Arizona's budget crisis: How did we get here and where are we going?

Everyone knows that Arizona has been mired in a budget crisis — worse, even, than in many other states — for three years now. But last summer, the Governor's office and the Legislature announced that the budget (for fiscal year 2010) was finally balanced. However, that budget was based on revenues remaining the same in 2010 as in 2009. As it turns out, revenues fell an additional 11 percent this year, said John Arnold, director of the Governor's Office of Strategic Planning and Budgeting. At the same, expenditures have continued to increase, Arnold explained to a group of business leaders at the Annual Economic Outlook Luncheon, sponsored by the Economic Club of Phoenix.

Everyone knows that Arizona has been mired in a budget crisis — worse, even, than in many other states — for three years now. But last summer, the Governor's office and the Legislature announced that the budget (for fiscal year 2010) was finally balanced.

However, that budget was based on revenues remaining the same in 2010 as in 2009. As it turns out, revenues fell an additional 11 percent this year, said John Arnold, director of the Governor's Office of Strategic Planning and Budgeting. Today, Arizona state general fund revenues stand at about 70 percent of their peak (2007) level.

At the same, expenditures have continued to increase, Arnold explained to a group of business leaders at the Annual Economic Outlook Luncheon, sponsored by the Economic Club of Phoenix. "I've had a lot of people ask me, 'Why don't you just cut the state budget? If you're a family and you lose revenue, you cut expenditures.'

Certainly we do some of that, but think in these terms: you've lost 30 percent of your family income, but you also have to go out and adopt three new kids." That, he said, is the situation the state faces. Though revenues today stand at fiscal year 2004 levels, expenditures are 30 percent higher.

"Since fiscal year 2004, Arizona added 121,500 new K-12 students at a cost of more than $1 billion. Enrollment at the state's universities rose by 18,100 at a cost of $393.5 million. The state's prisons now house 10,800 more prisoners at a cost of $405.4 million. And the state's Medicaid program, AHCCCS, added 475,000 Arizonans to its rolls (203,000 in 2009 alone) at a cost of nearly $1.5 billion," Arnold explained.

The best-case budget

Without implementing the budget solutions that the Governor has proposed, the estimated fiscal year 2010 budget deficit is about $2 billion. If the state were to do nothing, that gap widens to more than $4 billion in fiscal year 2014.

To balance the budget in fiscal years 2010 and 2011, Arnold said, the Governor proposed a mix of expenditure reductions (30 percent of the solution), revenue enhancements (26 percent), fund transfers (13 percent), and additional debt (31 percent).

That solution is based on the passage of Proposition 100 on May 18, which would generate nearly $1 billion in additional revenue in fiscal year 2011. In fact, the Governor's proposed revenue enhancements are made up almost entirely of income that would come from the Prop 100 1-cent sales tax increase, which has yet to be passed by the voters.

The revenue enhancements that come from the 1-cent sales tax increase would generate about $1 billion per year through fiscal year 2013, when the increase will expire. Additional income in fiscal year 2010 will come from debt that includes rollovers (funding 11 months of the current fiscal year and rolling over the last month into the following fiscal year), the sale of state buildings, and lottery bonds.

"There was a lot of ridicule toward the sale and leaseback of state buildings, but it was very well accepted in the financial markets," Arnold said. "The state can't issue debt off the general fund, so we had to pledge something. But now we're out of buildings, we've sold the lottery bonds, we don't have a lot of other sources for borrowing money."

In total, the state borrowed or rolled over nearly $3 billion, on a $10 billion budget. "But we're done borrowing," Arnold said. Expenditure reductions, which account for 30 percent of the Governor's proposed budget solution, had included nearly $400 million in cuts to AHCCCS and KidsCare, which would have eliminated health care coverage for 310,500 adult Arizonans and 46,000 children.

But the recently-passed federal healthcare reform bill prohibits states from making cuts to Medicaid programs. Additional cuts squeeze $36 million out of the state's mental health programs, eliminating a Medicaid-like program for 14,400 seriously mentally ill people. Without state services, Arnold said, "a lot of those people will end up on the streets or in jail."

The cuts will go into effect in late June. Welfare reform, which will save the state $27 million, reduces the lifetime cash assistance cap from 60 months to 36 months, "moving 10,000 Arizonan families off of welfare," Arnold said. $22 million will come from limiting childcare for the working poor ("mainly single mothers"), which means "throwing close to 11,000 kids out of the program."

The biggest share of the expenditure cuts ($422 million) will come from capping education expenditures at fiscal year 2006 levels. "That's not capping the per-student expenditure at 2006 levels," Arnold explained. "That's total education expenditures, and the state's schools have added 57,000 new pupils since 2006." Arizona's three universities will see 25 percent reductions in their current expenditure levels.

Additional savings of $45 million will come from reductions in state employees' payroll (which have been cut 20 percent since 2007). "The state will shut down for six days," Arnold said.

Finally, $25 million will come from increasing the "prison bed deficit" which, Arnold explained, means double- and triple-bunking jail cells.

Yet even with those cuts, even with the passage of the 1-cent sales tax, the state will still have a deficit in fiscal year 2011. "That deficit would have been closed by the nearly $400 million in cuts to AHCCCS and KidsCare but we're now prohibited by the federal government from making those cuts," Arnold said.

"If the sales tax increase passes, we can balance next year's budget with added Federal dollars and by sweeping some funds. But those resources won't be available in fiscal year 2012, and because we can't cut our Medicaid expenditures, we'll face a deficit again in fiscal year 2012."

The state will face a $1 billion deficit going into fiscal year 2012 and an additional $1 billion gap going into fiscal year 2013, even after the proposed cuts and assuming nearly $1 billion in revenue from the sales tax increase.

The worst-case budget

An already dismal state budget situation, Arnold made clear, will be even worse if Proposition 100 — the 1-cent statewide sales tax increase — does not pass. Then the state would adopt the "conditional" budget passed by the Legislature.

That would cut an additional $428 million from K-12 education, $120 million from higher education, $100 million from public safety, $175 million from health care, and $25 million from human services. For K-12 education, that means reducing total expenditures to 2001 levels.

"Higher education would lose funding equal to the entire amount given to Northern Arizona University each year," Arnold said. There would be a "massive" shift of prisoners from the state to the counties — despite the fact that many counties don't have the capacity to handle an influx of prisoners.

And because the state couldn't change healthcare eligibility (letting fewer Arizonans qualify for the state's Medicaid program), the state would have to reduce provider payments by 10 percent. "Some providers will sue the state, some will stop covering AHCCCS patients, and some hospitals will simply close," Arnold warned.

In that way, and others, the failure of Proposition 100 wouldn't only impact the state's budget. It would also negatively impact the state's economy, Arnold said. "It's difficult to project exactly what will happen if the sales tax does pass or what would happen if it doesn't. But I think the state will lose more jobs if voters don't pass the tax increase."

Restoring fiscal stability

Arnold called the state's budget crisis the result of an "odd wrinkle in the economy" and said that he's not sure when, or how quickly, Arizona will come out of it. And while he said that there is no way to prevent a catastrophe like this from repeating itself, there are ways to mitigate how severely the economy's cycles impact the state budget.

"The budget deficit is a function of the economy," Arnold said. "But it has been exacerbated by the use of one-time revenues to fund ongoing expenditures."

"For example, during Arizona's housing boom tax receipts from construction were thought of as base revenue, though they clearly weren't. AHCCCS expenditures were thought of as constant in the same way, but they've increased dramatically since the recession began."

The key to resolving that structural deficit — to restoring stability to the system — Arnold said, is to differentiate one-time revenues from ongoing revenue, and not to use one-time income for permanent budget changes (like cuts in other sources of revenue or increases in expenditures).

Instead, one-time or "bubble" revenues, as Arnold called them, should be redirected into a "rainy day" fund, used to retire debt or to pay off rollovers. That wouldn't have prevented the state's current fiscal crisis, Arnold said, but it could have mitigated its depth.

Bottom Line:

• Today, Arizona state general fund revenues stand at fiscal year 2004 levels. Yet expenditures are 30 percent higher than in 2004.
• Without implementing the budget solutions that the Governor has proposed, the estimated budget deficit for fiscal year 2010 (which ends June 30, 2010) is about $2 billion. If the state were to do nothing, that gap would widen to more than $4 billion in fiscal year 2014.
• To balance the budget in fiscal years 2010 and 2011, the Governor proposed a mix of expenditure reductions (30 percent of the solution), revenue enhancements (26 percent) — which includes the 1-cent sales tax increase — fund transfers (13 percent), and additional debt (31 percent).
• The state will still face a $1 billion deficit going into fiscal year 2012 and an additional $1 billion gap going into fiscal year 2013, even after the proposed cuts and assuming nearly $1 billion in revenue from the sales tax increase.
• An already dismal state budget situation will be even worse if Proposition 100 — the 1-cent statewide sales tax increase — does not pass.
• The key to restoring stability to Arizona's fiscal system is to differentiate one-time revenues from ongoing revenue, and not to use one-time income for permanent budget changes (like cuts in other sources of revenue or increases in expenditures).