Journey to recovery starts slowly for states

People wait in line to attend a job fair for military veterans and other unemployed people in Los Angeles, California, October 7, 2010.

WASHINGTON/CHICAGO (Reuters) - Since the financial crisis sapped growth and took a steep toll on tax revenues, Pennsylvania Governor Ed Rendell has laid off workers, slashed spending and fought with legislators over tax hikes.

But when the Democrat leaves office next week, he will have an unexpected laurel to put in his gubernatorial wreath: Pennsylvania is already on track to end its fiscal year in June without a deficit.

Pennsylvania, however, like other U.S. states struggling to get their financial houses back in order, is not yet out of the woods.

"Does Corbett, when he becomes governor, have to make cuts?" Rendell asked, referring to his successor, Tom Corbett. "Of course he does. I would too."

Even though states' tax revenue rose for three quarters in a row, according to the Rockefeller Institute of Government, the pace of growth is not keeping up with spending demands.

States still face tough decisions about closing budget deficits. And their revenue-recovery story is not likely to remove the cloud hanging over the U.S. economy or the $2.8 trillion municipal bond market where scared investors are dumping bonds amid a steady flow of stories about shaky local finances.

The high-water mark for many states' revenues came in 2008, before the housing market meltdown, financial crisis and economic recession sparked a financial collapse for most. Revenues fell by nearly a third from 2009 to 2010, according to the U.S. Census.

Investors, taxpayers and the international media began fearing worst-case scenarios, from nearly unheard-of state defaults on debts to shutting down schools.

Now, revenues are on the upswing. Pennsylvania's fiscal year-to-date tax collections, at $11.5 billion, are 1.7 percent above forecasts, and New York is pulling in more tax revenue than expected.

The National Conference of State Legislatures said 17 states expect total collections to rise at least 5 percent this fiscal year, which for most ends in June.

The increases, however, has not begun to make up for the huge hits to states' coffers.

"We got three quarters of positive revenues, but they're fairly small," said Raymond Scheppach, executive director of the National Governors Association. "You have to remember that even with these changes revenues are down relative to 2008."

In December, the NGA, along with the National Association of State Budget Officers found that revenue was more than 7 percent below 2008 levels.

With revenue growth slight compared to the 6.5 percent average annual increase in state revenues for the 30 years before the recession, Scheppach said, states will have to wait until 2013 or 2014 before their revenues return to 2008 levels.

In the future, growth will likely average closer to 4 percent, he added.

Unless revenue growth strengthens, most states will have budget gaps next year that are just as large as in the past two years, said Chris Cumberland, an economist at the Federal Reserve Board of Atlanta.

"Even when revenue stabilizes, I expect states will dedicate future revenue growth to rebuilding their reserves and addressing shortfalls in their pensions," Cumberland said.

COLLAPSE INSPIRES GOVERNMENT RE-THINK

Oklahoma is a case in point. Though revenues are slowly gaining, past spending levels will likely not return, said Oklahoma Treasurer Ken Miller. Fiscal 2012 starting in July will be "another difficult fiscal year," and spending cuts caused by revenue drops will not end until probably in fiscal 2013.

The recession, he said, has "given us opportunity to create efficiencies and reduce fat in government."

States confronted with low revenues usually have two choices to balance their budgets: cut spending or hike taxes. Vermont is the only one of the 50 states that does not have to end its fiscal year without deficits. Pennsylvania, for example, anticipates it will have to close a gap of at least $3.5 billion for fiscal 2012.

The political appetite for raising taxes is small, despite findings from the Rockefeller Institute that a significant chunk of the revenue growth has come from tax hikes. The Tax Foundation, a think-tank monitoring fiscal policy, found that in 2010 tax increases were in "a minority of states."

Illinois Governor Pat Quinn last week signed into law a major hike in the state's individual income tax and corporate tax rates. New Jersey Governor Chris Christie, however, may represent the more popular tack with his hardline commitment to not raising taxes.

And while Congressional leaders are debating a possible federal bailout of states like California, which has been hit especially hard, aid is unlikely. Last week, Federal Reserve Chairman Ben Bernanke reiterated his resistance to lending to states. Republican members of Congress have voiced strong opposition to sending more funds to states, and Scheppach said many governors would not want the money.

The national economic recovery that began in 2009 may help smaller states soon -- states' recoveries typically lag the national one -- but for those with immense budget shortfalls such as Illinois, "the rebound in the economy won't even come close to solving the states' problems," said University of Illinois economics professor Fred Giertz.

That leaves spending cuts as the most likely method to eliminate imbalances, especially because Republicans swept November's state elections promising to slash expenditures.

Giertz warned that spending cuts could drag on national economic growth.

State and local spending in the third quarter of 2010 accounted for about 12.1 percent of U.S. gross domestic product, down from 12.6 percent in the third quarter of 2008..

(Additional reporting by Jon Hurdle in Philadelphia; Editing by Leslie Adler)