The Tin State

• State budget messes have investors fearing a drag on economic rebound—but economic cycles drive budget balances, not the other way around.
• States with the largest deficits are mostly feeling self-inflicted pain.
• States like California should be careful about higher taxes, which can lead to larger future deficits.

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says early explorers named California after a fictional island. Recently, California's reputation for prosperity seems fictional—or at least less a Golden State and more Tin State. California's current budget deficit sits at a massive $26 billion—26% of its budget! And it isn't the only offender. Arizona's current shortfall is around 30% of its budget and Nevada's is 44%. But California's is the worst in absolute terms. Folks fear the economy can't recover because of the big deficit drag, but this is just backwards. Generally, state budgets tend to follow the economic cycle.

How did California et. al. get into this mess? States don't have budget deficits like the federal government. Most start their fiscal year balanced, and bad assumptions about expenses and income create the imbalance. Sometimes wonky assumptions lead to a surplus. Most deficits are due to lower-than-projected revenues, or unexpected spending, or both.

State budget blues reflect this recession's sudden steepness. In the fiscal year ending July 1, California tax receipts were down 27%. Sacramento wasn't counting on that. But just as weak economies reduce tax receipts and cause deficits, recovering economies can boost receipts—trimming deficits and leading to surpluses. Unbalanced budgets are a normal product of economic cycles—and provided there are no astronomical policy errors, deficits can go away on their own after recovery gets underway. Though there is normally a delay between recovery and state balance sheet impact.

States have options during fiscal crisis: draw down available reserves (if they have them), cut spending, or raise taxes. Not surprisingly states tend to raise taxes during recessions. During the 1990 recession, 44 states raised taxes, and in the 2001 downturn, 30 states did. But California should think twice. Businesses and productive people are already fleeing its exorbitant taxes. Those states choosing punitive tax rates over cutting spending will suffer emigration—shrinking their tax base still further.

Will California go bankrupt? (Note: States don't have a way to officially declare bankruptcy—unlike cities.) Credit markets don't seem to fear it. Interest rates on 10-year California General Obligation debt are around 5.2%—above national averages but not indicative of default. Like budget deficits, recent rating downgrades on California debt correlate with the economic cycle, there've been downgrades late in each of the last two recessions.

Normally, we'd say an improving economy should mitigate state deficits—and it probably will for most. But California is a special, special place. Maybe its predicament is an overdue wake-up call, forcing greater fiscal responsibility in the future. (We rather doubt it.) But, while emigration is bad for loser states (California, New Jersey, Michigan, etc.), it's great for winner states (Texas, Washington)—and overall has little net impact on the national economy. Either way, budget deficits are typically a lagging economic indicator. Wagons east!