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State budget woes: How much will they drag down US economy?

Cutting employees, raising taxes, and delaying payments to vendors could slow economic recovery, experts say, but perhaps only slightly.

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"That's good news," says Don Boyd, a senior fellow at the institute. "But it is still below the levels needed to finance the spending commitments the states have."

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That's the rub for public employees like Karen Flynn in Lincoln, Calif. She lost her job as part of Lincoln's need to reduce a $1.7 million deficit. She now lives with a friend to stretch her $1,700-a-month unemployment benefit, and keeps an eagle eye on every penny she spends, which does not help area retailers. Her Christmas spending last month: a $2 coloring book for her granddaughter and $20 for her grandson. "I've had much more lavish Christmases in the past," she says.

In Vineland, N.J., Joe Sangataldo, a jobs counselor laid off by the Garden State in October, has also pared back. He used to vacation in New Orleans. Now he plans to hop on a Megabus, which for $1 will take him to the Pittsburgh Convention Center. He'll spend the day there and then return for another dollar.

"I call it a budget vacation," says Mr. Sangataldo, adding that he learned how to scrimp from the people who have attended his job-counseling sessions.

The states' combined shortfall will total $140 billion for the 2012 budget year, which begins in June for most, according to the Center for Budget and Policy Priorities (CBPP), That mainly reflects lower sales- and income-tax collections.

"Usually, when a recession ends, it takes two to three years for state revenues to get back," says Jon Shure, deputy director of the State Fiscal Project at CBPP.

To avoid losing even more revenue, California's Governor Brown is proposing to retain a previous "temporary" tax increase that would have expired. In Illinois, the legislature approved a major increase in state and corporate income taxes. In some states, such tax hikes might in part offset the impact of the Obama-GOP deal to keep national tax rates from rising.

"I'm not sure if it would entirely wipe out the [tax] savings for some individuals, but it would be a dent," says Pete Sepp of the National Taxpayers Union, in Alexandria, Va.

The recent recession, however, is not solely to blame for the economic straits of states and localities. Many made spending commitments using unrealistic budget assumptions, says Mr. Boyd at the Rock­efeller Institute. For instance, some states assumed that a big jump in revenues from capital gains taxes was the new normal – and raised their spending accordingly. "Capital gains have since fallen more than 70 percent from 2007 levels," he says. "The point is, you can't act as if that ephemeral income is there to support spending."

States are committed, moreover, to some spending programs that are growing faster than revenues. In Illinois, for one, the cost of Medicaid, a federal-state program to provide health care for the poor, has grown 6.9 percent a year over the past decade.

Many states also face a rising demand on their resources to fund pensions for their employees. "Most [pension commitments] are underfunded," says Boyd. "Unless they make drastic changes in the way they fund their pensions, some places are on a path to run out of money in seven to 10 years. Many will have to raise contributions and crowd out other parts of the budget."

Illinois is a poster child for how bad things can get. Its general fund has run a deficit for eight of the past 10 years, according to Standard & Poor's, the debt rating service. The state has survived mainly by issuing short-term debt and delaying payments to vendors, local governments, and higher education institutions.

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