States in Fiscal Peril
Pew’s researchers started with two basic questions: How did California get into its current fiscal situation, and could other states find themselves facing similar difficulties?
To empirically gauge California’s fiscal conditions and assess if other states share similar characteristics, Pew’s researchers sought to understand the factors that contributed to the Golden State’s economic predicament. We reviewed the relevant literature related to public sector fiscal/financial management. In addition, we closely followed news accounts of negotiations between California Governor Arnold Schwarzenegger (R) and the state legislature.
A state’s fiscal health is determined and affected by a wide range of complex fiscal factors, including economic variables, demographics and political developments. Pew’s researchers chose to focus on six indicators, all of which played a significant role in creating California’s fiscal crisis and in stymieing solutions:
- Change in revenue
- Budget gap as a percentage of general funds
- Change in unemployment
- Foreclosure rate
- A supermajority requirement to raise revenue and ratify budgets
- The "money" grade from the Pew Center on the State’s Government Performance Project, which assesses how well states are managing their fiscal affairs
Pew used the best available and most current data as of July 31, 2009, to score California and other states based on these six indicators. We chose this particular time period to reflect the circumstances as of the first and second quarters of 2009, when state lawmakers were crafting their fiscal year 2010 budgets.
Pew’s researchers included change in tax revenue as one of our six indicators because tax revenue is required to counteract the effects of any recession. If tax revenues decline, then states must use rainy day funds, cut budgets, issue additional debt or, in the case of this recent recession, look to the federal government for an infusion of funds.
To calculate change in revenue, we used data on tax collections from the Rockefeller Institute of Government, which collects information directly from the states and shares its information with the U.S. Census Bureau. Because the recession officially began in December 2007, we looked at the amount of total revenue collected in the first quarter of 2008 and the amount collected in the first quarter of 2009—the most recent information available as of July 31, 2009—and measured the change between those figures.
Researchers looked at states’ total budget gaps as a percentage of general funds for fiscal year 2010. This indicator is important because if states have budget shortfalls as a result of increased expenditures or decreases in revenue, they must balance their budgets, typically by slashing services or raising taxes, both of which can worsen the effects of a recession, according to the economic literature. States also can issue debt.
We used data measuring budget shortfalls collected from the Center on Budget and Policy Priorities (CBPP). CBPP’s calculations of states’ budget shortfalls were originally published on September 8, 2009. These data are regularly updated and Pew’s researchers used the most recent data as of July 31, 2009. We also consulted the National Conference of State Legislatures’ (NCSL) data on budget gaps, which are derived from legislative fiscal offices across the country. NCSL indicates smaller budget gaps than CBPP, but the NCSL data are incomplete and do not cover all states. Nonetheless, we found that CBPP and NCSL’s data are highly correlated.
Next, we examined the percentage point change in unemployment from the second quarter of 2008 to the second quarter of 2009, the most recent data available as of July 31, 2009. A rise in unemployment increases demand for state benefits, such as unemployment insurance and Medicaid coverage. In addition, the resulting decrease in consumption can cause a decline in both payroll and sales taxes, in turn impeding revenue growth. Pew obtained unemployment rates from the U.S. Bureau of Labor Statistics, Local Area Unemployment Statistics dataset.
We also looked at the total foreclosure rate by state in the first quarter of 2009—the most recent data as of July 31, 2009—from the Mortgage Bankers Association’s National Delinquency Survey. Foreclosures are an important indicator because they shrink the base of state and local property taxes.
In addition, as foreclosures in a state increase, the possibilities of higher consumer debt burden and bankruptcy will lead to less consumption and a reduction in sales tax receipts. Finally, foreclosures decrease both the price and the demand for housing, which harms the construction industry—a major industry for many cities and states—and housing-related services.
Seventeen states require a supermajority vote by their legislature to enact tax increases, budget bills or both. We looked at supermajority requirements to enact tax increases because finance experts generally agree that this institutional arrangement significantly reduces taxes or constrains a state’s ability to generate greater revenue by increasing taxes. Pew’s researchers also considered a supermajority requirement to pass a state’s budget, which makes it imperative for state lawmakers to work together to cut budgets and pass budget bills.
For more than a decade, the Pew Center on the States’ Government Performance Project (GPP) has assessed how well states manage their money, people, information and infrastructure. For the “money” component of the latest report card, issued in 2008, the project evaluated the degree to which a state takes a long-term perspective on fiscal matters, the timeliness and transparency of the budget process, the balance between revenues and expenditures, and the effectiveness of a state’s contracting, purchasing, financial controls and reporting mechanisms.
The GPP typically surveys state budget offices, reviews state documents and public data and conducts in-depth interviews with state officials to determine how well states are managing their finances. The latest set of grades was based on data from states’ fiscal years 2005 and 2006, so it helps provide a measure of how well states were managing their finances leading up to the recession.
Pew collected data on all six indicators for all 50 states. We weighted each indicator equally and split the data into quintiles—assessing which states emerged as the worst in each category. Pew’s researchers then “scored” the states. If a state was in the worst quintile for a given indicator it was assigned five points; if a state was in the second worst quintile for any given indicator it was given four points, and so forth. There was one exception to the rule: the supermajority requirement to raise revenues. If a state had this requirement in place, it was assigned five points; if not, it was given no points. We then totaled the scores for each indicator to arrive at a final score.
Researchers also consulted Moody’s Rating Services to see how closely our list of states aligned with Moody’s most recent municipal bond ratings for states. The ratings often are done on a schedule or triggered by an event, and as a result, the majority of states had not been re-rated as of the beginning of 2009. But we observed that five states with new negative outlook ratings were also on our scorecard’s top 10: Arizona, California, Florida, Illinois and Rhode Island. The remaining five—Michigan, Nevada, New Jersey, Oregon and Wisconsin—were not reevaluated in 2009. Although this makes relying on any current evaluation a challenge, none of these states had a rating higher than AA+.
Again, we recognize there are other important variables to consider and other ways to slice the data to measure the relative fiscal stress of states. We chose to develop a scorecard in the manner described above because it provides a picture of the fiscal challenges that many states are facing through the lens of California’s experience.