 2000 to 2010, state spending grew by 72 percent in California, 98 percent in Texas, and 114 percent in Nevada. That new spending totaled $107 billion, $59 billion, and $7 billion respectively. State and local government spending as a percentage of each state’s gross domestic product (GDP) also rose dramatically. In 2009 it accounted for over 25 percent of Michigan’s GDP; the figure for California was 25.3 percent, for New York over 28.1 percent. California alone spent $431 billion in 2009, according to the U.S. Census Bureau. Add together New York’s expenditures of $276 billion and Michigan’s $86 billion, and the sum exceeds Turkey’s entire GDP, which is the eighteenth largest in the world. Many states have essentially become dependent on their own spending to prop up their economies. There is, of course, great discrepancy from state to state. In 2009 Texas government spending accounted for a relatively low 9.7 percent of GDP. But it’s not that Texas has been frugal. In fact, its expenses have been growing at a fairly torrid pace—up 98 percent from 2000 to 2010—but it has a larger revenue stream due to the thriving oil and gas industries.6

  Budgets are bloated with pet projects of lawmakers wanting to pump money into their districts and into constituents’ pockets. Taken individually, many of these projects seem well intentioned, reasonable, and even beneficial—the Boys & Girls Club facility in the Lacoochee section of Tampa Bay receiving $1 million out of Florida’s $70 billion budget or the Government House in St. Johns County, Florida, receiving $2.5 million to create an “Interpretive Film & Exhibit and Government Museum.”7 But the cumulative effect is devastating. Padding of budgets with fluff spending has been going on for so long that it has become a difficult habit to break.

  For years nobody seemed particularly worried. For the same reason so many people believed home prices could never decline, states never foresaw a decline in tax receipts—and certainly never foresaw a prolonged one. They spent as if the good times would never end and made big promises to state and local government employees based upon the deliberate bet that they wouldn’t. Total state tax collections peaked in the second quarter of 2008 at around $241 billion, according to the U.S. Census Bureau. Individual tax receipts collected by the states topped out in the same quarter at $99 billion.8

  Then came the bust. Within a year, the bottom fell out of real estate and states were caught shorthanded. Those states with the greatest exposure were left with the largest budget gaps. Foreclosures skyrocketed, and states and cities saw their tax rolls shrink at a time when they needed more cash, not less, to pay for the expensive benefits, pensions, and infrastructure and other projects (which invariably run over budget) they had just approved. The school district in Newton, Massachusetts, for example, spent $197 million on a new, bond-financed high school—a veritable superschool boasting an Olympic-size pool, indoor track, climbing wall, dance studio, arts wing, and electronic music center. Construction costs ran $50 million over budget, and when the new high school finally opened in 2010, the district was suddenly faced with a $6 million budget gap—which it closed by laying off teachers, increasing class size (one Advanced Placement math class had forty-six students), and eliminating classes in Latin and Russian.9 Of course, Newton wasn’t alone in its foolish excess: Many states and municipalities borrowed billions, willfully deluding themselves that the money would materialize from ever-increasing property-tax revenues.

  The severity of the recessionary storm was fully revealed in 2009, when second-quarter tax receipts plunged by $40 billion—a record 16.4 percent decline from the previous year.10 Thirty-six states posted double-digit revenue losses, the largest declines in history. The slump continued quarter after quarter with only modest gains, prompting Lucy Dadayan, a senior policy analyst at the Rockefeller Institute of Government, to warn that “state tax revenues will continue to be insufficient to support current spending commitments” and that more spending cuts and tax increases were most likely on the way for many states.11

  In fiscal year 2013, which began in July 2012, the Center on Budget and Policy Priorities (CBPP) expected 350,000 more K-12 students in our public schools and another 1.7 million college and university students, many of whom receive state aid. With more employers doing away with health coverage and an increase in the number of unemployed workers lacking any benefits, the CBPP projected that 5.6 million more people would seek Medicaid coverage, which is jointly financed by states and the federal government.12 Where will the additional funds needed to meet these obligations come from? Many states have already made deep cuts in health and education spending. Florida, for instance, slashed assistance to state colleges, and North Carolina took an ax to education spending, lopping $2.6 billion from its fiscal 2013 budget. That comes on top of the nearly $1.5 billion North Carolina schools have been forced to give back to the state in so-called discretionary reductions.13 In other words, faced with its own shortfall, North Carolina took back monies it had already appropriated to counties, cities, and school districts. But this is what happens when states put together budgets based on overly rosy revenue projections.

  The state of California has been the worst transgressor when it comes to foolish government spending. The state was in relatively good fiscal shape until 2000, when it fell victim to the implosion of the dot-com boom. With revenues shrinking and cost-of-living increases mandated for current and retired state employees, a budget gap opened; as the downturn dragged on, the gap widened into a chasm and then an abyss. One of the key reasons for the record deficits was that during the good years public sector unions negotiated some astoundingly rich contracts. In 2011 the Wall Street Journal cheekily advised young people seeking high-paying jobs to forgo Harvard and become California prison guards. Training, the piece pointed out, took four months instead of four years, and the state paid you while you learned, with starting salaries that ranged from $45,000 to $65,000 and went up—way up—from there. In 2010 one sergeant with a base salary of $81,683 collected $114,334 in overtime and $8,648 in bonuses. And he was eligible for an annual $1,560 “fitness” bonus for getting a checkup. The capper: He could retire at fifty-five with 85 percent of his salary and medical care for life.14 Thus the prison guard with thirty years of service, whose highest level of compensation was $100,000 a year, would be eligible to retire at age fifty-five with an $85,000 annual pension. According to the annuity calc
ulator on CNNMoney.com, a fifty-five-year-old male employed in the private sector would need $1.63 million in retirement savings in order to purchase an annuity with a comparable yield.15

  The city of Stockton, in California’s Central Valley, offers another example. Stockton is flat broke and in 2012 became the largest U.S. city to ever go bankrupt. City officials admit they approved outsized benefits for city workers without having any understanding of the eventual cost. Writing in the Wall Street Journal, Steven Malanga, a senior fellow at the Manhattan Institute, quoted the city manager likening Stockton’s fiscal history to a Ponzi scheme in which employees were promised “huge—and unfunded—salaries and benefits,” whose costs the city didn’t calculate and couldn’t afford. Citing “a lack of transparency” as Stockton’s biggest problem, officials now admit that the union contracts allowed for the insertion of hidden costs—a hundred different ways in which employees could quietly boost their pay. One egregious example: Stipends for a fire captain’s uniform, needed or not, could add $35,000 to a $101,000 base salary.16

  Even before the housing collapse in 2007, Stockton couldn’t afford its generous benefits, so it turned to risky investments. Using $125 million of borrowed funds, it invested in the California Public Employees’ Retirement System (CalPERS), California’s pension fund, hoping to earn returns higher than the interest rates it was paying on its debt. Instead, the city lost nearly a quarter of its original investment—money that it had borrowed in the first place!17 As Stockton’s fiscal situation deteriorates, residents are paying the penalty. There are now 25 percent fewer police officers, which translates into dangerously long waits for emergency assistance. If a house is burglarized and no one is hurt, chances are the police won’t show up at all. California municipalities like Stockton find themselves boxed in fiscally by a constitutional amendment California passed in 1978 called Proposition 13. Prop 13 capped property-tax assessments at the 1975 value of residents’ homes, limited rate increases, and, for good measure, required a two-thirds vote of the state legislature to increase income taxes (which now makes it harder for politicians to make up for lost property-tax revenues).18 No reassessments were allowed under this law unless properties changed ownership. So in spite of California more than doubling its home values during the better part of the last decade, little new revenue was collected from properties that hadn’t changed hands.

  Some of the gimmicks that chronic overspenders like New Jersey and Illinois have used to balance their budgets amount to little more than rearranging the deck chairs on a sinking ship. In 1991 New Jersey closed its budget gap by having the Turnpike Authority buy just over four miles of toll roadway from the state. New Jersey governors of both parties borrowed from the state’s pension fund to close gaps. In 1997 the governor invested state money in the stock market; you can probably guess how badly that worked out. In 2009 an amnesty plan for tax evaders netted New Jersey $725 million in delinquent taxes. Did the governor use the windfall to shore up the pension fund? No, he handed out property-tax rebates to citizens earning less than $75,000.19 The problems of New Jersey are so deep that even current governor Chris Christie—who came into office as an outspoken budget hawk—now appears to have been overly optimistic about what he could actually achieve as governor given the mess the state is in. Revenue expectations continue to disappoint, forcing Christie to cut infrastructure spending and back off a tax cut he once vigorously lobbied for.

  Unfortunately, when revenues don’t cover costs, you have a sure prescription for disaster, and when there is too much debt, there is little, if any, margin for error. In fiscal year 2009 California’s spending outpaced revenues by 224 percent (in 2010 it was 92 percent), while New York’s spending outpaced revenues by 177 percent (89 percent in 2010). For Texas that same year the number was 136 percent (99 percent in 2010), and for Florida 166 percent (89 percent in 2010). A rebound in state revenues improved those numbers, but the core problem remained: Tax collections were still woefully below spending, rebounding only back to 2006 levels in 2010. During this same year, Florida was the only one of the twenty-five largest states (by GDP) to lower its spending.20

  The economies of Florida, Arizona, and Nevada mirror that of California in that their GDPs are all lower than they were in 2007, with Florida down over 7 percent, Arizona 7 percent, and Nevada 9 percent.21 When nominal GDP is declining and fixed costs keep rising, states get caught in a vortex of spending cuts and layoffs, which put even more pressure on their economies. These states suffer lower tax receipts. (Tax receipts have gone up recently only because actual rates have been hiked. Repeated rate hikes are not only often counterproductive but also certainly unsustainable.) Lower tax receipts lead to wider budget gaps, more spending cuts, reduced consumer spending, and new job losses. This is a difficult cycle to break. The less desirable the economic opportunities are within a state—due to lack of jobs, education, training, or some other social services—the higher the probability that businesses and people will leave the state. In 2011 alone, pharma company Biogen Idec relocated three hundred R & D jobs from San Diego to Research Triangle Park, North Carolina; chip maker Intel decided to build a $3 billion research center in Hillsboro, Oregon, instead of at its Santa Clara, California, headquarters; and health-care company Medtronic announced the relocation of three hundred customer-service jobs from Los Angeles, California, to San Antonio, Texas. “They are going to save 30% to 40% on all factors versus Los Angeles,” said San Antonio Economic Development Foundation president Mario Hernandez of Medtronic’s move. “And [workers] can live very comfortably very near the facility.” According to a study by business relocation expert Joseph Vranich, the number of business relocations from California increased fivefold between 2009 and 2011.22

  State finances are more or less a zero-sum game. Imagine a fixed pie of tax receipts that pay for the provision and upkeep of education, health care, roads and bridges, sanitation, public safety, debt service, pension payments, health care insurance, etc. So when more money goes to one program, less is left for another. If the federal government is at the top of the food chain—the ultimate “rich uncle” willing to lend states a hand when times are tough—the local government is at the bottom of the food chain, with the states somewhere in the middle. One of the first things a state can do, after asking for a federal money infusion, is to reduce monies to the local governments. This is where it really smarts for the local governments. In 2010, which is the most recent data available, 41 percent of local-government money came from state transfers, the rest by and large from property taxes. By comparison, 36 percent of the states’ monies came from the federal government.23

  The process on the surface seems simple enough, but it has become far from simple over the past sixty years. Take fiscal year 2010, for example. States took in just over $700 billion in tax receipts but spent over two and a half times that amount, or $1.9 trillion. Cut another way, states spent $1.2 trillion more than they took in. In 2000, by way of comparison, states spent twice their tax receipts and spent $540 billion more than the tax dollars they took in. Needless to say, the trend has been going in the wrong direction. Some of this is explained by the increased demand for Medicaid and welfare assistance, programs subsidized by the federal government and administered by the states. In fiscal year 2010 states received roughly $585 billion from the federal government for these programs.24

  If states want to raise money so they don’t have to take from one project to fund another, they have three options: raise taxes, increase taxes, or sell assets. Over the past decade, states have been more inclined to plunge further into debt and/or raise taxes than to sell assets. States have papered over the disconnect between tax revenues and spending by issuing unprecedented amounts of debt—some secured by taxes, some by specific revenue (like highway tolls)—and by looting the pensions of their current and future retired state employees. Between 2000 and 2010, states doubled the amount of municipal debt outstanding and took mostly fully funded pension plans and other benef
it obligations into a deficit of close to $1 trillion.25

  Although this kind of public-sector overspending was irresponsible and unsustainable, on one level it’s understandable, especially when the economy was robust. States and cities wanted to make capital improvements, and low interest rates made it inexpensive to borrow money. Officials in Jefferson County, Alabama, borrowed $3.2 billion from JPMorgan Chase and other lenders to finance a sewer system. Harrisburg, Pennsylvania, got burned by a trash-to-energy incinerator project that left the town $310 million in debt.26 “It was easy to borrow the money . . . too easy,” said political consultant Jeffrey Bell.27 What politicians so conveniently forgot is that borrowed money, no matter how low the interest rate, eventually has to be paid back.

  Budgeting should be a simple process, but it’s not. The basic structure is supposed to work as follows: States collect income taxes or sales taxes in exchange for public services such as transportation, state agency services, higher education, and other locally administered programs. Local governments’ revenues are generated primarily through property taxes and nontax revenues such as transfers from states. For example, in 2008 local governments derived 33 percent of their revenues/funding from such transfers; by 2010 that number had risen to 40 percent. Local governments collect primarily property taxes in exchange for services largely related to K-12 education and police and fire service. Theoretically, states try to tie their budget projections to what they think their tax receipts and other revenues will be, but there is no requirement that they do so. In fact, today state expenditures have very little correlation to revenues. States’ expenditures are more closely linked to cost-of-living or inflation-growth projections. These numbers don’t always line up when times are good, so you can imagine what the past five years have been like. Local governments have increased property taxes and states have increased income-tax rates, but these efforts have failed to keep up with expenses. Even after laying off nearly 700,000 state and local employees, expenses are still rising, and revenues are not keeping up.