(FORTUNE Magazine) – Life in the executive suite may get a bit easier when the economy finally picks up, but not for many state and local budget planners -- nor for most taxpayers. Governors and mayors, facing growing demands to fix neglected bridges and roadways, make streets safer, improve education, and take care of the sick and homeless, are threatening drastic cutbacks. At the same time, taxes are headed up (see table, following page). The seeds of the trouble were planted well before the recession, and the problems will remain with us for years, through bad times and good alike. Part of the public dissatisfaction comes from expectations built up during the past decade. Until last year, most state and local governments were healthy enough to cope with whatever problems came their way, especially compared with big brother in Washington. While the federal government plunged ever deeper into red ink, states and municipalities ran a combined operating surplus that reached 3% of receipts in 1984-85. Counting the excess in their social insurance funds -- just as the federal budget includes the Social Security surplus -- they were in the black by more than $60 billion. Even late in the decade, state and local deficits -- including both current and capital spending -- were modest. Meantime the federal deficit soared past the $200 billion mark. The states did not stint on spending, either. Real outlays for payrolls, goods, and purchased services grew an average of 3% a year. Welfare and other transfer payments expanded at an even faster 4.5% pace. And public works projects financed by borrowing -- school buildings, water treatment plants, and the like -- seemed to be in progress everywhere.

THE STATES and localities managed this fiscal performance even as they were losing support from the federal government. With the demise of revenue sharing, among other Reagan-era cutbacks, total grants fell from 23% of receipts in 1980 to 16% last year. What's more, the cost of federally mandated programs grew faster than the grants earmarked to pay for them. As a result, income and health programs such as Aid to Families With Dependent Children and Medicaid now absorb 60 cents of each dollar in grant money, compared with less than 40 cents a decade ago. This forced devolution unleashed a lot of energy at the state and local level, says Steven Gold, who heads a think tank for studying states at the Nelson A. Rockefeller Institute of Government in Albany, New York. Largely as a result, says Gold, ''states are where the action is for domestic policy.'' He points out that innovative programs on the environment, economic development, and education are coming out of the states, not Washington. All that creative energy is sure to pay more dividends in the long run, but right now the crisis is overwhelming it. States can no longer shrug off reduced federal aid. By the first quarter of this year, operating deficits -- leaving aside untouchable surpluses on social insurance funds -- mounted to more than 5% of total receipts. The fiscal mess that states like New York and California find themselves facing is echoed less severely elsewhere. Says Henry Aaron, a government finance expert at the Brookings Institution: ''You have to go back to the Great Depression to find similar anguish in terms of the number of states that are facing unprecedented cutbacks in services or significant increases in taxes.'' $ Many of the woes began with overly optimistic revenue expectations when the states planned their budgets. According to an April survey by the National Association of State Budget Officers and the National Governors' Association, 29 states now find that tax collections for this recessionary fiscal year, which ends June 30 for most, will be lower than they initially estimated. And 45 report spending more on Medicaid or AFDC than they anticipated, forcing cuts of $8 billion elsewhere from budgets already enacted. Twenty-six raised taxes by $10 billion. Year-end balances in their general funds, which state governments watch as a guide to fiscal health, are expected to fall from nearly 5% of expenditures in 1989 to barely 2% this year.

TO KEEP the cupboard from getting even barer, governors of 23 states have proposed tax increases for fiscal 1992, designed to bring in another $6.6 billion. Many 1992 budgets were submitted with the hope that a recession would be avoided. Thus, receipts are likely to fall short again, and expenditures to increase more than the 4.8% now budgeted for. Fiscal expert Hal Hovey, editor of State Budget and Tax News, fears that as the year unfolds, tax increases could mount to twice the original requests -- or more. Hovey thinks that the governors won't ask for all the increases but instead will wait for legislators to make the requests, especially in states such as California, New York, and Texas that have the biggest holes to fill.

The other side of the coin, says Hovey, is that states are postponing or killing new initiatives. All plans for universal health care are either gone or reduced to demonstration programs, and at least seven states are debating proposals to cut back on welfare by reducing payments or by eliminating from the rolls people under 65 with no children. Among the few exceptions to the pattern: plans for school reform in Arkansas and in Texas as well, where that state's supreme court has mandated changes. Even when the economy begins to recover, life will remain tougher than before. With the federal government committed to holding down discretionary domestic spending for years, the states and localities will continue to feel the pressure to satisfy growing demands for services. It won't be easy. First, taxes don't produce the revenues they used to, says Robert Rafuse of the Advisory Commission on Intergovernmental Relations in Washington. On average these days, state income tax receipts increase about 1.25% for every 1% rise in personal incomes, vs 1.6% before the tax revolts. The decline reflects what economists call the elasticity of income taxes, and it is the result of both reforms and demographic changes. Tax rates are flatter, some states use indexing to protect taxpayers from inflation, and the growing number of elderly means a greater proportion of income is taxed at lower rates. Second, even the most creative governance cannot overcome growing needs for outlays. The aging population requires more health care, the mini-baby boom of the last few years means more teachers and schools, and aging infrastructure must be replaced. So states will be forced to come back to those taxpaying voters more often in the 1990s.

AT THE TOWN and county level, many budgets are still in disarray from the aftermath of the boom and bust in housing prices. Local governments depend heavily on property tax receipts, which grew like weeds on the lawn during the expansion. Despite the tax revolt which started a dozen years ago with California's famous Proposition 13, continually rising property values kept tax collectors fat and happy until about last summer. Now, with values down in some sections of the country, local governments are asking for rate increases, and troubled cities like Boston are considering ways to override statutory limits on property taxes. Because of such measures, total property taxes will increase about 6.5% in the next year -- roughly the same as in the year before -- despite the overall flattening of home values. As state officials return again and again asking for more, they could face a new tax revolt. No superexpansion is likely to save the bacon this time. FORTUNE's forecast is for the economy to grow at less than a 3% annual pace later this year and next, compared with growth of at least twice as much in the early quarters of most recoveries. One reason will be the fiscal drag from -- you guessed it -- state and local governments. They will increase real spending by only 1.5% over the next year, vs. 3.5% during 1990. At the same time, higher state taxes will kick in. The combination will pare operating deficits and dampen the economy much as the shrinking of the federal deficit will, though on a smaller scale. John Maynard Keynes, where are you now that we need you?

BOX:

THE ANNUAL budget dance is in full swing in most of the 50 states. Like their federal counterpart, state budgets are proposed by the chief executive, but legislators have a major say about the final product. This table is based on the proposals submitted by governors to their legislative bodies. But many of those are only starting points for negotiations: A number of states are likely to raise taxes more than shown here. Legislatures have been known to turn down new taxes too, but that is less likely in this time of distress. In 46 states the fiscal year begins on July 1, though budget agreements often lag behind. The general trend of tax changes is clear even from this preliminary tabulation. Twenty-three governors propose raising one or more taxes. Recent increases in federal excise and motor fuel taxes have forced many states to curb the use of these sources for new revenues. Though 15 have added to taxes on cigarettes, liquor, or gasoline, they are asking for only a fraction of the increases in fiscal 1991. Instead, ten governors have requested added miscellaneous taxes and fees. Twelve have proposed changes in personal income taxes, including Lowell Weicker, who wants to collect tax on earned income for the first time in Connecticut's history -- and intends to lower corporate and sales taxes in exchange. Seven other governors have asked for higher revenue from corporations, but 15 are looking for more sales or personal income taxes -- five hope to raise both. The dubious prize for the biggest tax-booster: Kansas Governor Joan Finney, who wants to broaden the sales tax base to include a vast array of professional services. States planning tax increases are in yellow. Unless otherwise noted, rates in the personal income tax column refer to earned income.

BOX: OVERVIEW

-- Twenty-three governors plan to raise taxes so far, and others are likely to follow. -- State and local spending will grow just 1.5%. -- Budget woes will slow the economic recovery.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART CAPTION: STATE AND LOCAL GOVERNMENT FINANCES TAXPAYERS AREN'T TAKING IT WELL Speaking for millions, a Houston woman shows how she feels about higher state and local taxes and shrinking services. The deficits here include spending on public works that are financed largely by borrowing.

CHART: NOT AVAILABLE CAPTION: WHAT THE STATES PLAN FOR TAXES IN FISCAL 1992 CREDIT: FORTUNE TABLE/SOURCES: COMMERCE CLEARING HOUSE; NATIONAL ASSOCIATION OF STATE BUDGET OFFICERS; VARIOUS STATE BUDGET AND TAX DEPARTMENTS

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART CAPTION: ALWAYS A GROWTH INDUSTRY Its share has fallen, but state and local employment still accounts for one in seven paychecks -- and the proportion is climbing again. STATE AND LOCAL PAYROLLS