States are in the midst of perhaps the most challenging fiscal environment of the postwar era. Spending and revenue patterns broke away from trend in the years leading up to the recession, leaving states relatively poorly positioned to overcome the slowdown. And while they have made adjustments to deal with $100 billion-plus gaps in each of the past two years, further action will be needed in 2011 and 2012. Some states that have skirted the edges of shortfall, thus far, may still face significant fiscal pressure.State finance ; Recessions ; Fiscal policy

Jason Saving

English

Research Papers in Economics

SouthwestEconomy    FEDERAL RESERVE BANK OF DALLAS • FOURTH qUARTER 2010 10
Poor State Finances  
Deepen Recessionary Hole
By Jason Saving
States are in the midst of 
perhaps the most challenging 
fiscal environment of the 
postwar era.
In the summer of 2009, California paid 
vendors with registered warrants rather 
than cash. The warrants, a kind of IOU, 
were used as lawmakers struggled to close 
a gap between expenditures and revenues 
approaching 25 percent of the California 
budget—a nearly unprecedented shortfall. 
As the situation deteriorated further in 2010, 
the governor ordered the wages of more 
than 150,000 state workers temporarily re-
duced to the statutory federal minimum of 
$7.25 per hour and directed the employees 
to take three unpaid furlough days each 
month until California’s underlying budget 
problems could be addressed. 
Given a rapidly deteriorating national 
economic environment, it is perhaps inevi-
table that some states would be especially 
squeezed—and the particulars of this reces-
sion were especially unkind to California. Its 
geography and zoning laws made it vulnera-
ble to real estate downturns, and some of its 
leading sectors, such as semiconductors and 
the Hollywood entertainment industry, are 
highly tied to world demand. California also 
has a unique legislative structure in which a 
two-thirds majority is necessary to make fis-
cal adjustments that many other states could 
accomplish by simple majority. A recession 
that combines a real estate bust and a col-
lapse in world demand and significant bud-
getary adjustments would almost inevitably 
hit California hard.
But practically every state is suffering 
during this recession, many with quite dif-
ferent characteristics. All 50 states requested 
and received funds from aid programs such 
as 2009’s American Recovery and Reinvest-
ment Act to weather these extraordinary 
economic times. And almost every state has 
undertaken spending cuts or tax increases 
or both over the past two years, ostensibly 
tied to the recession from which the nation 
is only now beginning to emerge.
To examine the fiscal health of states, 
it’s helpful to look at their health immedi-
ately before the recession—how many ran 
in the red and why those shortfalls emerged 
during good economic times. Looking at 
the extent to which these figures worsened 
over the past three years—as the nation 
struggled through the longest downturn of 
the postwar era—provides perspective on 
the depth of the problems. Additionally, 
why do budget pressures become especial-
ly pronounced during recessions and what, 
if anything, can be done to mitigate them? 
Finally, there is the case of one state that 
only now confronts a large shortfall, Texas, 
and why it came to the party so much later 
than its peers.
Where States Stood
At the onset of the 2007–09 recession, 
13 states wrestled with budget gaps totaling 
at least $23 billion. Another 11 states faced 
revenue shortfalls and/or expenditure over-
runs leaving them vulnerable to deficits, es-
pecially if economic growth slowed.
Standard economic theory suggests that 
states should run surpluses during expan-
sions. Extra revenue can be set aside into 
rainy-day funds to help weather recessions 
that inevitably follow expansions. How is 
it that almost half the nation’s 50 states ex-
perienced fiscal pressures even before the 
recession?
In 2007, states ramped up spending at 
a 9.3 percent annual rate (6 percent in real 
terms)—the strongest such growth in two 
decades (Chart 1). Among states boosting 
spending at above-average rates were Mas-
sachusetts and New York in the northeast, 
Florida and South Carolina in the southeast, 
Arizona and New Mexico in the southwest 
and California in the west—all would be 
particularly hard-hit in the crisis that fol-
lowed (see map).
A second cause is a greater reliance 
on borrowing. Between 1993 and 2001, 
overall state debt grew 5 percent annually, 
varying only slightly from year to year in 
response to business cycle considerations. 
As the 2002–03 recession struck, increased   FEDERAL RESERVE BANK OF DALLAS • FOURTH qUARTER 2010 SouthwestEconomy 11
demand for state services along with lower-
than-expected revenue drove overall state 
debt above the trend line (Chart 2). When 
that downturn ended, however, state debt 
levels did not return to trend—as both 
economic theory and previous experience 
would predict. Instead, policymakers con-
tinued borrowing at the elevated pace they 
had embarked upon during the recession, 
spending at historically high rates while 
also offering small but significant tax cuts.
This left states poorly positioned for the 
financial crisis that soon arrived.
National Recession Strikes
In fiscal 2010, 48 states wrestled with 
a total shortfall of $129 billion—five times 
the gap they faced three years before. Re-
Chart 1
State Budgets Expand During Housing Boom
(Budget changes by fiscal year)
Percent
–4
–2
0
2
4
6
8
10
2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990
Nominal
Real
SOURCE: “The Fiscal Survey of States,” December 2007, National Association of State Budget Officers.
State Expenditure Growth, Fiscal Year 2007
Below 5%
5% to 10%
Above 10%
SOURCE: “The Fiscal Survey of States,” December 2007, National Association of State Budget Officers.
In 2007, states ramped up 
spending at a 9.3 percent 
annual rate—the strongest 
such growth in two decades. SouthwestEconomy    FEDERAL RESERVE BANK OF DALLAS • FOURTH qUARTER 2010 12
markably, this number is after $63 billion in 
additional federal funding, such as stimulus 
aid, arrived. Without that money, the deficit 
would have ballooned to $192 billion.
The latest figure, along with smaller 
gaps in 2008 and 2009, led local lawmakers 
to make painful choices. In those years, 43 
states reduced funding for education, includ-
ing 32 that pared kindergarten–12th grade 
education funding.1 Thirty-one states reduced 
public health and welfare outlays by raising 
eligibility requirements, curtailing dental cov-
erage or mental health benefits or reducing 
physician reimbursement rates. And 29 states 
pared support for the elderly and disabled, 
often scaling back mental health and in-home 
nursing care, while also sometimes instituting 
across-the-board benefit cuts. 
These painful choices are reflected 
in overall levels of state spending, which 
fell in 2010 for 40 of the nation’s 50 states. 
Several large states with serious shortfalls, 
including New York and California, reduced 
spending by less than the national average 
and still confront difficulties. Others, such 
as Florida and Nevada, cut spending more 
dramatically during fiscal 2010. 
The arbiter of U.S. recessions, the 
National Bureau of Economic Research’s 
Business Cycle Dating Committee, declared 
that the recent downturn ended in June 
2009. With the recovery under way, one 
might expect improved forecasts for 2011 
and 2012. That isn’t the case. Aggregate 
state shortfalls exceeding $100 billion are 
expected for each of the two years, with 
sizable spending cuts likely as states further 
retrench from the rapid expenditure growth 
of the prerecession years. Additionally, at 
least 30 states increased taxes during fiscal 
2009 and 29 did so during this fiscal year, 
the 12-month period that for most states 
ended June 30.
This suggests widespread fiscal im-
balances across virtually every part of the 
country during the 2007–09 recession and 
its aftermath.
Becoming More Recession-Proof?
While it’s impossible for a state to be 
completely recession-proof, economic theo-
ry suggests some revenue sources are more 
resilient than others during downturns. 
Consumption remains much more stable 
than income during recessions, for ex-
ample, because individuals tend to smooth 
their consumption over time even when 
experiencing dramatic swings in income, 
such as following job loss.
Aggregated state revenue figures from 
fiscal 2009, the most recent year for which 
complete data are available, show sales tax 
revenue dropped 6.2 percent during the 12 
months. But state income tax revenue fell by 
almost twice that amount, 11.2 percent, and 
state corporate income tax revenue declined 
even more, 16.9 percent. And to the extent 
those income tax fluctuations are driven by 
Texas stands out as a state 
that faced only modest fiscal 
pressure over the past two 
years but now confronts more 
significant headwinds.
Chart 2
State Government Debt Grows Above Trend in 2000s
(Debt outstanding by fiscal year)
Millions of dollars
200,000
400,000
600,000
800,000
1,000,000
1,200,000
2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993
State government debt
Trend 1993–2001 average annual growth
SOURCE: Census Bureau.  FEDERAL RESERVE BANK OF DALLAS • FOURTH qUARTER 2010 SouthwestEconomy 13
Chart 3
Texas Follows U.S. into Recession in 2008
Change in nonfarm employment (percent)*
Texas
U.S.
–8
–6
–4
–2
0
2
4
6
’10 ’08 ’06 ’04 ’02 ’00 ’98 ’96 ’94 ’92 ’90
* Quarter-over-quarter, seasonally adjusted, annualized rate; quarterly employment figure is the last month of the quarter.
SOURCE: Bureau of Labor Statistics.
individuals and corporations seeking out 
lower-cost states, the recession’s fiscal impact 
could linger for some time in areas where net 
outmigration is occurring.
This doesn’t necessarily mean there 
should be less emphasis on income taxes. 
States relying on those levies tend to 
experience revenue booms in good eco-
nomic times as income growth outpaces 
consumption—the flipside of enduring 
greater suffering during busts. Addition-
ally, income-tax-reliant states can maintain 
greater progressiveness in their tax systems, 
ensuring that upper-income individuals, 
with the greatest resources, contribute a 
disproportionate share of revenue. Also, 
sales tax regimes run the risk of losing rev-
enue as commerce shifts toward untaxed 
out-of-state Internet sales. While economists 
and policymakers have devised sales-tax-
like “consumption-tax” plans that overcome 
these objections, such proposals are con-
troversial too, leading some states to con-
clude that cyclical revenue sources such as 
the income tax should remain a significant 
funding source. 
On the expenditure side, some have 
proposed that state spending be pegged 
to a constant share of that state’s economy, 
automatically contracting during recessions 
and rising during expansions. This ap-
proach fails to recognize that demand for 
government services goes the other way—
citizens hit by bad economic times increas-
ingly turn to the government for help. This 
is also true for education and even prisons, 
as poor job markets induce individuals to 
return to school or, in some cases, turn to 
crime. Even short-run reductions in nutri-
tion and learning, and short-run increases 
in crime, can have long-run consequences. 
Thus, there are no easy answers to 
fiscal volatility. Of course, states could bet-
ter cope with recessions by making larger 
deposits into “rainy day” funds during good 
economic times, as some policymakers have 
suggested. But this, too, involves sacrifice 
because these deposits cannot simply ap-
pear out of the ether and must be funded 
by spending less or taxing more. The bot-
tom line: Barring radical changes in state 
revenue and expenditure systems, one can 
expect states’ fiscal health to deteriorate 
during future recessions just as it has in 
past downturns. 
What About Texas?
Texas stands out as a state that faced 
only modest fiscal pressure over the past 
two years but now confronts more sig-
nificant headwinds. It entered recession 
months later than the nation (Chart 3) and 
created more jobs during 2008 than all the 
rest of the country, bolstering revenue at a 
time when much of the country struggled. 
But the lingering aftereffects of recession 
have ramped up demand for health services 
through the Medicaid program and other 
social welfare expenditures. The needs are 
particularly acute in Texas, which has the 
greatest proportion of uninsured individu-
als in the nation. Coupled with a revamped 
franchise tax bringing in $3 billion per year 
less than expected from business, a big 
drop in energy prices and the expiration 
of roughly $12 billion in stimulus monies, 
the state now faces a shortfall for the next 
biennium estimated at up to $21 billion—or 
11.5 percent of its $180 billion budget.
Other states will face similar pressures, 
even if the national economy gradually re-
gains its footing next year. Of course, large 
fiscal shortfalls in Texas and other states 
are not surprising in an era of trillion-dollar 
federal deficits. The difference is that every 
state (with the exception of Vermont) is 
constitutionally required to fill its shortfall—
and make painful choices in so doing.
Postwar Era Challenges
States are in the midst of perhaps the 
most challenging fiscal environment of the 
postwar era. Spending and revenue patterns 
broke away from trend in the years leading 
up to the recession, leaving states relatively 
poorly positioned to overcome the slow-
down. And while they have made adjust-
ments to deal with $100 billion-plus gaps in 
each of the past two years, further action will 
be needed in 2011 and 2012. Some states that 
have skirted the edges of shortfall, thus far, 
may still face significant fiscal pressure.
Saving is a senior research economist and advisor 
in the Research Department at the Federal Reserve 
Bank of Dallas.
Note
1 “The Fiscal Survey of States,” various years, published by the 
National Governors Association and the National Association of 
State Budget Officers.

Poor state finances deepen recessionary hole

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Poor state finances deepen recessionary hole

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