Unprepared for boom or bust: Understanding the current state fiscal crisis

Leslie McGranahan is a consultant to the Federal Reserve Bank of Chicago and an associate fellow in the Department of Economics at the University of Warwick. The author would like to thank Bill Testa, David Marshall, and Helen Koshy for comments and guidance. In October 2001, the state governors sent a letter to the U.S. Senate concerning the Senate's proposed stimulus package. The governors sought to prevent the passage of a package that would be detrimental to already weak state budgets and to ask for specific assistance from the federal government for state budget items. As a result of the connection between federal and state revenues and spending, state leaders often comment on federal changes. What is remarkable about this letter is that only seven months after the end of the greatest postwar economic boom, the states were already seeking fiscal help from the federal government. In addition to its concerns about mounting defense and intelligence obligations and the flailing macroecono-my, the government now faced the specter of service shutdowns by bankrupt state governments. The crisis facing the state governments emerged quickly. In August 2000, commentators at the National Conference of State Legislatures (NCSL) were boasting that states were " in their best financial conditions in decades " (NCSL, 2000). In January 2001, the NCSL asserted that the states remained in " excellent fiscal condition " (NCSL, 2001c). But by August 2001, the NCSL was detailing how states were coping with budgetary shortfalls (NCSL, 2001a). In this article, I ask how the states found themselves in fiscal trouble so quickly. I begin by discussing the excellent revenue news from the states throughout the economic expansion. Tax revenues increased, welfare reform kept block grants at high levels, and the tobacco settlement provided a generous new form of funds. As a result, states faced the pleasant dilemma of what to do with their windfall revenues. I investigate the ways states decided to use these revenues. They faced four fundamental choices: they could spend the money on high-priority programs; they could return the money to taxpayers in the form of rebates and reductions; they could reduce indebtedness; or they could save the money for a less brilliant future. All states chose a combination of these four. States increased spending. Much of the spending increase was due to mounting expenditure pressures in health-care related areas. States also aggressively cut taxes, particularly personal income taxes, …