During times of economic distress, state governments often face significant funding strains as tax revenues decline and demand for publically funded services increases. For New York and New Jersey, the fiscal challenges caused by the recent financial crisis have been especially acute. In fiscal year 2010, New York and New Jersey needed to address budget gaps of $16 billion and $9 billion, respectively, and they continue to experience firsthand the negative ramifications of relying heavily on sources of tax revenue that fluctuate sharply with changes in the business cycle.
In this article, authors Richard Deitz, Andrew F. Haughwout and Charles Steindel examine how New York and New Jersey’s dependence on volatile revenue sources, including income taxes from the financial sector, has exposed the states to substantial budget gaps and left lawmakers with difficult fiscal decisions. Moreover, the authors show that the ways in which both states deal with their budget problems could have a continuing impact on their economies and their citizens well after the cyclical downturn ends.
Deitz, Haughwout and Steindel begin their analysis with a review of the general principles of state finance and then proceed to a detailed discussion of the size and makeup of New York’s and New Jersey’s budgets, highlighting the problematic elements for each state. Additionally, the authors explain why recessions have a dramatic adverse impact on a state’s budget and why this recession in particular has been so damaging to the financial condition of New York and New Jersey.
Looking forward, the authors propose a few policy options that may help New York, New Jersey and other states avoid a recurrence of the very large budget shortfalls experienced in recent years. First, states could create a substantial reserve (or “rainy day”) fund to help insulate themselves from recession-generated revenue losses. Second, states could adjust the composition of their revenues by reducing reliance on cyclically sensitive tax bases and raising revenues from less volatile sources, notably sales taxes. Third, states could institute a policy rule of temporarily raising income taxes on high-income households during a downturn. Fourth, states could craft in advance a plan for spending cuts and tax increases to be implemented as needed. However, as detailed in the paper, all of these possible solutions pose challenges of their own.
In the near term, officials in Albany and Trenton will continue to face hard choices in their continued attempts to reconcile shortfalls in revenues and ongoing demands for spending.
Richard Deitz is a research officer and Andrew F. Haughwout a vice president in the Microeconomic and Regional Studies Function of the Federal Reserve Bank of New York; Charles Steindel is a senior vice president in the Bank’s Macroeconomic and Monetary Studies Function.