Arizona is considering putting its House and Senate buildings up for sale. Connecticut’s governor proposed a $1 per-pack tax hike on cigarettes. Michigan’s House Speaker suggested shifting its 400,000 public employees to a single health care plan, while another Michigander urged the reclassification of soda pop as a non-food item so it could be taxed at 6%.

From California to Connecticut, the global recession has squeezed state finances, forcing many state governments to slash services, raise taxes or find unusually creative ways to close the gap. The widespread budget shortfalls — expected to continue through at least 2011 — threaten to put a drag on the nation’s economic recovery and undermine President Obama’s stimulus plan, according to Wharton faculty and other experts.

Indeed, much of the more than $230 billion that the federal government sent to the states to stimulate their economies over the next two years is instead being used to balance budgets. “The states aren’t really playing the game like Obama hoped they would,” says Wharton finance professor Robert Inman.

“The dire condition of many states is a direct result of the financial crisis,” according to Wharton finance professor Itay Goldstein. “States depend on tax revenues, which decline in times of crisis due to rising unemployment, lower salaries, less spending, etc. Also, states depend on the credit market to smooth cash availability. [The credit] market has been in a freeze during the crisis, and this makes it more difficult to get financed. You combine these factors … and you get difficult times for states, just like for firms and individuals.”

At least 48 states either addressed or still face shortfalls totaling $163 billion in their budgets for fiscal year 2010, according to a recent report from the Center on Budget and Policy Priorities, a Washington, D.C.-based research center. A month after July 1, when the fiscal year in most states began, five states — Arizona, Connecticut, Michigan, North Carolina and Pennsylvania — remained deadlocked over how to balance their budgets. At least a dozen more states discovered billions in new shortfalls almost immediately after passing their budgets.

If projections are correct, the pain for most states won’t end anytime soon. The National Conference of State Legislatures (NCSL), a Denver-based bipartisan organization that serves state lawmakers and their staffs, estimates that the cumulative state budget shortfall for fiscal years 2008 through 2012 could top $348.2 billion.

Cliff Diving in 2011

“Many states say they are looking at a cliff in 2011 because they know [the federal stimulus funding they will have received from the American Recovery and Reinvestment Act of 2009] will be gone, and they do not expect state revenue performance to rebound strongly enough to make up the difference,” the NCSL reports in its recent State Budget Update for July 2009. “Many states are looking at a minimum of four to five consecutive years of deep fiscal problems.”

The sudden global meltdown has hit a number of states particularly hard because their revenues depend on taxes that fluctuate with the economy. Although revenue structures vary widely among states, most states rely heavily on individual income taxes, sales taxes or both. Local (city and county) governments rely more heavily on property taxes, which are less prone to economic swings.

“Unlike the federal budget, state finances are directly and immediately shaped by the economy,” says Robert B. Ward, director of fiscal studies at the Nelson A. Rockefeller Institute of Government in Albany, N.Y. “The federal government can borrow billions and even [as we now see] trillions of dollars to cover normal expenses. States generally cannot. The two primary sources of tax revenue for states are income and sales taxes. During the first three quarters of the last fiscal year, which ended on June 30 for most states, each of those taxes represented just over one-third of overall state tax revenue. Both taxes respond quickly to sharp ups or downs in economic activity.”

The Rockefeller Institute recently reported that state tax revenues fell by 11.7% in the first quarter of 2009, the largest decline ever recorded during the 46 years that quarterly data has been kept. Revenues from personal income taxes fell 17.5%, from sales taxes 8.3% and from corporate income taxes 18.8%, the report said. Early figures for April and May show a nearly 20% drop in overall state tax collections.

With unemployment increasing, the decline of tax revenues is likely to get worse before it gets better. The Federal Reserve recently projected that today’s 9.5% unemployment rate will peak at 10% in the fourth quarter and will remain at or above 9.5% for a year.

The pain of revenue shortfalls is especially acute given that most states are required by law to balance their budgets and cannot rely on deficit spending the way the federal government can. “Most states have balanced budget requirements,” says Wharton professor of business and public policy Alexander Gelber. “That means any shortfall in revenue the state has must be covered by either raising taxes or cutting services.”

Myopic Fiscal Planning

Problems also stem from myopic fiscal planning, says Wharton business and public policy professor Janet Rothenberg Pack. “Politicians are relatively short-term in their thinking. They want results while they’re in office,” she says. That means when the economy is good and tax revenues are flowing, states historically have spent the bulk of the cash on new programs instead of saving it for later emergencies. The recent housing bubble proved no exception.

“Expenditures almost always increase substantially when you have windfall revenues,” Pack points out. “These temporary spurts in revenues have almost always led to expenditure increases, many of which are clearly not one-time expenditures. Then, when funds go back down … or decrease, you have a constituency built in for new programs…. It’s very, very difficult to cut back.”

Today’s sudden shortfall of state revenues threatens not just new pet programs but also timeworn government promises, such as state pension plans. “The long-term obligations are coming home to roost,” says Wharton insurance and risk management professor Olivia S. Mitchell. Even before the recession, state pension plans were under considerable strain due to an aging government workforce, Mitchell notes. But the stock market crash sent state pension funds into a tailspin by reducing asset values by 25% to 35%. Public pension promises are now about $3 trillion underfunded, says Mitchell. That means states, just like individual investors trying to rebuild their 401(k) plans, need to set aside more money to make up losses.

“The states have been told [by the plan’s actuaries] that they have to kick in more to keep their pension funds above water,” Mitchell notes. “The gap this year is so big it’s hard to see how we’re going to fill it without a lot of political angst.”

As the financial pressures increase, so do the number of creative solutions states use to get around their fiscal dilemmas. The state of Washington, for example, came up with a more palatable number for its state pension obligations by declaring state employees would probably work longer and die sooner than expected. California shaved about $1.2 billion off its payroll obligations by simply writing state worker paychecks a day later than usual, shifting the costs onto next year’s books. “It’s a way of getting around the balanced budget amendments,” says Gelber. “It’s shifting liabilities forward in time.”

IOUs in California

But the fiscal problems of some states have grown too large to be wiped away by a magic eraser. The most obvious example is California, which faced a $24 billion budget shortfall this year and issued more than $1 billion in IOUs to vendors and taxpayers before Gov. Arnold Schwarzenegger finally signed a budget on July 28. Among the cuts the state was forced to make: $1.7 billion in general expenditures, $3 billion in health and human services, and $9.3 billion in education spending. Cuts next year could be even more severe.

California’s problems stem from a change it made to its constitution in 1978, says Wharton real estate professor Fernando V. Ferreira. Known as Proposition 13, the ballot initiative capped California property taxes at 1% of a home’s purchase price — a move that immediately slashed the amount of property taxes the state and local governments could collect. The initiative also imposed new restrictions on raising taxes, requiring any tax increase to win a two-thirds majority in both legislative houses. It imposed the same two-thirds restriction on local governments.

“What the state did over time to compensate is increase income taxes,” Ferreira says. When economic activity soared during the housing boom, California profited from this tax structure. The state raked in money, and voters passed dozens of propositions to spend the extra cash on everything from stem cell research to child welfare. “But as soon as the economy tanked and the bubble burst, the revenues from income taxes fell more than 30%,” Ferreira explains. “It’s much easier to vote on increasing expenditures, but they never say how they’re going to pay for it. And any time they propose to increase taxes, it always fails. That can lead to complete disaster in the long run.”

California and other hard-hit states are now in a perverse downward spiral of cutting costs and trimming services when residents need them the most. “The states that have been hit hardest by the recession should be the ones spending the most” to stimulate the economy, says Gelber. “The unfortunate feature of what’s happening now is they’re actually the ones spending the least.”

Problems with state finances also threaten to undermine the Obama Administration’s attempts to dig the country out of recession, because much of the stimulus money being sent to the states is being used to help reduce budget gaps instead of going into programs that could jump-start the economy.

“If the federal government is going to spend money on things, it really has to use state governments,” says Wharton’s Inman. This is because states are the largest providers of non-defense services such as education, transportation, health care, welfare, recreation, environmental protection and unemployment insurance. Out of every government dollar spent in these areas, about 20 cents is spent by the federal government, while 80 cents is spent by the states. “The federal government really does not spend much money for services, except for national defense,” Inman says.

In normal times, the average state brings in about $3,000 per person in taxes, fees and other revenues, and spends about $3,516 per person on unemployment, public services and other government programs, according to Inman. That leaves an annual gap of about $516 per person. But the average state receives $544 per year, per person in what Inman calls “non-welfare aid” from the federal government — funds that are not strictly earmarked to poverty and welfare programs. That federal contribution usually plugs these state shortfalls, leaving states about $28 per person in the black.

The current economic crisis has upended that balance. Due to rising unemployment and decreasing revenues from capital gains, states are collecting far less revenue. They’re also spending more money as more laid-off workers seek unemployment and Medicaid coverage. Result: The average state’s revenues have fallen by about $200 per capita, while its expenditures have increased by $163 — leaving the state with an $879 deficit, a gap $363 greater than in normal times. Consequently, even with the federal government’s non-welfare aid, the average state now finds itself in the hole to the tune of $335 per person.

Unable to meet their obligations without making drastic cuts or raising taxes, states have turned to the federal government for help. “The federal government is the financier of last resort. This is why the states turn immediately to Washington when their budgets go sour,” Inman says.

The Obama stimulus, while helpful, doesn’t entirely fill the current $335 per-person gap. The $787 billion stimulus allocates $223.2 billion over three years to the states — approximately $240 per person each year. Inman estimates that $108 of that is earmarked for poverty prevention programs such as unemployment, Medicaid, assistance for needy families and public housing. The remaining $132 goes to non-welfare programs, such as transportation, education and general-purpose spending.

Obama and his economic advisors are hoping this $132 will be spent right away, to stimulate the economy. But Inman’s research on state spending and taxation has revealed a potential problem for the Obama strategy. Historically, when states receive assistance from the federal government they save a portion of that assistance in “rainy day” funds, in anticipation of less federal money at a later date. “They spread it out, much like a family would if they received a check from the federal government,” Inman says.

He calculates that the average state will use about $69 of the $132 in non-welfare dollars to fill in revenue gaps, will spend about $8 more per person on capital outlays, allocate about $4 per person right away to pay off incurred debts, and then put the remaining $51 into a savings account, earning interest, for later contingencies — including, perhaps, less federal aid in the future. “The bottom line is, we’re going to give the states $132 in stimulus, but only half of it is ever going to find its way into the economy in the next year or two. All the best efforts to try to get states to spend the full stimulus package will be undone by the incentives of the states themselves.”