These states are a bigger fiscal mess than Illinois

David L. Ryan | The Boston Globe | Getty Images

A Boston public school student holds a sign while protesting proposed school budget cuts in Boston on March 7, 2016.

It's hard to imagine a state in worse financial shape than Illinois.

But three others face an even bigger fiscal mess, based on an analysis Wednesday from researchers at George Mason University.

Illinois lawmakers have set a pretty low bar. Late Tuesday, they failed in the latest, last-ditch effort to break a nearly yearlong stalemate that has left the nation's fifth-largest state without a budget. The relentless gridlock in Springfield has forced service cuts and threatens to close schools and colleges as the state enters a second year without a spending plan.

"We are like a banana republic," Republican Gov. Bruce Rauner told reporters late Tuesday after the latest budget standoff with the Democratic-controlled legislature. "We can't manage our money, and employers don't have any confidence in us. They won't come here unless we can get our act together and balance our budgets."

But as bad as things are in the Land of Lincoln, three other states are in worse fiscal shape, according to an analysis released Thursday by the Mercatus Center at George Mason University.

Connecticut, Massachusetts and New Jersey are coping with even bigger problems thanks to large accumulated debts, underfunded pensions and looming deficits, among other measures of fiscal health, the researchers found in an analysis of the latest state financial statements available.

Despite the wider recovery in the U.S. economy, state budgets have yet to recover from the damage inflicted by the loss of tax revenues during the Great Recession. As the job and housing markets have improved, many states have seen income and property taxes rebound.

But overall, the money states have to spend has yet to recover to pre-recession levels, according to a recent report from the Government Accountability Office. Based on that analysis, total state tax revenues — as a share of gross domestic product — won't recover to 2007 levels until 2047.

And despite spending cuts, many states face widening deficits as the rising costs of Medicaid and pensions continue to rise faster than economic growth boosts sales, income and property taxes. Those state-funded health-care costs will rise from about 4.2 percent of GDP in 2015 to 6.3 percent of GDP in 2064, the report forecast.

To close that long-term budget gap, the GAO estimates that states will have to cut spending (or raise taxes, or a combination of both) by 5 percent every year for the next 50 years.

Instead, many states have borrowed money or simply not set aside what's needed to make good on pension promises to current future retirees.

As of 2013, the latest data available, states owed $968 billion in unfunded pension benefits, or some 6.9 percent of total state-level personal income, which is a benchmark for their ability to make good on those payments, according to a report by the Pew Charitable Trusts. States also reported $587 billion in unfunded retiree health-care liabilities (4.2 percent of personal income) and $518 billion in outstanding debt (3.7 percent).

For the moment, none of the 50 states are in danger of defaulting on that debt, as Puerto Rico recently did, forcing Congress to step in with a proposed rescue package that includes a federal takeover of the territory's finances. (The bill has yet to be approved.)

But rising health costs and heavy debt loads have left states like Illinois showing "serious signs of fiscal distress," according to Mercatus researchers Eileen Norcross and Olivia Gonzalez, who analyzed the financial statements of all 50 states and Puerto Rico.

"Though the states' economies may be stronger than Puerto Rico's, allowing them to better navigate fiscal crises, their large debt levels still raise serious concerns," they said.

They found that three states — New Jersey, Connecticut and Massachusetts — are in even worse shape than Illinois. (Illinois ranked fourth from the bottom, and Kentucky ranked fifth, edging out New York from fifth place in last year's Mercatus analysis.)

Each of the three states at the bottom of the list share similar problems with large debts, big deficits and huge unfunded pensions and health-care liabilities. Here's how they're coping:

New Jersey

New Jersey's fiscal mess lands it third from the bottom on the Mercatus list, thanks to a budget deficit that could top $1 billion over the next two years.

Republican Gov. Chris Christie has proposed closing the gap with spending cuts and a small budget surplus. But the gap doesn't reflect the state's large unfunded pension liability, estimated at nearly $55 billion.

In 2014, Christie closed a budget gap by paying less into the pension fund than required by a 2011 law, prompting labor unions to sue the state. Last year, the state Supreme Court ruled that it was up to Christie and the legislature to figure out how to make up the pension funding shortfall.

The Democratically controlled legislature then approved a budget with tax hikes to help close the pension gap. Christie then used a line-item veto to rescind the tax hikes and restore the pension cuts.

Massachusetts

Massachusetts lawmakers are working on a final state budget proposal after the state Senate last week approved an overall $39.5 billion spending plan for the fiscal year that starts July 1.

The budget includes new spending for education, local aid and social services. But past budgets have left the Commonwealth with deficits that were covered by borrowing, leaving a debt pile of $26.7 billion and long-term liabilities of more than $6,200 per resident, more than double the national average.

With just 62 cents on the dollar set aside to pay its pensions, Massachusetts faces a shortfall of $94.5 billion. Together with a $15.3 billion shortfall in funding for other retirement benefits owed, the Bay State is more than $1 trillion short of what it needs to keep its promises to retirees.

Connecticut

Last month, Connecticut's lawmakers approved a $19.7 billion budget that closed a nearly $1 billion deficit for the 2016-17 fiscal year that begins July 1. The state's income tax revenue has fallen short of forecasts, even though residents of the Nutmeg State bear the second-highest tax burden per capita in the country. (New York is the highest.)

The budget plan includes the sale of another $510 million in general obligation bonds, which will cost more in higher interest payments thanks to a recent downgrade in its credit rating. The state has one of the worst funded public pension systems in the country, having set aside only about 52 cents on the dollar for what it owes.

Both Fitch Ratings and Standard & Poor's downgraded Connecticut's general obligation (GO) bonds to AA- from AA, still a high investment grade, with a stable outlook.

With taxes already relatively high and widening deficits looming, Fitch and Standard & Poor's said the state has little financial breathing room if the economy weakens.