When oil consumption is rising, it is possible for the economy to expand, and more jobs be added. But as oil limits are reached (really based on higher prices of oil, relative to other goods), fewer and fewer private sector jobs are added, and the economy stagnates. The government sector tries to make up for what the private sector is lacking (through expanded programs), and gets itself into financial difficulty, because tax revenues decline. (See also my earlier post on whether it is even possible to raise taxes enough. I don’t think it is.)

Below the fold is a guest essay by Michael Cain on how this squeeze is playing out in Texas.
– Gail Tverberg, editor of Our Finite World

For much of the last two years, newspaper headlines have regularly declared that state governments are facing a budget crisis. Those declarations are absolutely true. However, few voters have an idea of what that statement really means because they know relatively little about how their state government spends money, or how the budget is put together. I am confident of the accuracy of that statement because as a member of a state legislative budget staff, I helped with new member orientation every two years, and incoming members of the legislature were often clueless. Budget work can be deadly dull, and the mainstream media seldom covers the details. This essay provides an accessible (and hopefully interesting) look into the possible consequences of the budget crises on state government spending.

The states’ budget crisis is largely the result of decreased revenues. State government revenues from all of the normal sources – personal and business income taxes, sales taxes, etc 1 – have fallen sharply since the recession began in late 2007. Almost all of the states are required to have a balanced operating budget so state legislators and governors have been juggling madly to match their spending to the available revenue. For the past two fiscal years, very large program cuts have been avoided for the most part by making use of one-time revenue sources. The one-time sources included increased federal funds, and redirection of moneys collected for one purpose (e.g., fees for hunting licenses) for other purposes.

For the upcoming 2011 legislative season, when the budgets for fiscal year 2011-12 must be set (state fiscal years begin at various points in the calendar year), most of the one-time revenue sources appear to be exhausted. Congress does not seem inclined to pass another package of funding for the states. There is a possibility that revenues will increase dramatically, although no one seems to be forecasting that.

Without increased revenue, legislatures will have no choice but to make deep cuts in spending. Some argue that peak energy in general, and peak oil specifically, implies that the current levels of revenue are a “new normal.” If that is the case, the cuts made next year may well be permanent.

The budget problem, and the need to make program cuts, is especially painful to address because many of the services provided by state governments are counter-cyclical in nature. That is, demand for state services increases during a recession, at the same time that revenues are declining. More people apply for unemployment insurance (UI) benefits; more apply for other forms of public assistance, such as Medicaid; more stay in school, or return to school for additional training. In a very real sense, state government business booms during a recession.

Putting together a state budget is complicated because there are many revenue streams that must be spent for specific purposes. UI taxes go into a trust fund and can only be spent to pay benefits and administrative expenses associated with the UI program. Federal grants almost always come with strings attached that restrict usage. Gasoline taxes are almost always dedicated to transportation projects. These parts of a typical state budget are pretty much on autopilot: if gasoline tax revenue declines, road construction projects get delayed or cancelled in order to match expenditures to income. The real “action” in most state budgets involves the General Fund (GF), whose moneys can be used for many purposes.

Examples usually make things clearer. I’ll use the Texas state budget for this purpose. It’s not the state budget that I know best, but there are four reasons for using it. First, Texas is a large state in terms of population as well as area. Large states often function as leaders: the choices made by large states may restrict other states’ options. Second, the Texas state budget is already lean; Texas ranks among the states spending the least on a per-capita basis. Third, Texas’ conservative state government has become even more conservative as a result of the recent elections. Texas Monthly magazine says that this may be the most conservative government that Texas has ever elected. This is a legislature whose members ran on a promise not to raise taxes, and with a natural inclination to cut government spending. Fourth, the conservative shift that occurred in Texas also occurred, to a lesser degree, in Congress. If the trend continues in 2012, today’s Texas may be an indicator of future Congressional attitudes.

Let me begin by dismissing a question that is often raised regarding state budget problems: public employee pension plans. In February 2010, the Pew Center on the States published The Trillion Dollar Gap, whose title reflected their estimate of the aggregate shortfall in state retirement system funding. There are many public pension systems in Texas rather than a single very large one. One of the larger state funds is the Employees Retirement System of Texas. As of August 31, 2010, the System had an accrued liability of $28.4 billion and actuarially valued assets of $23.6 billion, a $4.8 billion unfunded liability. I’ll make two remarks about the situation. Amortized over 30 years at 5%, the state (or its employees) would need to make annual payments to the fund of about $260 million to cover the liability. That is about 0.6% of the state’s GF budget. And with $23.6 billion in assets, the point at which the System might be unable to meet its annual obligation is many years in the future. Yes, there’s a pension problem, but it is relatively small2 and occurs much farther in the future than the balanced budget problem the state legislature must address starting in January.

How does the Texas General Fund get spent? The following table is from the Legislative Budget Board’s Texas FactBook 2010, and shows the original GF appropriations for the major areas of state government for FYs 2009-10 and 2010-11 in millions of dollars, and as percentages. The Texas legislature meets only once every two years, unless called back for an emergency session. The Budget Board is a permanent joint committee of the legislature with an extensive staff. Many state legislatures have similar committees and staffs.

This table is a typical of the situation in most states3: in round numbers, 95% of the GF is spent in just four areas: K-12 public education; health and human services (HHS) largely for Medicaid ($22.9 billion in the case of Texas); higher education; and public safety (includes state police, courts, prisons, and probation officers). Call those the Big Four – state governments do lots of things, but most of the GF money is spent in only four areas. In normal times, this 95% is largely off-limits because each of those areas has politically influential advocacy groups. There may be additional constraints in the form of specific funding requirements written into the state constitution, or in the form of federal laws and court decisions.

These are not normal times. Absent a large and unexpected infusion of revenue, estimates are that the Texas legislature needs to reduce spending for the next two fiscal years by somewhere between $10 billion and $30 billion from the levels shown in the table. Wiping out everything but the Big Four, and the non-Medicaid portion of the HHS funding, won’t get them to $10 billion. Some cuts will need to come from the normally off-limits group. In the next few paragraphs, I’ll talk about what constraints there are on making cuts in the Big Four, still using Texas as the major example, with references to some other states as appropriate.

Article 7 of the Texas Constitution requires that the legislature establish, support and maintain an efficient system of free public schools. Certain revenue sources are dedicated to the public school system. If those sources are insufficient, the constitution allows (but does not require) the legislature to appropriate GF moneys to meet its obligation. State GF spending for public schools in Texas, as in many states, began as an equalization program. School districts in poorer areas of the state could not realistically raise enough money through property taxes to provide the same quality of education as richer districts, so the state provided money to “equalize” per-student funding. Reducing the funding for K-12 education is always politically difficult. States that have already reduced K-12 funding have tended to trim around the edges, reducing in areas such as prekindergarten and enrichment programs. Texas is likely to do the same. Cuts to per-student classroom funding might be challenged in court as a violation of the constitutional mandate.

Medicaid is a voluntary federal/state program that provides health care for the poor. If a state chooses to participate, its program must meet certain federal requirements. There are an extensive set of services that must be covered, including hospital care, physician’s services, and laboratory and x-ray services. State Medicaid payments to care providers are required to be high enough so that care and services are available to the Medicaid population to at least the same extent they are available to the general population in a geographic area. Several states are, in my personal opinion, already skating on thin ice with respect to this reimbursement requirement. For example, some states have entire counties where none of the doctors will accept new Medicaid patients. The federal Affordable Care Act (ACA) passed this year freezes all states’ eligibility standards4. In short, if a state chooses to participate – and all 50 currently do so – there are limits to how far they can reduce their payment schedule, and they can no longer tighten the eligibility standards. For Texas, whose covered services have never extended very far past the minimum set, and whose payment schedule has never been particularly generous, reducing Medicaid expenditures is largely an all-or-nothing proposition: continue spending at nearly the current rate, or withdraw from the program.

As with most states, reducing the public safety budget significantly in Texas means reducing the cost of prisons. There are limits to how far conditions in prisons can be allowed to deteriorate. For example, federal courts have placed limits on how many prisoners can be housed in a given space, and on the level of medical services that must be provided5. In California, the state prison health care system was placed in receivership by a federal judge, and the state is required to fund the level of medical service specified by the receiver. Because of these limits, reducing prison costs generally means reducing the number of prisoners, which means letting people out early. To quote an anonymous state budget analyst who had worked on the corrections budget for several years, “The problem with letting prisoners out early is that, in order to wind up in a state prison, you have to have originally done something really nasty.”

Like most states, the vast majority of criminal cases in Texas are settled by plea bargain. In the case of non-violent and victimless crimes, the charge is generally reduced to a point that the perpetrator serves their time on probation, or in a county lockup, or at a less expensive private prison. The violent cases are the ones that end up in state prison. When Colorado instituted a program to find people in the state prisons that might be suitable for supervised early release, the Parole Board identified only a handful.

And finally, the state higher education system sits there, with what amounts to a big fat target painted on it. Small amounts of the state funding for the Texas system are protected by the state constitution, but the large majority of the funding has no protection except the voice of advocates. This is very much the situation that exists in most states. California has cut funding for its once-fabled system deeply; Illinois stopped making the funding transfers to some of its state schools; the Colorado legislature required state colleges and universities to submit written plans explaining how they would deal with large cuts in state funding. Higher education is one of the few areas with heavy GF funding that has an alternate source of revenue – tuition – that can be increased. Large tuition hikes are occurring in many of the places where state law allows that to happen. Absent something extraordinary, higher education will almost certainly take a major cut.

There is the possibility of something extraordinary happening. The Wall Street Journal, as well as more specialized publications, has reported that several states, including Texas, have raised the question of withdrawing from the Medicaid program. I have asserted for years that Medicaid as currently constituted is a slow-motion train wreck for state budgets; the recent recession simply sped the process up a bit. Medicaid program costs have grown faster than state economies for years; state and local governments are up against the political limits of how much of the state economy they can take as taxes; so now Medicaid is beginning to crowd out the traditional state functions, starting with higher education. At some point, some state will withdraw, and once it is no longer “unthinkable,” a number of other states are likely to follow quickly thereafter. In fact, it appears that only one aspect of the program is seriously holding states back: long-term and nursing home care.

Long-term care currently accounts for about one-third of total Medicaid spending, but it is the fastest growing covered service. A typical situation might go as follows. Grandma has had a couple of strokes, but is otherwise very healthy. The strokes have left her with permanent cognitive disabilities. Now that her blood pressure is under control and she’s taking a blood thinner, she can live happily in a nursing home for a decade or more, puttering in the flowerbeds, but never recognizing those nice young people who come to visit her each week. Her assets have been sold and her pension plus Social Security benefits won’t cover the full cost of 24/7 supervision. Medicaid makes up the difference. Getting Grandma kicked out of the nursing home is not something on which state legislators want to campaign.

Let me conclude by speculating on what the Texas legislature is likely to do. This is purely speculation – I have no insider knowledge, and based on my own experience, legislators are full of surprises. I’m going to assume that Congressional Republicans stick to their position that it is more important to reduce the federal deficit than to provide aid to the states, and that the Texas Republicans stick to their promise that they won’t raise taxes. The key question remaining is whether the Texas legislature has to cut $10 billion, or $30 billion. If they need to cut “only” $10 billion:

• They’ll find on the order of a billion dollars in incremental revenue and cuts in areas outside of the Big Four. Lots of states are doing lots of little things: delayed payments, hiring freezes, furlough days for employees, reduced hours at the Department of Motor Vehicles, etc.

• They’ll find on the order of a billion dollars in public safety. The prisons will get more crowded and health care for prisoners will get worse. It will be more dangerous to be a prison guard.

• They’ll cut about three billion dollars from K-12 education. Enrichment and other “discretionary” programs will go away, and there will be small cuts in the per-student classroom funding.

• They’ll take five billion dollars out of higher education.

If they have to find another $20 billion in cuts, I believe that the unthinkable will happen, and they will withdraw from Medicaid. My estimate is that will leave them enough wiggle room to balance the budget and still fund a state-only program to provide partial nursing home assistance, making it more palatable to voters (the other poor who will be losing their health insurance generally don’t vote in large numbers). I also think the withdrawal will be the first move in a complicated game with the federal government. As part of that, I would expect members of the Texas Congressional delegation to introduce legislation that would make Medicaid a block-grant program with minimal state spending requirements. This would be the same type of change that was made to the federal welfare system during the Clinton administration.


1There are exceptions to these standard revenue sources. Some states are able to tax specific industries such as tourism or mineral extraction at a high enough rate to generate the necessary revenue. Such states are effectively able to tax other states rather than their own citizens.

2Other states may be better or worse off than Texas. A handful of states have fully funded public pension programs. Some states are facing significantly greater amortization costs than Texas. The situation may be further complicated depending on whether state law requires the state government to bail out under-funded local public pensions.

3There are exceptions to the typical breakdowns of GF spending. New Hampshire, for example, spends no money at the state level on K-12 education, leaving it to local government to fund public education. “Poor” states pay a smaller portion towards Medicaid because the federal government reimburses a greater portion of the state’s expenditures.

4The Arizona legislature had the unfortunate experience earlier this year of being required to roll back eligibility changes they had made as part of balancing their budget. If they had made the changes a few weeks earlier, before the ACA was signed, they would have been all right.

5The US Supreme Court has agreed to hear a case involving crowding and medical care in state prisons during its current term. The current rules may get changed.