WSJ: States Feel Economic Heat as Market Drops

As Investors Get Bit, States Feel Pain

By VAUHINI VARA

State-budget officials from around the U.S. were huddled in Utah earlier this month for an annual meeting when someone glanced at a BlackBerry and announced that the Dow Jones Industrial Average had fallen 500 points.

"It was one of the worst moments of the week," said Scott Pattison, executive director of the National Association of State Budget Officers.

The volatile stock market highlighted a growing problem for budget planners. In recent decades, states from California to New York have become increasingly reliant on taxes generated from their residents’ investment income. Now, they have found themselves more vulnerable than ever to the market’s gyrations—with serious consequences for state-funded schools, courthouses and other institutions.

Max Whittaker/Prime for The Wall Street Journal

Steven Ladd, a schools superintendent in Sacramento, Calif., has been watching stock-market updates that could hint at state budget prospects.

Overall, personal income taxes made up 36% of states’ revenue in 2008, up from 26% in 1978, according to the Nelson A. Rockefeller Institute of Government in Albany, NY. With middle-class wages stagnating, much of that increase has come from wealthy people whose taxes fluctuate with the stock market. These high-income individuals pay taxes on capital gains they realize through selling shares, income they earn from stock options and bonuses tied to the stock market.

"The market itself is volatile, and the choice by taxpayers of whether to realize capital gains depends on a host of personal factors," said Donald Boyd, a senior fellow at the Rockefeller Institute and an expert on budget volatility. "It makes it extremely hard to predict."

During a government revenue crisis of 1990-1992, 25% of state revenue forecasts fell short by 5% or more, according to the Pew Center on the States and the Rockefeller Institute. In 2009, 70% of such forecasts fell short.

Now, budget watchers warn that some states may have missed the mark again. After deep revenue declines in the 2009 and 2010 fiscal years, followed by a flat 2011, states had finally expected modest revenue growth this fiscal year, according to the National Conference of State Legislatures.

That had partly to do with the strength of the stock market earlier this year. On July 1, when most states began their fiscal year, the Dow was up 8.7% for the year. As of Friday, the average was down 6.6% for 2011.

"When people filed their tax returns in April, states saw a big bump in revenue, and some people looked at that and mistakenly concluded that happy days are here again," Mr. Boyd said. "But it’s not true."

California is among the states most dependent on the wealthy and their investments, along with such states as New York, New Jersey, Connecticut and Massachusetts, according to the Rockefeller Institute.

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In California, the top fifth of taxpayers accounted for 89% of personal state income tax revenue in 2007, up from 81% in 1993, as wealthy Californians profited from the dot-com and real-estate booms, according to state data. The contributions from all other income groups declined in that period.

Then came the recession, which sent the contribution of the top fifth of taxpayers slipping to 85% in 2009. That helped lead to a crippling budget crisis for the state, which resorted to IOUs to pay its bills that year.

As the state’s economy continued to suffer, state forecasters were puzzled this May when they saw that income-tax collections for 2010 had come in much higher than economic data had led them to predict.

That bolstered their confidence that a recovery was under way. That belief, along with pressure to close an enormous budget gap without added taxes, persuaded Gov. Jerry Brown to boost his earlier revenue assumption by $8.4 billion by the time he signed the budget for the fiscal year starting July 1. That increase denotes the apples-to-apples rise after adjusting for other changes to the budget, said a finance-department official.

A key source of the hoped-for boost: a rise in wages and capital gains for wealthy Californians, according to the finance-department official. That means the market downturn of recent weeks will "tend to make additional revenue less likely," the official said, "but we don’t know what’s going to happen in the coming weeks and months."

The California Department of Finance will update its forecast in December. If it seems then that revenue will fall short of expectations, the budget calls for up to $2.5 billion in midyear cuts to schools, higher education, public safety and other areas depending on the size of the shortfall. That’s on top of $15 billion in cuts and other spending-reduction maneuvers already approved this year.

The finance-department official declined to predict where the state’s revenue might end up. Chris Thornberg, founding partner at analysis-firm Beacon Economics, said he expected the market downturn to translate to a $1.3 billion to $1.5 billion reduction in revenue for the state, assuming markets recover slightly by year’s end. That would be enough to trigger some additional cuts.

H.D. Palmer, a spokesman for the state finance department, called Mr. Thornberg’s prediction "a sheer guesstimate" because it comes so early in the fiscal year. He added, "The only thing we’ve learned since late June is that you should keep a bottle of Dramamine at your desk."

Nonetheless, at Elk Grove Unified School District in Sacramento, Superintendent Steven Ladd has been following stock-market updates that could hint at the state budget’s prospects—which will in turn determine whether he has to make midyear cuts of his own.

"I have to live with the recognition that the volatility in the markets is beyond my control," he said.

Write to Vauhini Vara at vauhini.vara

Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

Kevin Wrege, Esq.

Founder & President

Pulse Issues & Advocacy LLC

Office: 202-625-1787

Mobile: 202-253-4929

4410 Massachusetts Ave., NW, #150

Washington, DC 20016

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