Strapped states recast fiscal nets

In some ways, the endless tales of woe coming from American statehouses are hard to figure: In the catalog of economic booms and busts, this downturn must rank among history's least surprising.

In the midst of the 1990s' irrational exuberance, when www was still the most coveted address in America, economists insisted that it couldn't last. States even took measures to brace themselves, creating massive rainy-day funds.

Yet now, as the nation emerges from its relatively mild recession, states are plunging deeper into crisis. Part of the problem is the lag time between the pace of the economy and the filing of government balance sheets. But analysts suggest that something more fundamental is at work: The new economy has changed the calculus of state budgets, and capitols are struggling to keep up.

With more Americans making more of their taxable wealth in the stock market, Wall Street's influence on state budgets has never been greater – or more troublesome. Unlike stable revenue sources such as sales tax, the trappings of the 1990s boom – such as stock options and hiring bonuses – have fluctuated wildly in recent years, making budget projections almost impossible. The result is a new, volatile trend, as states swing between huge surpluses and deficits.

"States are more dependent on these [capital-gains taxes]," says Nicholas Jenny of the Rockefeller Institute on Government in Albany, N.Y. With less emphasis on these taxes, "It would be less of a roller coaster ride, but you also wouldn't perform as well in good times. It's live by the sword, die by the sword."

During the days of the dotcoms, capital-gains taxes accounted for 5 to 6 percent of most state budgets. Today, that has shrunk to 1 or 2 percent – a difference that amounts to billions of dollars. In the most extreme example, that income was one-quarter of the state budget here in California. The legacy has left the state with a $24 billion deficit – the largest in the nation.

The problem is not the mere fact that capital gains declined. States expected that. However, they did not expect the money to fall so dramatically, so fast. It's a lesson in the new economy's risk: Budget experts have so far been unable to accurately project the trajectory of stock-market wealth.

"They didn't figure it out as it went up, and they haven't figured it out as it's going down," says Arturo Perez of the National Conference of State Legislatures in Denver. That makes this recession different from the one 10 years ago, when roughly half of budget troubles were caused by overspending. This time, 98 percent of the crunch results from revenues falling short of expectations, Mr. Perez says.

To make up for this vanishing cash, most states have trimmed their budgets, drawn on rainy-day funds, and raised fees:

• One-third of states are considering raising cigarette taxes.

• Wisconsin sold the rights to 30 years of tobacco-settlement payments for $1.2 billion.

• Iowa recently required several state departments, including Health and Human Services, to take an unpaid day off.

• New Jersey is considering laying off 2,400 state workers.

Some experts suggest that an antiquated tax code has deepened the crisis. Taxes are still geared toward an economy built on manufactured goods, even though America has largely become service-oriented. To avoid – or at least soften – future recessions, these experts say, states mustn't keep piling taxes on an old and declining sector.

"The very dramatic cycles won't change until we look at the structure we have for collecting revenue," says Scott Pattison, executive director of the National Association of State Budget Officers in Washington. "Our taxation is on goods, but [the nation has] switched over to a service economy, and much of that is not taxed."

Minnesota Gov. Jesse Ventura tried to change that. In one of the most ambitious tax reforms proposed recently, Governor Ventura wanted to implement a three-part plan that included a broadening of the sales tax.

The legislature passed every part except the sales-tax plan, in part fearing that the public often views the broadening of any tax – even if the rate is reduced – as an increase. Looking back now from the depths of recession, state economists say the broader tax base would have been nice – but not a cure-all. From his seat as Minnesota state economist, Tom Stinson sees one figure as the key to Minnesota's budget problems: 30 percent.

That's the decline in wages that Minnesota planned for when it was laying out itsbudget. In hindsight, he says, "It was way too optimistic." His primary culprit is the new economy, with its hefty hiring bonuses and widespread stock options.

The loss of such incentives "make state income-tax receipts more volatile," he says. Last year, Mr. Stinson estimates that capital-gains revenues fell by more than $3 billion, which would be more than 10 percent of this year's budget. The final figures won't be in for six months, and he knows they could be worse than expected – potentially shackling next year's budget as well.

Asked whether that makes predicting income more slippery, he adds, "It's more than slippery. It's impossible."