No More Local Heroes --- More and More States Are Going From Surplus to Deficit

By Diana Henriques
3,513 words
23 January 1989
Barron's
English
(Copyright (c) 1989, Dow Jones & Co., Inc.)

GAPING holes in the government budget. Endless bickering over who is to blame. Threats of higher taxes, proposals to cut public services, outraged protests over the pain that will cause.

Washington, D.C.? An oil-patch state? Nope. The scene is unfolding in Hartford, Conn., capital of the wealthiest state in the union.

Almost overnight, Connecticut's state ledgers have gushed red ink, wiping out a $320 million surplus left over from fiscal 1986 and putting a $116 million deficit on the books for fiscal 1987, which were closed last June. Current experience offers no comfort: Business tax collections are running shy of last year's levels, sales tax receipts are sluggish, and a gap of somewhere between $130 million and $190 million is expected before the 1989 fiscal year closes this summer. And next year? A deficit of $882 million, barring new revenues and sweeping cuts in spending.

Nor is Connecticut unique. Over the past eight months, serious budgetary ailments have been reported in Massachusetts, New York, California, New Jersey and Arizona. Local excuses range from lost lawsuits to revenue-forecasting mistakes.

Desite unprecedented national prosperity, the financial health of America's state and local governments has worsened sharply in the past 18 months. Surpluses are vanishing. Budgets aren't balancing, and business and sales tax receipts are shrinking. By one commonly used way of reckoning, state and local governments were more than $10 billion in the red as 1988 closed. A more conservative accounting approach shows the aggregate surplus plunging from more than $20 billion in 1986 to $3 billion at the end of last year.

And as state officials and legislators truculently undertake the inevitable pruning and patching, a few are pausing to wonder: If so many states are slashing their budgets and hiking their taxes now, as the good times roll, what will happen when the economy turns sour?

"There has been a tremendous swing in the negative direction in the past two years," says Steven D. Gold, director of fiscal studies at the National Conference of State Legislatures. "A recession would be disastrous."

What's the reason for this growing shortfall? After all, it seems like just yesterday -- it could have been yesterday -- that some economists and others were arguing that federal budget deficits were no cause for alarm because bulging state treasuries put aggregate public-sector finances comfortably in surplus. The fact is, such reassurances relied on figures plainly out of date. Surpluses at the state level peaked in 1986, and have been dwindling ever since.

The reasons are far from clear. But part of the answer, at least, lies in Washington, where curtailment of spending growth has shifted more spending to the states and cities. And federal tax reform clearly led to huge shifts in revenue flows at the state level, leading officials to miscalculate the size -- and direction -- of future tax takes. The implications are far-reaching, for state taxes on businesses and individuals and on the tax-exempt bond markets.

There's no mystery as to why some states are hard-pressed. With more than 13% of its labor force still out of work after a six-year national boom, West Virginia remains depressed. Budget deficits are chronic; the population is declining and the infrastructure is deteriorating.

By contrast, Louisiana and Alaska were flying high just a decade ago. When oil prices collapsed in the mid-'Eighties, so did their state and local tax bases. Indeed, shortfalls the size of Connecticut's would be wonderful news in Baton Rouge, where the state budget was more than $1 billion in the red when the 1989 fiscal year opened last July. "There is a propensity for public officials to take the windfalls and build them into their permanent operations," sighs William Oakland, professor of economics at Tulane University in New Orleans. "God knows we did that with our oil revenues here in Louisiana."

Undaunted, Gov. Charles "Buddy" Roemer scraped together airfare to Vienna last year to implore OPEC to stop squabbling and start acting like a decent cartel. A similar trip was made a few months later by envoys from Alaska, where a $200 million shortfall is expected in the fiscal year that will end in June, and a $900 million gap is feared for fiscal 1990.

Elsewhere in the oil patch, Texas is beginning to recover and Oklahoma, too, is ambulatory, although it took a $275 million tax increase to balance the state's books without massive cuts in school aid. In the Midwest, the farm economy was battered by last year's drought.

The scene is only marginally brighter in the Great Lakes industrial belt, where the shrinkage of steel and heavy equipment payrolls demolished local government finances early in the decade. But the durable national recovery, which might have fueled a boom in the region, in large part merely helped repair the damage of the earlier calamity.

The Northeast and the Far West, by contrast, have outpaced the nation in generating jobs, and have seen their income-tax revenues rise. Real-estate values have skyrocketed, pulling local property tax revenues up with them. Well-heeled shoppers and busy businesses have boosted sales tax receipts. New York, Massachusetts, Connecticut, New Jersey, California -- no states have prospered from this marathon economic revival more than these.

Yet they, too, are now struggling to balance their budgets. New York Gov. Mario Cuomo is proposing an array of new taxes and cuts in aid to local governments -- including New York City -- to close an estimated $2 billion gap in the 1990 fiscal year. California, which spent most of its $1 billion surplus to balance its budget last June, has attained a somewhat precarious balance in the current fiscal year, largely through substantial -- and still controversial -- spending cuts. And in Massachusetts, the high-tech miracle state of the 'Eighties, Gov. Michael Dukakis has introduced a package of $730 million in new taxes -- on gasoline, cigarettes, alcohol, and long-distance telephone calls, for example -- in an attempt to cure a $630 million shortfall developing in the current year's budget.

How did these states get in trouble? "Their economies are still very sound," states one municipal bond analyst, Russell Newton of Prescott, Ball & Turben. "They just misjudged how their revenues would be affected by the 1986 federal tax law changes."

By eliminating a host of deductions, Congress theoretically enlarged the amount of personal and corporate income subject to taxation. Those states that apply the federal definition of taxable income, all other things being equal, should have experienced a windfall.

Taxpayers, of course, reacted to those changes in ways that might have been predicted but that could not possibly have been measured. They rushed to sell stocks, property, bonds -- anything that would produce a capital gain -- before the preferential treatment for such profits disappeared. They snapped up big-ticket items before sales tax deductions vanished. They pushed ahead with construction projects before tax-exempt financing for them was eliminated. And in the process, they made an unholy mess of state revenue projections.

Officials anticipated these aberrations, to a degree. But the trick was figuring out how much of a spike in sales taxes, capital gains taxes and personal income taxes was a one-time event, and how much was the result of economic growth and the permanently enlarged income-tax base created by the federal tax revisions. Some guesses were better than others.

But almost nobody guessed right about the promised windfall in corporate income taxes. States had expected to reap more in corporate taxes, as business deductions and tax shelters were scrapped. But they haven't -- and no one is quite sure why.

As of last March, nearly half of the 45 states that levy a business tax actually saw collections in fiscal 1987 fall short of the prior year's level, according to Gold at the National Conference of State Legislatures. States that do not rely heavily on such taxes were disappointed; states that do were staggered.

With no broad-based personal income tax, Connecticut raised more than 16% of its total 1986 state revenues from its corporate income tax assessments. "Back then, people were saying we'd be awash with cash," reports Dan Schnobrich of the state's Office of Fiscal Analysis. "The business community was saying we should cut our tax rates to adjust for it. We were skeptical, and convinced the legislature not to cut the rates." And what happened? "We had estimated $740 million (in business tax receipts) in the budget act for fiscal 1988. We actually got $660 million -- which was $20 million less than the prior year." Maybe the checks are in the mail? "We don't have December numbers yet," says Schnobrich, "but through November, collections were down from a year ago."

Similar budget shortfalls have emerged in New Jersey, California, Massachusetts and New York. "Business seemed to be booming along; all the forecasters were indicating that corporate profits were up," reports Lonnie Mathis of the California Office of Financial Research. "But that did not get translated into taxable profits."

This isn't just a state problem, it turns out; Uncle Sam is coming up short in his corporate income tax collections, too. Data from the Congressional Budget Office show that corporate income-tax receipts in fiscal 1987 were almost 17% less than the tax reformers expected in 1986. In fiscal 1988, they ran 21% less than originally projected. Naturally, the forecasts are now being scaled back sharply. Back in January 1987, the CBO was expecting the Treasury to collect $126 billion in corporate income taxes in the current budget year, fiscal 1989; the new projection is $103 billion. Meanwhile, personal income tax receipts are actually exceeding the original CBO forecasts.

What all this means, of course, is that Corporate America has been shouldering substantially less of the tax burden than everyone thought it would -- while the individual taxpayer has been taking up the slack. "What worries me," frets one administration loyalist, "is what will happen to business when Congress figures this out."

A Washington-based economic consultant, Charles deSeve, who has been enlisted by some private-sector clients to examine the corporate revenue phenomenon, has his own theory about why so little has been said about it. "If you're averse to dealing with the revenue side of the equation, and something is going awry on the revenue side, you're unlikely to point it out, lest someone suggest that you fix it on the side where it's broken." He adds, "When the time comes -- and it's getting closer -- when the revenue side is addressed, someone will bring it up."

Someone from a state budget office, most likely. In the absence of any guidance from Washington, several states are trying to find out for themselves why corporate tax revenues have fallen so far short of expectations. How else can they tell if this is a temporary phenomenon or a permanent shrinkage in their tax base?

Some suggest that corporations are becoming increasingly savvy about managing their state tax liabilities, which would mean the revenue downdraft is permanent. Others think businesses are awaiting the still-unwritten regulations for the 1986 act, and have thus not fully accounted for their new liabilities, which offers hope that the windfall is still around the corner.

Or perhaps businesses are responding to the fact that the 1986 tax act created incentives for eligible corporations to convert to "Subchapter S" status -- a form of corporation that avoids the taxation of earnings passed on to shareholders as dividends. Massachusetts and Connecticut both have some evidence that "Sub S" conversions have cost them a chunk of corporate tax revenue, reports Robert Tannenwald, economist with the Federal Reserve Bank in Boston. Nationally, the number of federal conversion applications in the first half of 1987 was more than twice that in the last half of 1986, according to a recent paper presented to the American Economic Association by George Plesko, an analyst at the U.S. Treasury.

And last, there is the growing suspicion that corporations engaged in leveraged buy-outs or takeovers have started taking interest deductions that are far greater than anyone at the state or federal level has anticipated.

This -- dubbed the LBO effect -- has already been quantified in Connecticut, where Schnobrich reports that "dramatic increases in interest deductions" by local companies involved in buy-outs accounted for as much as $5 million of the state's corporate tax shortfall. New Jersey, too, is checking the role played by LBO interest deductions, confirms State Treasurer Feather O'Connor. "I am scheduled to report to the legislature in March, and I expect to have some sense of it by then."

Speaking of LBOs, O'Connor fumes, "I've talked to the wizards of Wall Street about this, and their view is that these buy-outs result in such huge capital gains for the investors that we'll get it back on the income tax side, anyway." She sees a few holes in that comforting theory: Some big winners may not be taxpayers in New Jersey; others, like pension funds, may not be taxpayers at all.

So far, Washington bureaucrats are pooh-poohing states' fears that some sort of LBO time-bomb is ticking away in their corporate tax base. The trend in corporate interest deductions does not suggest a problem of any magnitude for states, one budget source reports.

But the data that Washington theorists use are several years old, given the lag in collecting and analyzing corporate tax returns. The most recent corporate returns under study these days date back to 1985; when the estimates were being made for the 1986 Tax Reform Act, forecasters were relying on 1984 tax returns. That's ancient history on the LBO scene. The cumulative price tag for all the LBOs undertaken between 1979 and the end of 1984 was $24.9 billion; by the end of 1985, the dollars involved had doubled, to roughly $49 billion. And by mid-1988, when states first started to notice that corporate tax revenues were not pouring in as expected, the LBO total was at least $115 billion, which, of course, doesn't include the $25 billion RJR/Nabisco deal.

An examination of individual deals bodes even less well for the tax collectors: By some estimates, the RJR buy-out will completely eliminate the company's tax liabilities for years. Macy's paid more than $200 million in taxes before its LBO in 1986; in its 1988 fiscal year, it got a $32 million refund. These are not just revenues lost to Uncle Sam; the states are affected too, and they're worried. "We don't know what to do about it," frets Schnobrich in Connecticut. "Nor do we know how to account for it in the future, because you don't know what tomorrow's deals will be. If one of our biggest taxpayers was involved, there would really be a huge problem."

Worrisome as they are, withering corporate revenues aren't the only cloud on the state budgetary horizon. A common thread in the fiscal pattern in the Northeast is that sales-tax revenues have been less than expected. It may be, of course, that those states were just overly optimistic. But Gerald Miller, executive director of the National Association of State Budget Officers in Washington, isn't so sure.

"Something is going on that I just can't understand," he confesses. "The anecdotal stuff about retail sales is all very robust -- but it's not showing up in the sales tax revenues." Any theories? "Maybe television sales and mail-order shopping are cutting more deeply than we thought," he suggests. "And we're clearly getting greater consumption going into non-taxable items and services. We can't automatically assume that this is just an estimating problem. We're going to be looking at this further."

Economists point out that state and local governments have always lagged behind the gravy train during periods of economic expansion -- they just can't adjust their tax structures quickly enough. Property values rise faster than localities can reassess them. Sales taxes don't catch every transaction. Excise taxes tend to be pegged to units, like gallons of gasoline or cartons of cigarettes, and not to the price of the goods.

In the past, however, prosperity has also brought the states more abundant federal aid and fewer claims on their welfare and unemployment programs. But in the past decade, notes economist Robert Inman, professor of finance and public policy at the Wharton School of the University of Pennsylvania, there has been a steady shift of public-service chores from the federal to the state level. And that trend is likely to continue.

"States are going to be asked to assume more and more responsibility, primarily in education, potentially in health care, and certainly in income redistribution programs," Inman warns. "To the extent that the feds continue to pull out, states will become the government of last resort."

Those increased responsibilities have come at a time when taxpayer tolerance is wearing thin. To some extent, of course, states and cities sowed the seeds of some of their current problems by initiating "tax wars" to lure businesses from elsewhere and lavishing tax abatements on the businesses they already had.

The visible but largely unacknowledged consequence of all these poorly understood forces has been, quite simply, that the financial condition of state and local governments has taken an abrupt turn for the worse.

Based on national income accounting, a common approach to measuring government resources, state and local treasuries collectively were $9.2 billion in the red by the end of 1987. Their combined deficit for 1988, by this measure, is estimated at $11 billion.

John E. Petersen, senior director of the Government Finance Research Center in Washington, contends that national income accounting is not well-suited to state and local finances; he and several analysts prefer to measure the "adjusted current combined funds" available to governments. This approach, among other things, counts government pension funds as assets, which seems fair, since many governors have patched up budget gaps by temporarily scaling back pension contributions. It also excludes bond-financed capital expenditures from the debit side of the ledger, while including interest and principal payments on the debt.

But even by this more generous calculation, the surpluses available to these governments have been plummeting in the past two years, from a peak of $20.2 billion in 1986 to an estimated $3 billion in 1988. "They really had a surge of recovery in 1985 and '86," says Petersen. "That has tailed off in the last year and a half. Governments are probably on the verge of running an operating deficit, in the aggregate."

Agrees Edwin Mills, a Northwestern University professor and editor of the Journal of Urban Economics, "In the last two years, things certainly have soured."

Economists agree that the deteriorating finances of state and local goverments inevitably will increase the pressure for new taxes -- especially new corporate taxes, given recent experience. One measure of current concern is the number of states considering various excise and sales tax increases in the current legislative year. Almost three dozen are considering gasoline taxes, according to a recent report in City & State, a public-finance magazine. Connecticut's towns have even proposed applying the state's personal property tax to computer software, in a bid to boost their revenues. And, as noted, in the states already incurring deficits, the legislative combat over tax increases has already begun.

But Inman at the Wharton School notes that "there is still a lot of pressure on states not to raise taxes, because they compete for corporations. So they are more likely to adjust by cutting services. They'll focus on their central agenda -- education and state infrastructure. All the other stuff -- the financing of large, center-city services -- that's what gets cut. If I were going to worry about anybody in this scenario, it would be the big cities."

Gold of the National Conference of State Legislatures sees the same danger. "We've got to start reforming the state-local relations," he warns. "The federal government is out of the game. The 1990s are likely to be a period of major change in our federal relationships. These will be times of great fiscal distress, and the states have to help the cities and counties."

Sobering as the current situation may be, life would be even bleaker for state and local governments if the national economy had faltered last year. When California faced its $1 billion deficit last June after a statewide tax revision, prosperity was all that held back the red tide, points out fiscal analyst Lonnie Mathis. "That's what bailed us out. If the economy had slowed as much as we thought it was going to, we'd have been in even more trouble." As it is? "We're holding our breath."

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