OPINION: Silver Lining in State Fiscal Crisis?

This past year, governors across America
watched their state’s fiscal health deteriorate. For the first time since World War II, state revenue growth was negative and budget
shortfalls were the worst since the downturn of the early 1980’s.

Ray Scheppach – Special to Government Technology

The state budget process became a bitter, protracted battle in many states. Governors and state legislatures went back to the drawing
board once, twice and some even three times trying to balance their budgets. Many of them are back at it again and preparing for another
very difficult year making tough decisions on what to cut and how to raise the revenues necessary to fund important state programs.

However, the most recent recession was one of the mildest in terms of declines in gross domestic product, which is the broadest
measure of economic activity in this country. So why is the fiscal situation so desperate in the states?

The underlying reason for this dichotomy is the state fiscal problem was only partly due to the cyclical downturn in the economy. Two
longstanding structural problems — an eroding tax base and the explosion in health care costs — were the major cause. Both of these
problems were camouflaged by the phenomenal economic growth in the second half of the 1990’s. The recession unmasked the problems
— but it was not the reason for the swift and steep decline in the state fiscal situation.

Unfortunately, state tax systems were developed for the manufacturing economy of the 1950’s, not for the service-oriented, high
technology, international economy of the 21st century. Sales tax revenues are being eroded by the change in the mix of products
purchased by consumers and the growth in electronic commerce, which is largely tax exempt.

Most states do not tax services, which have grown from 41 percent of household consumption in 1960 to 58 percent in 2002. This is a
major cause of erosion. States are also losing revenues due to their inability to require out-of-state sellers to collect state sales and use
taxes.

Finally, taxes on corporate profits have been eroding for years partly due to an increase in tax credits enacted by states, and also
because corporations have become more sophisticated in minimizing their tax liability. Since sales and corporate taxes represent about 45
percent of state revenues, the erosion over time has been dramatic.

Health care represents 27 percent of the average state budget. Medicaid alone represents 20 percent of this cost. Total health care costs
are growing at 13 percent this year, which follows an 11 percent increase last year. This health care cost crisis is a national problem. But
there are few policy options available to states to control costs — particularly given the difficult political environment in reducing benefits
and eligibility within the Medicaid program.

Few Americans understand that Medicaid is now larger than Medicare in terms of the number of people covered — 44 million vs. 40 million
— and in total spending — $230 billion vs. $215 billion. Medicaid eligibility is growing twice as fast as Medicare. The cost of long-term care,
such as nursing homes, as well as the low-income individuals who are both Medicaid and Medicare eligible, "dual eligibles," are expensive
and probably should not be a state responsibility.

However, there may be a silver lining in the dark clouds that have been hovering over state budgets. A growing awareness of the
significance of these structural problems in both Washington, D.C., and state capitals is increasing interest on the part of our elected
officials in reforming both state tax systems and the federal-state Medicaid program.

There are recent signs that Medicaid reform is moving up on the national agenda. For example, the National Governors Association
recommended creating a high level Medicaid Commission to spearhead reform and the Senate adopted a resolution on a commission earlier
this year.

Sen. John Breaux, chairman of the Aging Committee, is advocating long-term care reform. Perhaps most important is a bill recently passed
by the U.S. House of Representatives that would have the federal government pay for drug benefits of the dual eligibles, saving states
more than $45 billion over the next 10 years.

Though actual Medicaid reform may be three to five years away, momentum for change is growing.

November is a big month for the nation’s governors, with 36 states facing elections. Given term limits and governors who have chosen not
to run, there will be at least 21 new governors in office by next year, including Guam. Some new governors who anticipate being in office
for eight years will decide that the only way to avoid a continuing fiscal crisis will be to enact tax reform. History shows that making this
move during the first year in office makes the most political sense.

For state sales taxes, reform could mean lowering the rate on goods and increasing the rate on services. One of the basic tenets of good
tax policy is to have a low rate on a broad base so that taxes do not bias market decisions. With respect to electronic and other remote
sales, states are currently developing a simplified system whereby all states will adopt common classifications and definitions while
maintaining their different rates.

The hope is that Congress will pass legislation requiring out-of-state sellers to collect use taxes. Reforms of corporate taxes may mean
phasing them out altogether, eliminating most tax credits, or replacing them with a proxy for a value added tax.

Fixing either one of these structural problems takes the kind of bold and progressive public policy action that is often so difficult for elected
officials.

But the desperate fiscal situation in states has perhaps provided the impetus in both Congress and statehouses to take on the challenge. If
so, states will be put on solid long-term fiscal footing so they can stabilize spending, focus on education, the efficiency of state programs
and be the innovators of public policy.

Now that really would be a silver lining.

Ray Scheppach is the Executive Director of the National Governors Association. The views expressed are his own and do not represent
the views or the policy of the NGA.

http://www.govtech.net/news/news.phtml?docid=2002.07.26-3030000000017213