The Next Decade:
Legislating for the Future

Kil Huh, PhD, directs The Pew Charitable Trusts’ work on State and local fiscal health and economic growth. He shared his extensive research with the Forum, providing State-by-State comparisons to identify innovative approaches that States are using to help solve complex challenges. Dr. Huh summarized the key challenges facing all the States, which include slow (and volatile) revenue growth fueled by new spending patterns among millennial consumers, growing pension costs, and increasing Medicaid spending.

Dr. Huh conveyed measured optimism about the fiscal health of the States, noting that they have done much to bring themselves out of the economic downturn and to prepare for future fiscal challenges. The States have a number of positive options available, Dr. Huh continued, including opportunities to benefit from federal policy (taxes and interest rates) and the federal infrastructure program, to pick up gains from strong financial markets, and to implement stronger fiscal management policies. “The States have been thoughtful about setting fiscal management policies in place,” he observed.

Slow Recovery

Dr. Huh’s research indicated how well each State’s tax revenue has recovered from its plunge in the Great Recession. He compared each State’s tax-revenue peak before dipping in the recession—and then measured how current tax collections—adjusted for inflation—compare to that peak. Overall, State tax revenue fell nearly 13% following the recession, and it then took nearly 5 years for the 50 States collectively to get back the purchasing power they had in 2008.

As of the first quarter of 2016, States were taking in 6.5% more than at their peak—or 6.5 cents more in buying power compared to 5 years earlier, Dr. Huh said. However, this extra purchasing power must cover any increases in population since 2008, including increases in the number of school-age children, higher Medicaid enrollment, and other emerging needs that put additional strain on State budgets. The extra income must also restore spending or investments that might have been cut or deferred during the recession, such as funding for public-employee pay raises or infrastructure development. “This is a slower recovery than after any of the past 3 recessions, but it looks like States overall have put the recession behind them when it comes to tax revenue,” Dr. Huh noted. “However, State-tax recovery has happened slowly and unevenly,” he added.

Uneven Recovery

This uneven recovery is of concern as States face new uncertainties and questions about how long the current economic recovery will run before the next inevitable downturn. Dr. Huh reported that as of the end of the last fiscal year, 23 States (shown in orange in the image) were taking in less tax revenue in inflation-adjusted terms than they did more than 7 years ago; 27 States in blue had surpassed their tax revenue levels after adjusting for inflation. Leading all States is North Dakota, where oil fracking has pushed its tax revenue to a level 37% higher than in 2008. And trailing all States is Alaska, now 93.9% below its peak in 2008, when oil prices were at their all-time high. The effects of low energy prices can particularly be seen in Wyoming, Louisiana, and Oklahoma—where tax revenue is 15% below where it was at its peak.

Among all 50 states, tax revenue has grown the most in North Dakota (52.5%), Iowa (27.6%) and Minnesota (21.5%). Those at the bottom in a ranking of tax-revenue growth since the recession are Alaska (92.8%), Wyoming (28.4%), and Louisiana (18.3%), all of which have severance taxes from oil and coal in common. For 8 states, tax revenues are now 15% or more ABOVE their peak, while 4 States are still 15% or more BELOW their peak.

 State Tax Revenue Collection

Tax-Revenue Volatility

Volatility of tax revenues makes budget projections harder to predict, subjecting revenue and budget predictions to closer scrutiny and demanding that legislatures undertake more rigorous planning and management processes, Dr. Huh observed. All States experience some level of tax-revenue volatility, with the majority of States (39 of 50) subject to volatility scores ranging between 3 and 7 points, and tax revenue volatility has grown worse, Dr. Huh reported.

Tax volatility is affected by the mix of tax-revenue sources collected in each State, whether it is corporate tax, personal income tax, sales tax, business taxes and fees, motor fuels, severance taxes, or property taxes. Dr. Huh illustrated the tax-revenue changes for several States for the period of 1997 to 2015, demonstrating how different mixes of taxes have affected volatility. Between fiscal years 1995 and 2014, corporate income taxes and severance taxes on oil and minerals were consistently more volatile than other major State taxes, such as those on personal income and sales of goods and services, Dr. Huh’s research indicated. Corporate tax was most volatile in 25 out of 30 States where that type of tax is a major revenue source, while personal income tax was most volatile in 8 out of 41 States where it is a major source.

The challenge largely is how to manage tax volatility. Dr. Huh advised the States to conduct regular examinations of their tax-revenue volatility so they can devise ways to manage it. “Severance-tax States by and large have dealt with these tax swings by having big reserves. Some States are moving toward policies to deal with their cyclical revenue by taking extra tax dollars in good years and setting them aside—as in rainy day funds—for bad years,” he reported.

Federal Contributions to State-Government Revenue

Income volatility for the States is further exacerbated by uncertainty about future federal contributions, and this uncertainty may weigh more heavily in some States than in others, Dr. Huh observed. Federal dollars are the second-biggest source of State revenues, after tax dollars, making up 30.8 cents of states’ money in FY 2014, he reported, but the share of federal funds varies across the states, ranging from 40% in Mississippi (40.9%) and Louisiana (40.1%) due to their high Medicaid matching rates, to a low of 17% in North Dakota. Federal funds make up 30% to 39.9% of State revenues in 29 States and 16% to 29.9% in 19 States.

 State Government Revenue

Trends

Slow Revenue Growth

Dr. Huh alerted the Forum participants to several trends that legislators will need to consider during State-budget deliberations. Future revenues will continue to grow slowly in the coming years due to structural factors, he pointed out. There is a decline in real income and decreased consumer spending, Dr. Huh reported, and few investments in large capital projects. “People are putting money into the stock market and housing. Consumer spending, which is about 40% of GDP is staying on the sideline and and not growing,” he noted.

Revenues Are Less Than Spending

Required State spending on pensions, debt obligations, and Medicaid costs will exceed most States’ revenues, he predicted. Medicaid spending is the critical element that will drive budget uncertainty, Dr. Huh forewarned.

Volatility Increasing

Volatility is likely to increase in the next 5 to 10 years while federal funds may grow more unpredictable, he anticipated.

Medicaid Drives Budget Uncertainty

While the federal government covers almost 60% of total Medicaid costs to provide health care insurance for the disabled and low-income children and the elderly, the 40% funded by State-generated dollars is an unpredictable but growing burden on the States. “Because Medicaid is an entitlement program, State policymakers have less control over growth in their states’ costs than they do with other programs,” Dr. Huh pointed out.

Medicaid is taking a greater share of each State-generated dollar than the program did at the start of this century, and more than it did before the recession. While States altogether were spending 12.2 cents of every revenue dollar on Medicaid in 2000, they were spending 16.8 cents in 2014, or 4.6 cents more of each dollar.

Forty-eight States spent more of each own-source dollar on Medicaid in 2014 than in 2000. Medicaid accounted for more than 8 cents extra of every dollar generated by Louisiana, and nearly 8 cents more of every dollar raised by California, Maine, and Pennsylvania. Six States spent more than one-fifth of their own-source revenue on Medicaid in 2014: New York (26.2%), Rhode Island (24.1%), Pennsylvania (23.9%), Missouri (21.9%), Tennessee (21.8%), and Massachusetts (21.2%). New York has spent the largest share of its own-source revenue on Medicaid in every year since 2000. Medicaid’s claim on each revenue dollar affects the share of State resources available for other priorities, such as education, transportation, and public safety,” Dr. Huh reminded the Forum.

 Medicaid Mix of Federal and State Dollars

Spiraling Drug Costs

States could face a $1.6 billion blow to their budgets next year from Medicaid, Dr. Huh warned.

Most of the hike is the result of higher prices for prescription drugs, he observed. In 2006, when Congress added prescription drug benefits to Medicare (Part D), they mandated that State Medicaid agencies would pay the Part D premiums for dual-eligible enrollees, people whose low-income status makes them eligible for both Medicare and Medicaid. These costs are expected to increase by nearly 12% in 2017. The increase marks the second year of hikes by a double-digit percentage and the largest annual increase since Part D began. Rising prescription-drug prices are a broader phenomenon. From 2013 to 2016, drug spending in the US increased by 27%, Dr. Huh cited.

Federal Uncertainty Increases Volatility

Federal proposals and policies could profoundly affect State budget planning, Dr. Huh said. Healthcare inflation is difficult to predict, he noted, and it is a key driver of State budget uncertainty. And federal proposals to provide Medicaid through block grants would reportedly force States to cover more of the costs of healthcare. States will have to decide what services to cover and what provider networks to use. “By relying on the use of evidence-based quality measures and assessing what States are getting for their healthcare dollars, States can actively manage these high-cost services,” Dr. Huh noted.

Sen. Wayne Niederhauser (UT) said, “Medicaid expenses are the biggest challenge we all face. We incentivize the pharmaceutical sector to innovate and cure diseases by not setting prices. We also want to give everyone the best medical care we can. This is a train wreck for our whole economic system. Healthcare will consume all of our GDP given its current trend. The demand for healthcare is inelastic, with everyone wanting the best. But how can we afford this?” A strategy used in Utah is to create a Rainy Day Fund specifically for Medicaid. In years when there is a Medicaid surplus, the surplus goes into the Fund for use in low years.

Dr. Huh recognized the value of the Utah model and also described capitation programs, where the State sets a price per participant and health maintenance organizations (HMOs) manage the delivery of healthcare services. The HMOs can assess the individual’s needs and create a health plan that meets those needs. “We need innovation in healthcare,” Dr. Huh acknowledged. “In some cases, drugs may be cheaper than other interventions and manage diseases more effectively. The challenge is the inelasticity of healthcare demand.”

New Factors Driving Budgets

Dr. Huh reported that a number of States have yet to recover from the recession in terms of their 1) tax revenue, 2) financial cushions, and 3) employment rates. Demographic and economic drivers will start to shape policy during the next decade, according to Dr. Huh’s research. He explored emerging trends in employment, personal income, migration, poverty, and population trends that will strain State budgets in the coming decade.

Employment

Employment has not rebounded following the recession as was expected, Dr. Huh reported. In 2007, leading up to the recession, nearly 80 of every 100 people ages 25 to 54 in the US had a job. By the middle of 2016, seven years after the recession ended, only about 78 (77.6) of every 100 in that age group were working. So for every 100 prime-age adults in the nation, 2 to 3 (2.4) fewer were working as of mid-2016 than were before the recession. “There are actually now more people than before the recession sitting along the sidelines of the economy. Some States are struggling with significant unemployment, such as Alaska with the worst unemployment rate at 6.9% and New Mexico at 6.7%,” he noted.

Personal Income

The economy is a key driver of tax-revenue trends, and Dr. Huh’s research tracks the growth in State personal income as a proxy for change in the economy. It includes all income received by its residents—from paychecks, Social Security checks, rent, government benefits, and interest and dividends on investments. State personal income shows that recovery from the recession is widespread. Overall, US personal income has grown the equivalent of 1.7% a year between the start of the recession in late 2007 and the second quarter of 2016. But the historic trend has been a 2.8% growth rate over the past 30 years. So growth is still lagging and is uneven among the States, Dr. Huh said.

Personal income fell in 6 States (ND, WY, SD, AK, OK, WV), mostly due to lower oil and coal prices but also to agricultural declines. Poverty rates across the south varied from 16% in Oklahoma to 21% in Mississippi. At the other end of the spectrum, Utahns’ personal income grew the fastest at (4.0%), followed by GA and OR, tied at 3.7%.

Population Factors

A lower fertility rate, aging workforce, and less mobility have combined to put stress on worker replacement and additional strains on State budgets, Dr. Huh reported. Net migration has declined except in Southeastern regions and Texas, where manufacturing jobs have relocated. In some States, real income has declined and home prices have not recovered, making it more difficult to move.

Preston Baldwin (Centerpoint 360) commented that 10,000 Americans are turning 65 every day, and it requires 2 workers to replace each retiree. Dr. Huh agreed that the silver tsunami is a threat to State economies and that policies must anticipate this trend. In 5 to 10 years, there will not be enough workers to replace retirees.

The elderly comprised 12% to 15% of the population in most States in 2016. By 2020, States will have a higher concentration of elderly residents who will be earning less income and contributing fewer tax dollars, spending less on durable goods, and contributing to higher healthcare costs, Dr. Huh reported.

Sen. Kevin de Leon (CA) commented that California faces a “tsunami in retirement insecurity.” Most workers do not have defined pension benefits, and many do not have savings, Sen. de Leon noted, and 50% of middle-class workers are likely to retire into poverty. This is creating a strain on the State’s safety nets, he pointed out.  “We are not able to give the elders proper care.”

California’s response to this challenge is Senate Bill 1234, which requires all California companies with at least 5 employees to either offer their own retirement savings plan or enroll workers in the new California Secure Choice Retirement Savings Program. Secure Choice would be structured as an individual retirement account but operate much like a 401(k), with a small percentage of every paycheck automatically diverted into the program unless workers take action to opt out.

The Problem of Pensions

The liability of public pensions is growing, pension payments are up, and there is insufficient revenue to meet this demand, Dr. Huh observed. Volatility in pension earnings is increasing as pension investments fail to yield anticipated returns, thereby leading to riskier investments.

Pensions represent the largest State liability and claim on future revenues, Dr. Huh advised. Recent reporting rules mandate that government balance sheets reflect unfunded pension liabilities. As many State and local pension plans are underfunded, this rule adds substantial liabilities to governmental balance sheets. The risk is that credit-rating agencies may downgrade ratings on State and municipal bonds, which are vital sources of funding. “The increased cost of debt financing can significantly affect government budgets,” Dr. Huh stated.

Conclusion

Dr. Huh cited additional long-term factors that can strengthen or weaken the States’ fiscal health. Many States have still not recovered from the recession, he noted, when it comes to tax revenues, reserves and balances, and employment rates for prime-age workers. And many States face fiscal pressures from uncertainty about federal funding levels, unfunded retirement costs (pensions or retiree healthcare), higher Medicaid costs, and volatile tax revenue. “Now, 8.5 years since the recession started in 2007, the Great Recession may be long over, but its effects still linger in States. That’s particularly relevant given speculation on how long this recovery will last before the next recession,” Dr. Huh said. The critical factor in facing these challenging trends is to capture “above-trend revenues” and bank them in Rainy Day Funds in anticipation of future shortfalls.

“The future is cloudy, but with a silver lining,” Dr. Huh concluded. The States shed jobs during the Recession and have not replaced them. They exhibited restraint on spending and have better management policies in place. They are seeking evidence-based outcomes for investments in healthcare and education. New fiscal controls and more stringent management will help States weather future downturns. Strong fiscal management will lead to greater resilience, he predicted.

Discussion

Sen. Kevin de Leon (CA): Do your projections take into account potential actions by President Donald Trump?

Dr. Huh: States could receive an economic boost from President Trump’s infrastructure plan, but more debt would be incurred. It is not clear whether Speaker Paul Ryan will support the plan. There is a lot of uncertainty about the mechanics of the Trump Administration’s policies. We are seeing behaviors in the market in anticipation of possible changes. Capital that has been held on the sidelines may come into play, if tax benefits are forthcoming, he concluded.

Sen. Tom Alexander (SC) and Sen. Aaron Ford (NV) discuss the implications of Dr. Huh’s research during a break in the sessions.

Speaker Biography

Kil Huh

Kil Huh directs Pew’s work on state and local fiscal health. He leads Pew’s work on state and local fiscal health and economic growth, which includes projects that seek to strengthen states’ fiscal planning and budgeting and how they use tax incentives for economic development, track and analyze states’ health care spending, and provide officials with analysis and insights on the financial conditions of America’s largest cities.

As the project lead, Huh oversees Pew’s work to inform state policy on a wide range of issues including state and local public sector retirement benefits, state tax systems, and housing finance. He also supervises a vigorous research portfolio that has contributed to federal and state legislation and has been cited widely in national media including, The New York Times, The Washington Post, The Wall Street Journal, and NPR. Huh has appeared as a guest on Fox Business News, CBS Nightly News, and both PBS’s News Hour and Nightly Business Report.

Prior to joining Pew, he was most recently the director of policy and consulting at the Fannie Mae Foundation and previously manager of the foundation’s state and local initiatives.

He holds a B.S. in urban regional studies from Cornell University, a M.S. in urban planning from New York University and both a M.Phil. and a Ph.D. in urban planning from Columbia University.

Other Winter 2017 Forum Highlights articles:

Kil Huh, PhD

Senior Director

State and Local Fiscal Health

The Pew Charitable Trusts

The key challenges facing all the States, which include slow (and volatile) revenue growth fueled by new spending patterns among millennial consumers, growing pension costs, and increasing Medicaid spending.

The challenge largely is how to manage tax volatility.

Federal dollars are the second-biggest source of State revenues, after tax dollars, making up 30.8 cents of states’ money in FY 2014.

Medicaid spending is the critical element that will drive budget uncertainty.

Medicaid is taking a greater share of each State-generated dollar than the program did at the start of this century.

States could face a $1.6 billion blow to their budgets next year from Medicaid, Dr. Huh warned.

Healthcare inflation is difficult to predict, he noted, and it is a key driver of State budget uncertainty.

Sen. Wayne Niederhauser (UT) said, “Medicaid expenses are the biggest challenge we all face.”

Sen. Kevin de Leon (CA) commented that California faces a “tsunami in retirement insecurity.”

Sen. Kevin de Leon

(CA)

Kil Huh, PhD

Senior Director

State and Local Fiscal Health

The Pew Charitable Trusts

Senate Presidents’ Forum

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