The hardships of recession aren't confined to the private sector. Dallas Fed regional economist Jason Saving takes a look at how state budgets are faring in the long, deep slump--starting with Texas.Economic conditions - Texas ; State finance ; Taxation - Texas ; Recessions ; Budget

Jason Saving

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Research Papers in Economics

OnTheRecord
SouthwestEconomy    FEDERAL RESERVE BANK OF DALLAS • FOURTH QUARTER 2009 8
A Conversation with Jason Saving
Texas in Better Fiscal Shape than Most Other States
Q. What can you tell us about Texas’ state 
finances? 
A.  Texas  hasn’t  had  the  same  tax  revenue 
losses  as  many  other  states.  Our  economy 
has generally fared better than the nation’s 
during  this  recession.  The  state  unemploy-
ment  rate  has  been  a  percentage  point  or 
more below the national rate. Job losses have 
been smaller. Personal income has fallen at 
a slower rate, and the same is likely true for 
total output.
Faring better hasn’t meant escaping re-
cession, and the state did confront some fiscal 
turbulence in 2009. Several one-time revenue 
gains, including $6 billion in federal stimu-
lus funding, offset declining tax receipts and 
enabled Texas to maintain services without 
drawing down the state’s rainy-day fund. 
State sales tax revenue has softened con-
siderably during the recession—for example, 
the second quarter saw a 6.5 percent decline 
from the same period last year. At the same 
time, outlays in key programs, including Medi-
caid,  continue  to  increase.  This  suggests  a 
more challenging fiscal environment in 2010 as 
policymakers attempt to reconcile greater de-
mand for state services with shrinking revenue. 
Q. Has the recession been as hard on states as 
it’s been on the federal government?
A. The federal deficit has more than tripled, 
going from $454 billion in 2008 to $1.4 trillion 
in 2009. This expansion has had two main 
causes—a  dramatic  increase  in  spending 
aimed at getting the economy moving again 
and a dramatic reduction in tax revenues as 
firms and individuals face lower profits and 
incomes.
Almost every state has had to confront—
or  is  still  confronting—budgetary  shortfalls 
since the start of the recession. Taken togeth-
er, the shortfalls are in the neighborhood of 
$100 billion in fiscal 2009, and they’re expect-
ed to total about $170 billion in fiscal 2010. 
At first glance, it might seem the reces-
sion has been far easier on states than the 
federal government. But this would be incor-
rect. It’s important to remember that states, 
with the exception of Vermont, are required 
to balance their budgets year-in and year-out. 
The federal government can spend more 
as revenues decline, but states have to make 
difficult decisions that often impose real and 
immediate pain on ordinary citizens. When 
revenues can’t cover expenditures, states are 
required to raise taxes or scale back spend-
ing—typically at a time when cash-strapped 
citizens need all the help they can get. 
Q. Why has Texas had fewer fiscal problems 
than most other states? 
A. Several factors are at work. One is a busi-
ness-friendly environment, which has helped 
keep alive firms that might have succumbed 
to the recession elsewhere. Another is a rise 
in state government spending that was slower 
than the national average after the 2001–02 
recession, creating less of a spending over-
hang to pare back in hard times. Yet another 
is that the Texas economy entered recession 
later than other states, partly due to such fac-
tors as high energy prices and the friendly 
business climate.
But a key factor often missed in these 
kinds of discussions is Texas’ reliance on sales 
taxes rather than income taxes. Income takes 
a much bigger hit than consumption during 
economic downturns because people try to 
maintain their living standards while endur-
ing temporary wage cuts or unemployment 
spells. So income tax revenue tends to fall 
further than sales tax revenue during reces-
sions, leaving income-tax-reliant states facing 
deeper fiscal shortfalls.
We’ve seen this during the recession. In 
the second quarter, overall revenue from state 
income taxes fell 15 percent from the same 
period last year, whereas sales tax revenue 
across the 50 states was down only 6 percent. 
The flip side is that income-tax-reliant states 
have greater room to increase spending dur-
ing recoveries. That’s not receiving a lot of 
play at the moment—for obvious reasons.
Q. Does Texas face any significant budget 
issues?
A.  Texas  certainly  faces  fiscal  challenges. 
A  short-term  issue  is  the  newly  reformed 
franchise  tax,  which  is  generating  about   
$1 billion less in annual revenue than fore-
cast. Only part of that gap can be attributed 
to the recession. Recent changes to the tax 
have  actually  further  reduced  revenue—for 
example, by raising the income threshold at 
which taxes must be paid. The franchise tax 
provides less than 10 percent of state reve-
nue, but this is still an issue the state will have 
to deal with in the near future.
An intermediate-term issue is Medicaid, 
which has almost doubled in size over the last 
decade in Texas and now consumes a quar-
ter of the state’s overall budget. Getting those 
outlays under control would free up money 
for other priorities, but virtually every state 
has struggled to reach this goal in an era of 
rapid increases in health care costs. The fed-
eral government’s health care reform has the 
potential to slow the rise in costs, but most 
The hardships of recession aren’t confined to the private sector. Dallas Fed regional 
economist Jason Saving takes a look at how state budgets are faring in the long, deep 
slump—starting with Texas.   FEDERAL RESERVE BANK OF DALLAS • FOURTH QUARTER 2009 SouthwestEconomy 9
proposals now on the table would also dra-
matically expand Medicaid rolls. If not prop-
erly handled, reform could actually worsen 
Texas’ fiscal strains.
Over the longer term, the most impor-
tant fiscal issue will be improving education 
and  infrastructure  without  sacrificing  the 
low taxes and business-friendly climate that 
have helped the state’s economy grow faster 
than the nation’s. If the state fails to improve 
graduation rates among Hispanics or fails to 
modernize its highway network, for example, 
economic growth and tax revenue could suf-
fer over time. On the other hand, failing to 
maintain a low-tax policy environment may 
also slow growth and exacerbate state fiscal 
imbalances. 
Q. Besides Texas, are other states doing 
reasonably well on the fiscal side?
A. A number of Great Plains-area states man-
aged to get through fiscal 2009 without sig-
nificant fiscal shortfalls, including Arkansas, 
Iowa,  Kansas,  Montana,  Nebraska  and  the 
Dakotas. Most are states with the fewest job 
losses in this recession, including one—North 
Dakota—that has actually gained jobs over 
the past nine months.
But the best available estimates suggest 
that even these states face significant fiscal 
pressures in 2010 and 2011, partly because 
of the sheer depth of the recession and partly 
because of fluctuations in the food and en-
ergy prices that help drive their economies. 
Q. Which states are facing the biggest budget 
messes?
A. The state facing the greatest fiscal chal-
lenge—bar none—is California, where legis-
lators wrestled with a shortfall of almost $40 
billion in fiscal 2009 and face even greater 
fiscal pressures in 2010. Spending in the pre-
vious five years rose 3 to 4 percentage points 
faster than inflation and population growth. 
Then  the  recession  hit.  Revenue  from  the 
state’s steeply progressive income tax has fall-
en by a whopping 20 percent over the past 
year, so the spending levels simply couldn’t 
be maintained with available revenue.
Other states that face an especially chal-
lenging  2010  include 
Arizona,  Nevada  and 
New York. Each of these 
states  increased  spend-
ing at a relatively rapid 
rate  during  expansion, 
and  each  is  now  strug-
gling to close very sub-
stantial shortfalls.
Q. When states cut 
spending, what usually 
gets the ax?
A. State spending is divided into three broad 
categories of roughly equal size: social ser-
vices, education and criminal justice. All are 
valuable and all tend to be trimmed when 
states  face  recession-induced  budget  short-
falls. Eligibility requirements are tightened for 
welfare  programs  and  checks  are  reduced; 
funding for schools is curtailed and elemen-
tary and high school class sizes are increased; 
judicial backlogs grow and enforcement ef-
forts can suffer.
Unfortunately, these cutbacks often oc-
cur at precisely the time the programs are 
needed most, when poor job market pros-
pects induce individuals to seek social assis-
tance, return to school or perhaps even com-
mit crimes. 
Q. How can states prepare themselves for the 
fiscal shock of recession?
A. They can do a couple of things to be better 
prepared for adverse economic circumstanc-
es. One is to lessen reliance on taxes that 
are strongly tied to current economic condi-
tions, so that tax revenues will be less likely 
to plunge precisely when demands for state 
services are greatest.
Another  is  to  resist  the  temptation  to 
dramatically  ramp  up  spending  during  re-
coveries, so that fewer cuts will be needed 
during recessions. Balancing the budget over 
time requires saving during booms—whether 
we’re talking about states or individuals. The 
strategy can be hard to do at times but pays 
dividends when the economy worsens.
The most important thing a state can do 
to prepare for the fiscal shock of recession is 
offer a business-friendly environment. Doing 
so helps states enter recession with a relative-
ly strong tax base and helps sow the seeds of 
a relatively quick recovery because startups 
can make profits earlier in the business cycle.
Texas  has  done  relatively  well  along 
most of these dimensions, generally relying 
on taxes that don’t swing wildly with current 
economic conditions and providing a condu-
cive tax and regulatory environment for busi-
ness. It’s important to bear in mind, though, 
that no state can fully insulate itself from re-
cession or its fiscal consequences.
Q. Will economic recovery be enough to resolve 
most states’ budget troubles? 
A. It typically takes two to three years for 
state  fiscal  pressures  to  abate,  in  part  be-
cause firms don’t hire as quickly as consum-
ers  would  like  and  consumers  don’t  open 
their pocketbooks as quickly as firms would 
like. Going by historical record, it wouldn’t 
be at all surprising to see further tax hikes 
or spending cuts at the state level in 2010 
or even 2011 as policymakers struggle to get 
back on an even keel.
Some  analysts  believe  the  depth  and 
breadth of the current recession could ex-
tend these postrecession blues by an addi-
tional year or two beyond the norm. It’s too 
early to say whether this scenario will play 
out, but it’s fair to say the onset of economic 
recovery won’t immediately take care of state 
fiscal woes.
“A key factor is Texas’ reliance on sales taxes rather 
than income taxes. Income takes a much bigger hit 
than consumption during economic downturns.” 

On the record: Texas in better fiscal shape than most other states: a conversation with Jason Saving

http://dallasfed.org/assets/documents/research/swe/2009/swe0904e.pdf

On the record: Texas in better fiscal shape than most other states: a conversation with Jason Saving

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