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State budgets look bad now, but they’re set to get worse.

As lawmakers fight over patching current budgets, larger problems loom in the next few years. The bulk of funds from the federal government’s stimulus package will be allocated by 2011, but tax collections aren’t likely to be enough to take their place — even if the economy is recovering.

The drop in tax revenue is set to be deeper and last longer as collections have become more sensitive to business cycles in recent years. At the same time, states face growing health-care costs and the need to replenish pension programs funded by decimated investments. And some of the stimulus funds expand programs that will require state money to sustain them after the federal largesse runs out.

“There are so many issues that go way beyond the current downturn,” said Scott Pattison, executive director of the National Association of State Budget Officers. “This is an awful time for states fiscally, but they’re even more worried about 2011, 2012, 2013, 2014.”

Already, acrimony is building as states grapple with budget problems. In Illinois, lawmakers failed to pass a budget Sunday after rejecting the tax increases that Gov. Pat Quinn, a Democrat, said were needed to close an $11.6 billion spending gap. The Texas Legislature adjourned Monday in disarray, without approving funding needed to keep the state’s transportation and insurance agencies running.

In Arizona, Gov. Jan Brewer, a Republican, on Monday released a controversial budget proposal that would temporarily raise the sales tax and partly revive a state property tax.

And in California, Republican Gov. Arnold Schwarzenegger warned Tuesday that lawmakers have until June 15 to close the state’s budget deficit, or California will be unable to borrow the cash it needs to pay its bills after July.

With most governors busy stanching the current budget bleeding, only a few have taken steps to head off future problems.

Tennessee Gov. Phil Bredesen, a Democrat, in March laid out a four-year plan to balance the budget without using rainy-day funds. In Oregon, Democratic Gov. Ted Kulongoski has called for a “reset” of state government, arguing that voters must reconsider 1990s ballot measures that shifted school funding from property taxes to income taxes and that imposed mandatory minimum prison sentences. Gov. Schwarzenegger is proposing lasting cuts to health care and prisons.

Altogether, states face aggregate budget shortfalls of at least $230 billion from fiscal 2009 through fiscal 2011, said Mr. Pattison. For most states, that covers the period from July 1, 2008 to June 30, 2011.

That aggregate figure is nearly double the roughly $130 billion in federal stimulus funds that states can use flexibly over three years. (About $120 billion in further stimulus funding comes with stricter requirements, and sometimes new, costly mandates.)

When today’s federal assistance peters out, a number of state budget officers don’t expect new tax revenue to replace it. As the recession grinds on, states are posting significant declines in revenue from their three major sources: sales, personal-income and corporate taxes.

About a quarter of states saw their economies contract last year, the Commerce Department said Tuesday. Alaska’s gross domestic product — the total value of all the goods and services it produced — slipped the most in 2008, falling an inflation-adjusted 2% from the previous year largely because of declining oil output.

The Great Lakes states of Michigan, Ohio and Indiana posted some of the steepest GDP drops, as the woes of Detroit’s auto makers hurt manufacturers throughout the region.

North Dakota’s GDP gain of 7.3% topped the nation. Its largely agricultural economy has been well shielded from the housing bust, financial crisis and manufacturing decline that have weighed on the overall U.S. economy.

Still, in general most forecasters see a very slow recovery, which suggests a commensurately slow upturn in state revenues. Federal Reserve officials, for instance, see unemployment, at 8.9% at last report, averaging between 9% and 9.5% next year and remaining elevated through 2011; some private forecasters are more pessimistic.

State tax collections could take five years or more from when the recession began in December 2007 to recover to prerecession levels, says Donald J. Boyd, senior fellow at the Nelson A. Rockefeller Institute of Government at the State University of New York.

In addition, revenues appear to have grown more sensitive to the business cycle in the past decade, in part because capital-gains taxes have become a bigger component of tax bases, according to new research by Federal Reserve Bank of Chicago economists Leslie McGranahan and Richard Mattoon. That could prolong the effect of the downturn and, by increasing volatility, make it harder for states to plan budgets.

The best outcome they can imagine, some state officials say, is that the stimulus funding allows them to make spending cuts gradually: for example, by relying more on attrition and less on layoffs to cut payrolls. (Unlike the federal government, states generally are required to balance their budgets.)

That’s sparking tough choices. In April, Tennessee’s sales tax revenue was 9.9% below the previous year, and total tax revenue for the month was nearly $200 million less than the state’s forecast.

The state expects general-fund tax revenue to rise about 4.4% in the fiscal year beginning July 1, 2010, from a year earlier. But that entire increase is expected to be eaten up by inflation in education costs, increased Medicaid enrollment, and funding a pension plan whose nominal value has dropped from $32 billion to $25 billion.

So the state is looking to make long-lasting spending cuts. It plans to eliminate 1,373 jobs. Some economic-development projects are potentially on the chopping block.

“This is not simply trimming around the edges,” said the state’s top budget officer, Dave Goetz. “This is entire programs.”

States also can raise taxes and fees, of course, but if residents continue to hold down their spending, that thriftiness will limit additional sales-tax revenue. Massachusetts state Treasurer Timothy P. Cahill, a Democrat who is considering a run for governor next year, has been critical of discussions in the Legislature to raise the sales-tax rate.

“This is such a consumer-based recession that I think you’d be compounding the problem by increasing a tax on consumer spending,” he said.
—Stu Woo, Justin Lahart and David Wessel contributed to this article.

Write to Amy Merrick at [email protected]

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