Sizing up the shortfalls: The states in straits.

• Author: Jenny, Nicholas W.

When state officials closed the books on 2002, they ended a year that had been among the worst for state finances in many decades--if not the worst. While the national recession that started early in 2001 was the root cause of these problems, the severity of the state fiscal meltdown was far in excess of what general economic conditions would have seemed to predict.

State tax revenues for a standardized fiscal year running from July 1, 2001, to June 30, 2002, were down by 6.3 percent nationally. (1) Adjusted for inflation, per capita state tax collections were down by 9.4 percent. This decline has opened huge gaps in the budgets of most states. (2)

In this article, we will look first at how the states got into this situation. We will examine the most recent recession in comparison with previous ones, as well as the prospects for future years. Then we will look at what the states have been doing to balance their budgets, and what they can still do. Finally, we will see what effect state fiscal conditions are having on local governments, and we will discuss one way the federal government could help state and local governments.

BOOM AND BUST

The late 1990s were a good time to be a policymaker in most states. The strong economy created a flow of ever-increasing revenues into state coffers. Exhibit 1 shows that once states emerged from the fiscal troubles of the early 1990s, state tax collections--adjusted for inflation and legislated tax changes--not only grew, but the growth seemed to accelerate. Year-over-year growth was more than 6 percent a year by the end of the decade.

In the 41 states that have broad-based personal income taxes, a phenomenon appeared called the "April surprise." This occurred when an unexpectedly strong flood of revenue came in with the final tax returns--due in April in most states. The effect of the two largest of these surprises can be seen as spikes in Exhibit 1; these represent April 1998 and April 2000.

In fact, the sometimes startling growth in personal income tax collections was the source of the rapid state tax revenue growth in the late 1990s. While sales tax revenues grew at a steady and moderate rate, personal income tax revenues surged. In the quarters with the biggest April surprises, personal income tax collections grew at an annual rate of nearly 20 percent.

While employment and wages were growing in the late 1990s, they were not growing at anything like this rate. Therefore, the explanation for the huge personal income tax growth must lie elsewhere. Looking more closely at state personal income tax receipts, we find that most of the growth was in quarterly estimated tax payments, which for the most part represent the tax that the highest-income taxpayers pay on their non-wage income. This income is often from investments, especially capital gains realized in the stock market. Exhibit 2 shows the growth in capital gains in the late 1990s, which reached more than 6 percent of gross domestic product by...