As States Face Sluggish Revenue Growth, They’re Threatened by Federal Policies

State revenue collections remained sluggish in fiscal 2017, but spending, fueled by money from Washington, easily beat the national inflation rate, according to a new report from the National Association of State Budget Officers. Yet trends in federal policy, as well as slow wage growth, bode ill for state budgets in coming years.

Total expenditures by state governments, including federal funds, reached almost $2 trillion in fiscal 2017. As a point of comparison—federal expenditures approach $4 trillion. State spending increased by 5.2 percent over fiscal 2016, according to NASBO’s Annual State Expenditure Report released on Nov. 16.

State funds totaled $1.32 trillion; federal funds accounted for $620 billion; and $39 billion were from bonding funds. The 111- page report is full of what might be called “finance facts” and fiscal information about the major programs. So, let’s cover what’s in the report, and then allow me to make some observations.

Key State Expenditure Data

All eight geographic regions showed growth, with the largest growth occurring in the Far West and Southeast; and nearly all program areas increased.  

Spending growth of federal funds and state-only funds was nearly equal, with the feds winning by a nose. The report contains extensive expenditure information about all major spending areas, including Medicaid, K-12 education, higher education, public assistance, corrections, public assistance and transportation.  Separate chapters discuss capital expenditures and a final chapter focuses on revenue sources in the general fund.  

The two largest spending areas remain Medicaid ($574 billion) and K-12 education ($384 billion).  Medicaid continues to increase faster as a percentage of total state spending—from 20.5 percent in fiscal 2008 to 29 percent in fiscal 2017. Elementary and secondary education (K-12) decreased from 22 percent of total spending in fiscal 2008 to 19.4 percent in fiscal 2017.

That’s not because K-12 spending has declined but rather because it has grown more slowly than Medicaid spending. In fiscal year 2017 Medicaid spending increased by 6.1 percent and K-12 education increased by 3.9 percent. K-12 funding remains the largest of states' commitments, at 36 percent of all spending.

An informative chart in the report indicates that $107 billion was spent on capital items (including bond funds). The largest spending area is transportation at $70 billion.  

State-only revenue continues to grow slowly increasing only 2.2 percent. Personal income taxes totaled $353 billion, or 45 percent of revenue (2.9 percent growth).  The sales tax totaled $246 billion, 31 percent of total revenue (2.5 percent growth). Corporate taxes totaled $43 billion, a decrease of 5.8% from the prior year.

Six Key Observations

• The report did not specifically indicate how much is spent for employee pension and health benefits. These expenditures are quite significant in many states. Almost all states have unfunded accrued liabilities (some very large)—and most states fund their health benefits for retirees on a pay-as-you-go basis. The states with the largest pension challenges include Illinois, New Jersey, Connecticut and Kentucky—but many states face these long-range challenges and the unfunded liabilities continue to increase as states must now report data in accordance with GASB Statements 67 and 68. At some point these retirement cost issues must be funded or otherwise addressed, as with reductions in benefits.
• Medicaid spending is the largest single cost center and the fastest growing program in most state budgets—with federal assistance totaling $351 billion and state funds of $223 billion. The federal portion has increased significantly with the expansion of the Affordable Care Act, as 31 states elected to accept the ACA. For the first three years the feds have picked up the entire cost. In fiscal 2017, states began to match with their funds (5 percent). The match will increase to 10 percent in subsequent years, further challenging state budgets.
• As might be expected,  California ($90 billion) and New York ($51 billion) spend the most on Medicaid. Wyoming spends the least ($600 million). According to the Kaiser Family Foundation the national average cost per enrollee is $5,736. Costs vary with the size of the state, caseloads, services, and local cost structures. California, for example spends $4,193 while South Carolina’s costs, at $3,691, are the lowest in the nation. North Dakota is the highest at $10,392 per full-time or partial enrollee.
• While state funding for K-12 education is the second largest component of states’ budgets, it should be noted that a roughly equal share of funding is raised at the local level through property taxes. Specifically, an average of 47 percent of funding comes from state government while 45 percent comes from property taxes. Some states are more dependent on the property tax; New Jersey, for example, at 53 percent.
• The $107 billion expended for infrastructure and capital items is minimal compared to need, and woefully inadequate given that the American Society of Civil Engineers has rated the condition of American infrastructure a D+. Experts say our total need for infrastructure spending over the next 10 years is at least $3 trillion—and most likely considerably more. Currently most funds are raised by state governments with some support from local and federal governments. This deficiency ranks high among challenges facing states in coming years.

• State revenues grew by a very modest 2.2 percent—following an even slower growth rate of 1.8 percent in fiscal 2016. In fact, in three of the past four years state revenue has either grown very slowly or declined. A state-by-state comparison is deceiving as some states increased taxes while other cut them. In Kansas, for example, revenues were flat in 2016 but increased by 6 percent in 2017, as taxes were first cut and then raised. The Kansas story is now notorious as a lesson in how not to manipulate tax policy. While the national economy has grown, wages haven’t kept pace, slowing collections of state sales and income taxes. New Jersey, which has basically maintained the same tax base for the past eight years, has seen revenues grow at slightly less than 2 percent per year over this time period.

Final Observations

State spending will likely remain modest as states contend with sluggish revenue collections and modest growth in the national economy. States will target spending in certain priority areas while addressing long-term obligations (read retiree costs and infrastructure), building up reserves and promoting structural balances.

More importantly, a real worry is what’s lurking on the federal horizon—especially regarding tax reform, health-care changes and decreases in funding levels.

President Trump and Republicans in Congress are intent in reducing the discretionary federal budget—a large part of which is sent to state governments. If significant cuts are made in social programs, transportation, higher education and environment-oriented programs, states will be confronted with some difficult choices.

GOP tax reforms that would eliminate or reduce deductions for state and local tax payments  would reduce disposal income of taxpayers in high-tax states. To date Medicaid and the ACA has been maintained, but continuing proposals by Congress and the president to change both programs would have a dramatic impact on state spending for health care and for the neediest folks in the state. Stay tuned as events unfold.