States, Localities Face Deeper Crisis

WASHINGTON - State and local governments are facing a fiscal crisis that will be far worse than the 2001 recession because sharp declines in income and sales tax collections will lead to more widespread budget cuts in the months ahead, a new Rockefeller Institute of Government report warns.

But governments may have to issue more debt as a result of their financial difficulties, according to Don Boyd, the author of the report, titled The Damage is Just Beginning, and other market participants.

Boyd said he expects a major drop in income tax revenue in the April-to-June 2009 quarter that will make the current fiscal difficulties even worse than the "very bad" crisis following the mild 2001 recession. The state tax revenue report, which the institute releases quarterly, focused on data from April to June of this year.

"If you remember the last recession, [it] was mild," Boyd said. "If you remember its impact on state governments, though, it was huge against historical standards. It was dramatically bad. At the early part of this particular crisis, it looked hard to believe that it could be back as bad as the last one. The last one was essentially a 50-year event. This one now looks worse."

The last fiscal crisis was so bad, Boyd said, despite the "mild" economic recession, because of the dramatic fall-off of investment income, such as capital gains taxes, which devastated states with lower income tax collections. He expects another drop to occur this time, but it will be even more dramatic.

"It is a very bad market decline," he said. "That suggests that income tax revenues are going to plummet in the April to June quarter, and there will certainly be further weakness before then. There's nowhere to run. If you rely on the income tax, you're going to get hammered."

Arizona, California, Florida, Michigan, and Rhode Island have been suffering the most, but the fiscal woes will spread to Connecticut, New Jersey, and New York due to their reliance on the financial services industries and steeply progressive income taxes that extract much of their revenue from individuals with high wages and investment income, according to the report.

"These states - in addition to California - are expected to face extreme difficulty in the wake of the financial services industry meltdown," Boyd said in a release accompanying the report.

And while states found relief in strong sales tax revenues during the last downturn, they are not going to this year.

"The consumption decline is already much worse than it was in the last recession. Much worse," Boyd said.

Because sales and income taxes are the two most important revenue sources for state and local governments, budgets likely will be hit hard, he added.

The report found that while state tax collections overall rose 3.6% in the second quarter of 2008 from the same period a year earlier, the gain was because a 6.6% growth in income tax offset a 1.4% decline in the sales tax, an 8.3% decline in the corporate income tax, and a 3.4% decline in gas taxes. But that growth in income taxes was driven by income earned in 2007 and will be "ephemeral," the report said.

Year-over-year growth in state taxes, adjusted for inflation, has averaged just 0.5% over the last four quarters, down from the 2.1% average growth of a year ago.

Local government tax revenue has been slowing sharply, even though the property taxes that local governments rely upon so heavily historically have been stable, the report said. But declining property taxes will catch up to local governments, as well, according to Boyd.

Year-over-year growth in local taxes has slowed to an average of just 1.3% over the last four quarters, from 3.2% a year ago, the report said. Adding to those woes, state and local governments continue to be squeezed by rising prices, with inflation for their purchases up 6.6% over the past year.

Meanwhile, the inaccessibility of the primary municipal market has some state and local issuers uneasy, because in past downturns, governments have beefed up debt issuance to meet budget requirements in response to lagging revenues.

A Standard & Poor's report issued in July said that states would increase debt issuance in fiscal 2009 in response to the weakening revenues.

Robin Prunty, the analyst and author of that report, said this week that the agency still expects states to increase issuance, but that she is watching the market to see whether the current market conditions will be a longer-term trend.

"Certainly the last two weeks have been difficult in terms of bond sales," Prunty said, adding that higher interest rates have been the biggest deterrent for issuers.

Scott Pattison, executive director of the National Association of State Budget Officers, said that states are concerned about the current market conditions.

"In the long term, almost everybody's concerned," he said. "They're worried about their ability to issue debt."

"I think what will happen is that they will really hesitate to issue debt if they're not comfortable with the interest rates," Pattison said. "And so you'll just have some issuances that would normally be really routine that are not coming to market. They're delaying the bridge, or the bridge repairs, or the road, or the building on a campus."

Some states are also concerned because delaying capital projects removes the rousing effect that construction has for their economies during rough times, he added.

Boyd said he also still expects more debt issuance, "assuming we can get through this current liquidity crisis."

"My belief is they will be able to issue, but it may be at higher rates than they'd like," he said.

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