BUDGET BOOM

States Set Big Spending Plans As Washington Preaches Austerity

Washington may currently be focused on fiscal austerity.

But a major spending spree is shaping up in the states, as local
legislators abandon a half-decade of fiscal conservatism to pursue
bigger budgets. From New York to Montana to California, states are
proposing budget increases that outpace inflation and far exceed the
1% rise in domestic outlays -- outside of defense and homeland
security -- that President Bush recently proposed in his fiscal 2008
federal budget.

In Montana, Gov. Brian Schweitzer is cutting taxes and boosting
spending by 26% over two years, including $100 million for new "meth
prisons" that blend incarceration with intensive drug rehab for those
convicted of methamphetamine crimes.

In Vermont, Gov. Jim Douglas wants to borrow $40 million to create
"the nation's first e-state," where free wireless broadband is
available to all. And in Arizona, the only dispute between a
Democratic governor and a Republican legislature over a
half-billion-dollar road-repair program is whether to borrow the
money or pay cash. The binge is bipartisan. Last year, the
Massachusetts legislature approved a $1.56 billion universal
health-care plan under Republican Gov. Mitt Romney, who is now
running for president.

This year, at least ten states -- most notably Republican Arnold
Schwarzenegger's California -- are weighing similar programs. But
that's just one of many areas where state governments are seeking to
expand services that were long considered distant dreams by
advocates. Universal prekindergarten is being championed by several
incoming Democratic governors, such as New York's Eliot Spitzer,
Deval Patrick of Massachusetts and Mike Beebe of Arkansas. Democratic
leaders in Colorado and Pennsylvania and several other states want to
create funds for state "energy independence." Many of these proposals
will be topics of conversation at the National Governors
Association's annual meeting, which begins in Washington today. The
new state activism is driven in part by the Bush administration's
budgetary focus on Iraq, defense and homeland security, which leaves
states to grapple with domestic concerns on their own. Higher tax
receipts and growth in energy royalties, from higher oil and
natural-gas prices, have also left many states flush.

But even states faced with declining revenue are mulling ways to ramp
up spending -- not with unpopular tax increases, but by privatizing
valuable public assets in return for big slugs of cash. Michigan and
Illinois, among others, are looking at selling off their lotteries,
while Missouri is considering doing the same with its student-loan
portfolio. The growing popularity of health-care programs and higher
teacher salaries raises the risk that states, giddy from surging
revenue, may be in danger of expanding beyond their means, using
short-term windfalls to create new long-term obligations at a time
when tax increases remain unpopular with voters. It was just a few
years ago that states last found themselves in financial dire straits.

In the early 2000s, many state governments were hit hard by recession
and constitutional requirements to balance budgets.

Reluctant to unwind fresh tax rollbacks, states were forced not only
to cease creating new services but also to cut back on many basics,
such as road repairs and prisons. In 2003, the National Governors
Association reported that states collectively were undergoing the
worst budget crisis since World War II. Even after their economies
and revenue streams recovered in the middle part of the decade, state
governments concentrated on building surpluses and kept spending
relatively in check.

But now, many states are returning to their old ways: along with
spending more, several governors are proposing hefty tax cuts as
well. Like many governors, Arizona Democratic Gov. Janet Napolitano
faced a looming budget shortfall -- $1 billion in her case -- when
she took office in 2003. Now, thanks to strong economic growth,
surging sales-tax revenue and low unemployment, the state has $650
million in reserves.

For fiscal year 2008, Ms. Napolitano has proposed a $10.4 billion
budget that calls for a 6.9% increase in spending on top of the 18%
increase last year. The extra money allows Ms. Napolitano to put tens
of millions of dollars toward her priorities: pay raises for
teachers, 12% more for state universities, and $60 million for
projects to train and attract high-tech workers and businesses.
"Somewhere out there is the next Microsoft," Ms. Napolitano said.
"I'd just as soon that it be in Phoenix or Tucson." Montana's Mr.
Schweitzer, who also faced an austere outlook when he first took
office, is now enjoying a $1 billion surplus, largely due to higher
tax revenues on capital gains and energy production. As he sees it,
states spend nearly all of their money to "educate, medicate and
incarcerate." His two-year, $7.7 billion budget boosts spending on all three.

Legislative analysts peg the budget increase at 26%; Mr. Schweitzer
excludes the rainy-day fund and payments towards pension obligations
and says the jump is closer to 13%. The state's prison system will
see one of the largest increases.

Mr. Schweitzer says Montana leads the nation in the per-capita number
of citizens incarcerated. Because the vast majority of those are for
drug-related crimes, he's proposing a program that would marry the
state's prison system with its Department of Health. The resulting
"meth prisons," as he calls them, would combine incarceration with
intensive rehab programs, which he says would allow for more early
releases and, over the long term, would lower the state's cost of
maintaining its prisoners.

It's an unusual idea, and one he says that the federal government is
unlikely to help finance. "The feds aren't really interested in new
and novel things," he says. Mr. Schweitzer's budget also offers about
$150 million in tax cuts and a $170 million capital construction
program. "The best part is I don't have one dollar of bonding in my
program," Mr. Schweitzer said. "We're paying cash." Another reason
states are loosening their purse strings is to compensate for a
sustained decline in federal revenue sharing.

In the past, the federal government could often be relied on to help
finance big projects such as highways and new state initiatives, such
as antipoverty programs.

But the days of expanding federal revenue sharing have been on the
wane for years. And the Bush administration, with its focus on war
and antiterror spending, has shown little interest in supporting
these efforts. In fact, governors and others say they expect cutbacks
in federal support. "I don't think anyone feels the federal
government is going to be a source of revenue increases any time in
the near future," says Robin Prunty, a credit analyst, who
specializes in state finances for bond-rating firm Standard & Poor's Corp.

In New Mexico, Democratic Gov. Bill Richardson, who is running for
president, is proposing a $5.7 billion budget, 11% bigger than last
year's. The spending plan not only provides more than $100 million in
raises for school employees, but includes some projects he had
originally intended to supplement with federal grants, such as the
state's commuter-rail system. "We had a commitment from the feds for
$65 million but we haven't seen it yet, so I'm putting it in my own
budget," Mr. Richardson says. His budget also includes a $77 million
proposal to expand health care. In many states, universal-health-care
proposals are potentially the most expensive propositions, and none
top the gargantuan plan offered by California's Mr. Schwarzenegger.
His $12 billion health-care plan would insure an estimated 6.5
million people by imposing new fees on doctors and hospitals and
giving $1 billion in tax breaks to individuals who purchase their own
health insurance. Mr. Schwarzenegger is touting his plan over the
objections of many legislators in his own party, who argue that the
program will cause budgetary havoc if the state's economy sours. It
wouldn't be the first time an ambitious insurance plan created fiscal
problems for a state.

Tennessee launched such a plan in 1994 but was forced to painfully
unwind the program in 2005, when it had grown into a $7.8 billion
behemoth that accounted for nearly a third of all spending and
threatened to throw the state into deficit.

The biggest contributor to costs: insuring middle-aged citizens,
especially those with pre-existing medical conditions. They were the
first of the estimated 170,000 Tennesseans to be tossed out of the
program. Scott Pattison, executive director of the National
Association of State Budget Officers, says the Tennessee experience
is unlikely to be an anomaly. While it's relatively cheap to insure
healthy children, "a 52-year-old diabetic is a lot more expensive to
cover," he says. To be sure, some states, fearing a quick reversal of
fiscal fortunes, are trying to keep a lid on spending.

In Alaska, a state that derives much of its revenue from oil
royalties, high energy prices are expected to increase general-fund
revenue to $5 billion this year, from $2 billion in 2003. Yet
freshman Republican Gov. Sarah Palin vowed to limit budget growth to
$3.3 billion, up less than 3% from this year. She points to a recent
legislative report that predicts falling energy prices will result in
declining revenue for the state as early as next year and a potential
$1 billion deficit by fiscal 2010.

Already, there are indications that the flush times are ending.

One early sign: by late 2006, nearly a third of those states
participating in an annual survey by the National Conference of State
Legislatures -- 14 of them -- were either experiencing or expecting
to see a decline in revenue. Moreover, the group says, for the first
time in years, projected spending increases this year seems likely to
outstrip revenue growth, with outlays expect to rise 7.5%, and
receipts, just 3.1%. The obvious solution to flagging revenue is new taxes.

But while many governors seem disposed to spend more, those same
politicians remain largely conservative on taxes.

Big increases, particularly on broad levies like income and sales
taxes, are still considered political suicide.

Instead, states from Arizona and Montana to New York, Florida and New
Jersey have enacted or are considering tax rollbacks. Many states are
looking at other ways to raise cash. In Massachusetts and New York,
Messrs. Patrick and Spitzer are toying with the idea of legalizing
gambling to raise money.

In New Jersey, which already has legalized gambling, Democratic Gov.
Jon S. Corzine is entertaining a wager of another sort: leasing a
portion of the state's turnpike to a private company in order to
raise cash. Governors in Pennsylvania and Texas are considering
similar proposals. The schemes can be a windfall for states: In
Indiana last fall, Republican Gov. Mitch Daniels essentially sold
Interstate 85 under a 75-year lease that garnered a $3.8 billion cash payment.

Now he is proposing to lease the state's lottery in return for a
similar windfall -- as are several other states, including Illinois,
Texas and New Jersey. But lease deals have proven controversial.
Critics fret that states won't properly value the assets or will
strike deals that somehow hinder future growth. Chief among the
critics is the Owner-Operator Independent Drivers Association, a trucker lobby.

The lease deals being considered involve sections of some of the
nation's busiest roadways.

Because the deals almost always include provisions that bar states
from building new roadways that might compete with the toll routes
being sold, future gridlock is all but assured, the group says. In
some states, there's plenty of cash -- at least for the moment.

In Arizona, Ms. Napolitano finds herself allied with the conservative
Goldwater Institute as she tries to beat back a proposal by the
Republican-dominated legislature to raid the state's rainy-day fund
for a $400 million road-improvement program.

Like her Republican brethren, Ms. Napolitano wants to fix the roads.

But she would rather borrow the money and keep the $650 million
rainy-day account for the economic downturn she assumes is all but
inevitable. "When I came in, we had no rainy day fund," says Ms.
Napolitano. "I wouldn't wish that on anybody."