Thirteen years ago, the state of Indiana followed most of the rest of the country into recession, after enjoying almost a decade of uninterrupted growth.  That downturn triggered a fiscal crisis in state capitals across the country, as dwindling tax receipts followed the economy south.  At the height of the storm, in the year 1991, the combined budget deficit of all fifty states was almost $10 billion, measured in today’s dollars.

The recession of 2001, by most measures, has been similar in severity to the one that preceded it.  But the hangover in state capitals has been much worse.  Through 2002, the most recent year for which data are available, the combined deficits of states is over $50 billion.  That’s roughly 4 percent of state and local spending, and five times worse than 1991.  Why was this recession such a rough ride for state treasuries?

Recently published research by the Chicago Federal Reserve Bank addresses that very question.  As we drown in a tidal wave of election season rhetoric, their dispassionate analysis of the situation is like a breath of fresh air.

Just about everything has gone wrong for fiscal balance sheets in state government over the last several years.  Increases in broad-based taxes like the income and sales tax, used in past recessions to prop up revenues, are political suicide today.  As the health care and services sector of our economy continues to grow, the base of the sales tax, which exempts most of their activities, continues to shrink.  And the growth in state government’s role in financing education and Medicaid shows no sign of letting up.

The Rockefeller Institute calculates the changes in state tax revenue for each state that are due to policy changes, and those that are due to the ups and downs of the economy.  In response to the 1991 recession, states left no stone unturned in raising taxes. Hikes in personal income, sales, tobacco, and motor fuels taxes ultimately produced about 8 percent more revenue.

The situation today is completely different. In fiscal year 2002, at the peak of the recession, tax rate changes in the fifty states produced no revenue changes whatsoever. States actually reduced personal income tax rates slightly, which were offset by tiny increases in business income taxes.  Even in fiscal 2003, with most states in unprecedented budget difficulty, tax rate changes brought in only about 1.5 percent more revenue, mostly from hikes in narrow-based taxes on tobacco and casinos.

Meanwhile, the obligations of state government, particularly in education and Medicaid, continue to grow.  Even after correcting for inflation, health care expenditures by states are 40 percent higher today than they were in the 1991 recession. Roughly half of all nursing home bills are now paid by Medicaid.

What emerges from all of this is a clear picture of a budget deficit situation that is structural.  There is an imbalance between revenue growth and expenditure growth that is not related to the state of the economy, and that faster economic growth will not cure. And what will cure it is not popular.

On the revenue side, states like Indiana need broader-based taxes.  By exempting spending on things like services and internet commerce, the sales tax not only becomes increasingly unfair, but also less effective. Relief on the expenditure side, especially for Medicaid, requires some help from the Federal government.  The experience of the 1990’s with welfare reform, which greatly improved the stress of those programs on state budgets, shows us that real reform is possible.