States Of Emergency

Gov. Arnold Schwarzenegger is in a jam. Even after $10 billion of proposed cuts, California still faces a $17 billion budget gap. Most voters and lawmakers don't like his plan to fix it by borrowing billions against the state's lottery, meaning the Governator will likely have to resort to raising taxes, something he vowed never to do, and bump the state's sales-tax rate by one cent.

Arnold isn't the only governor facing a killer budget crunch. After two years of surpluses, the housing market and national economy have plunged more than half the states—29, and the District of Columbia—into red ink this spring. Altogether, the total budget shortfall is $42 billion for the rest of this fiscal year and for fiscal year 2009; the biggest gaps are in states where the housing boom and-bust was most pronounced, such as Arizona, Nevada and Florida, which are now coping with too many unsold houses and tanking property values. And the bottom is at least a year away, says Mark Zandi, a chief economist with Moody's. "You have to go back to the Depression to see a decline this big," he says.

Unlike the federal government, states aren't allowed to run deficits, so most are choosing to cut spending rather than raise taxes. That means deep cuts to education and public-health programs, as well as hiring freezes, which has stalled one of the few economic sectors that had been holding strong. Tennessee Gov. Phil Bredesen wants to cut 5 percent of his state's workforce to cover a half-billion-dollar gap; Florida lawmakers, grappling with what they call the state's worst-ever budget year, cut spending by more than $4 billion. All those cuts take a toll. "They tend to hurt the most vulnerable, those who depend on public health care and can't afford private schools," says Iris Lav of the Center on Budget and Policy Priorities.

Economists are predicting a prolonged crisis that could rival the one that began in 2001 and peaked in 2004, when 42 states faced a combined $84 billion deficit. "Everyone's holding their breath," says Scott Pattison of the National Association of State Budget Officers. "We haven't seen the worst yet."