WASHINGTON — Governmental groups expect 2008 to be a tough year for state and local budgets, with the slowing economy — largely driven by the subprime mortgage crisis — lowering already pessimistic revenue growth projections as spending needs continue to rise. The groups are not forecasting a recession, but point out that should one occur, the situation will be even bleaker. “Although early warning signs do not portend immediate bad news, concerns for current year budgets are mounting with even greater concern for some states in fiscal 2009,” the National Conference of State Legislatures said in its state budget analysis released Dec. 10. “This assumes no national recession. If the economy takes a turn for the worse, state finances undoubtedly will decline from the situation reported here.” In its report, the NCSL said the biggest challenge facing state budgets is a slowdown in revenue growth. While the vast majority of states are currently meeting or exceeding their revenue targets, that fact alone is not a cause for optimism, according to the group. “This statistic is somewhat misleading. With a few exceptions, states may be only modestly above target or may be on target with a new, lower forecast,” it said. “When considered in greater detail, the situation indicates reasons for concern.” According to the NCSL, the trends surrounding projections are more significant. While some states are meeting overall targets, they are falling behind significantly in some key areas or are meeting expectations that have been lowered from original goals. The housing slump is not just hitting borrowers and lenders, but pinching state budgets as well in terms of revenue collections. Twenty-four states and Puerto Rico told the NCSL that problems in the housing sector have negatively affected their revenues. In some cases, states said taxes related to real estate, such as mortgage or deed-recording taxes, have been hit as potential homeowners currently are avoiding the market. In addition, 13 states reported that sales tax collections are down due to housing issues, since fewer home purchases mean a reduction in the purchase of significant durable goods like furniture and electronics. To address the revenue slowdown, states are expected to temper their spending habits this year, according to the National Governors Association and the National Association of State Budget Officers. Their fiscal survey of states, which was released Dec. 5, found that, while state expenditures grew at an above-average rate of 9.3% last year, growth this year is expected to be only 4.7% — a much lower rate than the 30-year average of 6.4%. In another effort to offset disappointing revenues, states are expected to offer fewer tax cuts this year as well, according to the NGA and NASBO. Last year, states cut taxes by a net $2.1 billion, mostly because 38 states were able to bring in revenues above their expectations. This year, only $115.5 million is projected to be cut, as governments position themselves to weather the economic storm. LEGISLATION Health care, transportation, and education are expected to be major players in state legislatures this year, as lawmakers try to balance them with tightened budgets, the NCSL said. Nineteen states will take up health care concerns this year, mostly in the areas of Medicaid, the State Children’s Health Insurance Program, and general health care reform. Seventeen states have transportation funding legislation in the works, with some concerned about the ability to secure revenue streams to provide adequate funds. Sixteen states are currently preparing to tackle education reform, with many looking to expand to universal kindergarten and expanding facilities. To complicate matters, or at least not simplify them, Congress last year cut off a potential new revenue stream to state and local governments when it approved legislation that temporarily extended the ban on taxing Internet access beyond its Nov. 1 expiration date. The ban, which was first enacted in 1998 to foster Internet growth, was extended seven more years when President Bush signed legislation on Oct. 31. It marked the third time Congress has approved an extension of the ban. While it was widely accepted that the ban should be extended, it was unclear whether Congress would be able to reach a compromise on the details before the deadline passed. Several lawmakers, mainly Republicans, wanted to make the ban permanent, while Democrats wanted another temporary extension to allow for it to be reevaluated in the future. Had Congress been unable to reach an agreement by Nov. 1, state and local governments would have had the opportunity to impose taxes on Internet access, as well as Internet-related activities, such as e-mail and instant messaging. Nevertheless, the NGA praised the extension when it passed the House. “This bill maintains the balance intended by the original moratorium — one that encourages the growth of the Internet and respects state sovereignty,” said NGA executive director Raymond Scheppach. Congress will have to reconsider the ban as the extension approaches expiration in 2014. DAVIS CASE While states will address a variety of economic and financial issues this year, perhaps no single event potentially will have a larger and more universal impact than the U.S. Supreme Court decision in the closely watched Kentucky v. Davis case. The high court is expected to announce its ruling in the municipal bond case during the first part of the year, before the court concludes its session in June. Hanging in the balance is a taxation practice shared by 43 states nationwide and the $2.5 trillion municipal bond market. The case stems from a lawsuit filed by a Kentucky couple, George and Catherine Davis, in a Kentucky appeals court that claimed their state’s practice of taxing interest on bonds issued out of state while exempting in-state bonds violated the dormant commerce clause of the U.S. Constitution.v The Kentucky court ruled in the couple’s favor, the state appealed, and after the Kentucky high court refused to hear the case, the U.S. Supreme Court agreed to take it up. If the high court concurs with the Kentucky court and finds the preferential exemptions unconstitutional, the long-held practice would be abolished and most states would have to either tax all bonds or exempt them all from state taxation. In addition, states would lose their main ability to encourage residents to support their debt, by offering them preferable interest rates due to the exemption. However, it appeared during the oral arguments before the Supreme Court on Nov. 5 that a majority of the justices favored maintaining the status quo and permitting the exemptions. Chief Justice John Roberts pointed out that Congress has the ability at any point to outlaw the practice, and has not done so in its century-long existence. “If it’s kind of a close question, leave it for Congress. It’s never shown the slightest interest in addressing the state tax-exemption,” he said. Justice John Paul Stevens noted that the presumed victims of the exemption — states competing with Kentucky — appeared to support the practice. All 50 state attorneys general joined together to file a friend-of-the-court brief in support of Kentucky with the high court. Justices Antonin Scalia and Clarence Thomas, while quiet during arguments, have said in the past they do not believe in the existence of the dormant commerce clause, indicating they would side in favor of Kentucky as well. And Justice Ruth Bader Ginsburg argued in a previous case that the clause should not apply to nonprofit groups, a broad category that would include states.