The U.S. economy entered a financial-market-driven recession in December 2007 from which it has yet to fully recover. The boom of the mid-2000s has been replaced with a stubborn national reality of high unemployment and sluggish output growth, with no clear indication when economic activity will return to more normal levels.Budget deficits ; Labor market

Jason Saving

English

Research Papers in Economics

	 FEDERAL	RESERVE	BANK	OF	DALLAS	•	FOURTH	QUARTER	2011 SouthwestEconomy 3
States Still Feel Recession’s Effects 
Two Years After Downturn’s End
By Jason Saving
The nation ultimately is the 
sum of its parts and cannot 
fall into a serious recession 
without it affecting most 
states and their finances.
The U.S. economy entered a financial-
market-driven recession in December 2007 
from which it has yet to fully recover. The 
boom of the mid-2000s has been replaced 
with a stubborn national reality of high un-
employment and sluggish output growth, 
with no clear indication when economic 
activity will return to more normal levels.
Yet the states have, in many ways, borne 
the brunt of the recession. Demand for public 
services increased at the very moment tax 
revenue—especially from property taxes—de-
clined. As late as this October, a full two years 
after the recession ended, states from Florida 
to California to New York warned of new 
shortfalls that must be addressed through 
spending cuts and tax increases. In Texas, 
lawmakers completed work on cuts totaling 
at least $15 billion for the upcoming two-year 
budget cycle. 
As the nation’s economic woes contin-
ued, the federal budget deficit climbed, pos-
ing potential limits on aid Washington could 
provide. The deficit soared to $1.4 trillion in 
2009 and is expected to remain above $1 tril-
lion annually until 2013. At least one major 
ratings agency downgraded the country’s 
top-tier credit rating, warning as part of its 
unprecedented action that officials must do 
more over the short term to stabilize and im-
prove the deficit picture. Other ratings firms 
have similarly cautioned that their assess-
ments of U.S. creditworthiness could be cut if 
fiscal imbalances aren’t addressed.
How Have States Done?
Following the 2001 recession, state 
budget outlooks improved. After posting 
collective budget gaps of about $80 bil-
lion in 2003 and 2004, fiscal retrenchment 
coupled with above-average economic 
growth virtually eliminated shortfalls by 
mid-decade. Even in the first full year of 
the most recent recession, 2008, it appeared 
states might weather the national economic 
storm relatively unscathed.
Unfortunately, the nation ultimately is 
the sum of its parts and cannot fall into a 
serious recession without it affecting most 
states and their finances. On the revenue 
side, job losses and wage cuts reduced indi-
vidual income and consumption, crimping 
state revenue. And at the very moment rev-
enue fell, residents beset by poor economic 
conditions increased their demand for an 
array of state-provided social services rang-
ing from Medicaid to job training, driving 
up expenditures beyond projections. The 
result: a dramatic widening of state fiscal 
gaps.
The depth of the recent recession 
is vividly illustrated by ballooning state 
deficits in 2009–11, which produced an 
unprecedented three consecutive years of 
more than $90 billion shortfalls (Chart 1). 
In 2010 alone, 43 states confronted a cumu-
lative $174.7 billion budget hole—the larg-
est ever recorded. And while those deficits 
narrowed somewhat in 2011, they are not 
Chart 1
State Shortfalls Reach Record $174 Billion in 2010
Billions of dollars
0
20
40
60
80
100
120
140
160
180
200
2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002
Estimates Projections
SOURCE: National Conference of State Legislatures.SouthwestEconomy    FEDERAL RESERVE BANK OF DALLAS • FOURTH QUARTER 2011 4
expected to return to prerecession levels for 
at least two years amid the relatively weak 
economic recovery.
With balanced budgets required in 49 
of the 50 states by law or state constitu-
tion, jurisdictions coming up short must cut 
services (or raise taxes) to bring spending 
plans into balance. To be sure, budgetary 
tricks—for example, strengthening near-
term economic assumptions or making 
favorable assumptions about social-service 
caseloads—can sometimes soften the blow. 
These devices can only go so far, ensuring 
that some sacrifices will be required.1
But were those measures limited to un-
necessary and little-used programs, or did 
states reduce funding to key budget areas, 
such as health and education? 
In 2010 (the last year for which data 
are available), 43 states reduced funding for 
higher education, according to the National 
Association of State Budget Officers (Chart 
2). This coincided with a period when out-
of-work individuals increasingly turned to 
colleges for occupational retooling. Some 
states also enacted policy changes to re-
duce support for higher education over the 
longer term, continuing a trend seen over 
the past few decades.
A slightly less common target was 
K-12 education, which 34 states cut in 
fiscal 2010 (October 2009 to September 
2010). The reductions coincided with de-
bate over whether class sizes had become 
too large and student test scores too low. 
Since a majority of most states’ outlays go 
to education and health, substantial budget 
cuts cannot—from a purely mathematical 
perspective—occur without affecting ei-
ther item. Typically, such reductions are at 
least partially restored in later years as the 
economy improves. The 2007–09 recession’s 
aftereffects have lingered longer than many 
expected, perhaps delaying by several years 
the reinstatement of funding.
Public health programs were pared in 
31 states; support for the elderly and disabled 
was trimmed in 29. These cuts revealed a 
paradox. States, while well-positioned to help 
individuals when most citizens (and the tax 
base) are healthy, struggle to offer their stan-
dard menu of benefits when widespread and 
pervasive economic shocks increase the num-
ber of people needing assistance. 
The difficulty could be mitigated by giv-
ing states more leeway to incur deficits. But, 
as has become evident at the federal level, 
deficit spending can create problems of its 
own, at least over the medium to long term.
What About Texas?
As a majority of state economies en-
tered recession in late 2007, Texas contin-
ued growing (Chart 3). And as most state 
economies emerged from recession in 
2009–11, Texas outperformed the remain-
der of the country in employment growth 
by a full percentage point—about equal to 
Texas’ historical advantage over the past 
few decades. 
Texas’ favorable performance stems 
from a number of factors, including its oil 
and gas industry, a low cost of living, favor-
able demography, restrictive home-lending 
laws, an attractive business climate and a 
housing sector that held up better than it 
did elsewhere. These items do not and can-
not guarantee growth here will exceed that 
of the nation—Texas trailed the U.S. in 10 
of the 86 quarters depicted in Chart 3, for 
Chart 3
Texas Exceeds Nation in Job Growth
Quarter/quarter percent change*
2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990
U.S. Texas
–8
–6
–4
–2
0
2
4
6
* Seasonally adjusted annualized rate.
SOURCES: Bureau of Labor Statistics; Texas Workforce Commission; Federal Reserve Bank of Dallas.
Chart 2
Most States Cut Health, Education, Other Areas in 2010
Number of states
0
5
10
15
20
25
30
35
40
45
50
Govt. workforce Higher education K-12 education Elderly/disabled Public health
SOURCE: National Association of State Budget Officers.	 FEDERAL	RESERVE	BANK	OF	DALLAS	•	FOURTH	QUARTER	2011 SouthwestEconomy 5
example. But they do suggest that, other 
things being equal, Texas economic activity 
should be at least slightly stronger than the 
national average. 
Despite this relatively favorable envi-
ronment, Texas entered the 2012–13 bud-
geting biennium with a shortfall of between 
$15 billion and $27 billion, depending on 
the spending baseline chosen.2 This gap 
represents about 10 percent of state spend-
ing and 1 percent of economic activity over 
the two-year cycle. In light of the $3 bil-
lion to $4 billion in debt accumulated by 
the federal government daily, roughly $20 
billion over two years may not seem espe-
cially significant. But it is a large amount 
in a state that offers little assistance to the 
poor and prides itself on a business-friendly 
(read: small and efficient) tax and regula-
tory regime. (See accompanying box.)
The Legislature passed and the gov-
ernor signed a $172.3 billion budget for 
fiscal 2012–13—about $10 billion below 
the previous two-year budget and $15 bil-
lion less than actual 2010–11 expenditures. 
Each spending category depicted in Chart 
2 was cut, with an especially large propor-
tion borne by health services. A variety of 
elements prevented even larger reductions. 
These included increased revenue from a 
recovering state economy, a larger-than-ex-
pected withdrawal from the state’s rainy-day 
fund and just under $5 billion in “nontax 
revenue enhancements” such as higher li-
cense and registration fees.
Downgrading Debt?
As if state budget cuts were not 
enough, questions about excessive state 
government indebtedness have arisen. Fol-
lowing S&P’s downgrade of U.S. borrow-
ings, ratings firms said debt-ridden states 
might themselves be lowered in the near 
future—as Nevada and New Jersey were 
earlier this year and California was in 2010. 
Texas, however, has not been cited as a 
As most state economies 
emerged from recession in 
2009–11, Texas outperformed 
the remainder of the country in 
employment growth by a full 
percentage point—about equal 
to Texas’ historical advantage 
over the past few decades.
How Dependent Is Texas on Federal Funding?
Texas has significantly trailed the national average in federal spending per capita since the late 1980s 
and has been somewhat below the national average in federal spending per tax dollar paid to Washington. 
This means the Texas economy isn’t as dependent on federal spending as the typical state and receives less 
for its contributions. 
In 2005—the latest year for which complete data are available—Texas received roughly $6,500 per 
person in federal outlays, compared with a national average of $7,600. The Texas figure is 86 percent of the 
national average and places the state 42nd out of 50 in per capita federal funding.
Another way to address the conceptual question of Texas’ dependency on federal funding is to exam-
ine federal aid to state governments themselves, a narrower but somewhat less volatile measure of federal 
support for a region. Here the answer is similar: Texas received $1,179 per person, compared with the 
national average of $1,460, putting it in 43rd place.
This makes Texas somewhat of an outlier in its “neighborhood.” New Mexico routinely receives larger 
per capita federal outlays than any other state, for example—about 50 percent more than Texas. Louisiana is 
also somewhat above the national average, receiving about 15 percent more than its much larger neighbor. 
What about stimulus funding? Might it be that Texas has received an influx of funding whose sudden 
withdrawal would cause hardship relative to other states?
It turns out that official government data on stimulus funding by states are broadly consistent with 
other outlay data. To date, Texas has been awarded $674 per person in stimulus-related contracts, grants 
and loans from the federal government. While this puts Texas in second place among the states in total 
dollars received, Texas ranks 48th on a per capita basis, behind only Florida (whose governance resembles 
Texas’ in many respects) and New Jersey. The bottom line: Texas is not disproportionately dependent on 
stimulus monies. 
One final issue concerns the possibility of a downgrade to Texas’ credit rating if the nation’s credit-
worthiness were reduced. Texas is currently one of 15 states to boast a top-tier rating from Moody’s, for 
example. Five of those 15 were recently placed on a downgrade watch and would face a likely cut if there 
were a technical default by the U.S. But Texas was not one of the five, in part because it is less dependent on 
federal funding. So while the possibility of a state downgrade cannot be ruled out, there are few indications 
it will happen in the near term.SouthwestEconomy    FEDERAL RESERVE BANK OF DALLAS • FOURTH QUARTER 2011 6
downgrade candidate. How do its debt lev-
els compare with those in other parts of the 
country?
Such a comparison would generally 
use per capita state debt. Over the past two 
decades, per capita state debt shows Texas 
at about one-third the debt level of the rest 
of the nation (Chart 4). In 1993, for exam-
ple, Texas incurred per capita state debt of 
$478 versus $1,576 for the remainder of the 
nation. In 2009, the last year for which data 
are available, the comparison was $1,228 
versus $3,599. 
However, Texas has historically en-
abled localities—cities, counties and school 
districts—to undertake functions that else-
where might be done (or at least paid for) 
by the state. This suggests that a more valid 
comparison would need to include local as 
well as state debt.
In terms of state and local per capita 
debt, Texas essentially tracked the rest of 
Chart 5
Texas Mirrors Rest of Nation in State and Local Per Capita Debt
Thousands of dollars
0
1
2
3
4
5
6
7
8
9
10
Rest of U.S.
Texas
2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993
SOURCES: Bureau of the Census; U.S. Treasury.
Texas has historically enabled 
localities—cities, counties and 
school districts—to undertake 
functions that elsewhere might 
be done (or at least paid for) 
 by the state. 
Chart 4
Texas Trails Rest of Nation in State Per Capita Debt
Thousands of dollars
0
1
2
3
4
Rest of U.S.
Texas
2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993
SOURCES: Bureau of the Census; U.S. Treasury.	 FEDERAL	RESERVE	BANK	OF	DALLAS	•	FOURTH	QUARTER	2011 SouthwestEconomy 7
the nation over the past two decades, with 
a slight uptick over the past several years 
(Chart 5). This suggests that looking at state 
government data alone may provide a mis-
leading impression of the extent to which 
Texas is a small-government state. Rather, 
Charts 4 and 5 illustrate what economists 
sometimes call “fiscal federalism”—the del-
egation of responsibilities to the smallest gov-
ernment unit able to carry them out. (Florida 
is also notable in this regard.)  
Such a structure is neither inherently 
desirable nor inherently undesirable on eco-
nomic grounds alone. On one hand, delegat-
ing tasks to localities can help government 
better tailor the services it provides to the 
needs of individual communities and may 
improve efficiency by making civil servants 
more accountable to their constituents. On 
the other hand, it can exacerbate income in-
equality by impeding revenue-sharing across 
jurisdictions and perhaps reduce economies 
of scale that larger jurisdictions may produce. 
There is some economic evidence that em-
powering localities can boost state economic 
growth, though both state and local debt pat-
terns must be considered when this is done. 
States have an additional key liability 
not captured by debt-issuance figures: the 
degree to which their pension programs are 
underfunded. Any time a jurisdiction makes 
pension promises to its workers without 
adequately setting aside revenue streams 
to pay for them, future taxpayer liabilities 
are created, even though these promises do 
not immediately increase measured state 
debt. Media reports have revealed states 
with large and under-recognized fiscal gaps 
in their pension systems. That liability will 
eventually swamp the rest of their debt and 
require very large fiscal adjustments. Might 
this be true for Texas?
Chart 6 illustrates the extent to which 
the continental states have adequately funded 
their pension systems. Nineteen states, includ-
ing Texas, were at least 80 percent funded 
in both 2008 and 2009, a benchmark for 
sustainable pension systems. In those states, 
relatively modest fiscal adjustments should 
be enough to maintain solvency over the 
medium to long run. Nineteen other states 
fell below the 80 percent threshold in both 
years, sometimes by a significant margin. In 
those states, considerable adjustments may 
eventually be necessary, whether they come 
in the form of reduced benefits or higher tax 
revenues, or both. The remaining 10 states fall 
between these two extremes.
Texas doesn’t appear to be an outlier 
when it comes to government debt and un-
funded pension liabilities. 
Meeting Service Needs
State finances have eroded consider-
ably over the last few years, leading to 
cutbacks across wide swathes of program 
areas nationwide. Texas joined this group  
in the 2012–13 budget cycle, addressing a 
$15 billion to $27 billion shortfall almost 
exclusively through expenditure reductions.   
Across the country, state debt issu-
ance has risen in recent years. Texas has 
followed suit, though its overall borrowing 
levels and unfunded pension liabilities lie 
well within national norms.
Provided the nation does not fall back 
into recession, state shortfalls are expected 
to gradually recede toward more usual 
levels by about 2013. But sizable fiscal 
challenges will remain in the areas of in-
frastructure, education and health as states 
struggle to catch up in the aftermath of the  
recession and slow recovery. Across the 
nation, including Texas, those issues can 
be addressed when economic headwinds 
diminish.
Saving is a senior research economist in the Re-
search Department of the Federal Reserve Bank of 
Dallas.
Notes
1 This article will look primarily at state expenditures. For more 
information on the revenue side of the equation, see “Poor State 
Finances Deepen Recessionary Hole,” Federal Reserve Bank of 
Dallas Southwest Economy, Fourth Quarter 2010.
2 When matching previous spending levels, unadjusted for 
inflation and population growth, the figure is $15 billion. 
Addressing these factors and compensating for certain previous 
spending cuts raises the figure to roughly $27 billion.
Chart 6
Texas Pension Funding Exceeds Recommended 80 Percent in 2009
Less than 80
At least 80 in 2008, less than 80 in 2009
At least 80
Percent of pension system funded
SOURCE: Pew Center on the States.

States still feel recession's effects two years after downturn's end

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States still feel recession's effects two years after downturn's end

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