Numerous headwinds confront the economic recovery in the U.S. One of the biggest is the states' budget situations. With revenue shortfalls (states experienced an 18% decline in tax collections during the recession) and growing demand for entitlement programs like Medicaid, states are facing an uphill fiscal battle. For fiscal 2011, which begins July 1 for most states, 38 states and Puerto Rico are grappling with budget gaps that total $89 billion, according to the National Conference of State Legislatures. That's nearly $34 billion more than projected four months ago.

To get insight from an ear on the ground, I spoke with the Governor of Virginia, Bob McDonnell, who told me in an interview that Virginia is not projecting a budget gap for fiscal 2011 because of tough spending cuts he's instituted. On the revenue and growth side, business friendly policies and aggressive recruiting have enabled Virginia to record the third highest increase in jobs of any state in the country -- about 28,000 -- over the last 30 days. Such policies have also encouraged companies like Northrop Grumman (NYSE: NOC) to relocate their corporate headquarters (in this case, from California to Virginia). Still, like many states, Virginia still faces tough choices to maintain a balanced budget in years to come.

What follows is an edited transcript of our conversation.

Jennifer Schonberger: I'd like to start off with Virginia's budget. You're coming up on the end of your fiscal year. What are your expectations for fiscal year 2011? What type of budget gap, if any, are you projecting now?

Governor Bob McDonnell: We made a number of major adjustments to the budget at my request back in January and February, cutting $4.2 billion of spending out of the budget to get it in order and position ourselves for a leaner operation, and for economic recovery. It was tough, but we had to do that, given what our revenue picture showed, and given the fact that I had pledged to veto any tax increases, which is not the right policy in this down economy.

We were in reasonably good shape coming out of that budget cycle, and the last couple of months, we've had the first two positive gross revenue months in three years, which is good. We are somewhat optimistic that we're going to finish this fiscal year with a surplus. We're slightly ahead year-to-date right now. If we have flat months the next two months, we should finish with a slight surplus, which is the first time in about three years.

Schonberger: Where specifically are you targeting spending cuts? Which areas?

McDonnell: We made dramatic cuts this year in K-12 education, and in health care. We also made some cuts in retirement system benefits, and then a number of other areas, to a smaller degree ... We cut places that are usually the last areas to be cut -- and they're difficult cuts, because of the opposition from the stakeholders, but I think it was the right thing to do.

If you look at Virginia's spending over the last decade, we've grown spending about 75%, while population and inflation haven't grown nearly that much. In fact, our spending in Virginia, even after these cuts, has grown about 27% faster than the rate of growth of population and inflation. So, as tough as these cuts were, you look at the macro level over the last decade, and it shows us that Virginia, like most states, has spent at a faster clip than the population and inflation indicators would suggest. We felt it was the right policy for Virginia.

Schonberger: Congress is expected to pass legislation this week that would extend aid to states for Medicaid funding. How does this aid potentially change your budget situation?

McDonnell: Like most of the states, we stacked in the likelihood that Congress would extend the FMAP funding for Medicaid. But we also made a fairly significant contingency plan in the budget if Congress did not pass it. So, either way, the way we pass the budget, we are either able to appropriate those monies or make the appropriate cuts.

... Medicaid spending is one of those areas that we are focused on intently. Like most states, I think we have a looming crisis in Medicaid spending. It has run 1600% in 45 years in Virginia. It consumes 20% of the budget, and that's before this recently passed federal health-care bill. With that measure, starting with the dramatic increases in spending we expect in 2014, we're looking at another $1.5 billion of new unfunded Medicaid spending that will be required by the year 2022. So, it is a crisis for the next couple of governors ...

Schonberger: You mentioned you saw positive revenue growth for the first time in three years. What are you seeing now in terms of tax collections? Do you anticipate the recovery that you're seeing to continue?

McDonnell: We're certainly hopeful, Jennifer. We think somewhere around February/March we started picking up a little bit. We had 3% growth in March, and a 0.4% growth in April. As I said, those are the first two back-to-back positive months in three years. So, that's a good sign. May is steady so far, with another seven days to go. We are at least cautiously optimistic that we're getting into very modest, sustained, positive growth territory now in Virginia.

That said, we're one or two bad stock market days away, or a week of bad news out of Europe away from having all those gains wiped away. So, we're not at all saying that we're out of the woods.

Schonberger: Given the consensus for a subpar recovery, the potential chances of a double dip with what's going on in Europe, and the fiscal challenges facing most states, economists are saying that could mean layoffs at the state level in 2011. What are the chances of layoffs for Virginia?

McDonnell: I wouldn't say that that's off the table. We had a fair amount of layoffs during this last year -- about a little over 1,000 employees. In fact, this Friday is a state furlough day, meaning we've had a one-day furlough where most of state government will be off, and that'll save a fair amount of money.

... In a couple of weeks we'll begin to look at every aspect of state government, to find ways to consolidate, to privatize, to innovate, to use technology in order to streamline government and save money. Part of that might mean a targeted reduction in employees in some areas. It'll mean any number of things to help make government run more efficiently and more effectively ... [But] there's no question that during this fiscal year coming up that there'll be some layoffs directly related to our spending cuts -- probably in the health care and education areas ...

But going forward, if we have any layoffs, we hope it'll be because of our strategic realignments.

I'm certainly hopeful that the worst is over, after coming up on 20 months of a recession, that we are starting to turn the corner. Now that we've got our spending under control, I think we are positioned for growth. But as you pointed out, Jennifer, there are things well beyond my control in Virginia, like federal government spending policies, which I think are still bad, like the commercial real estate market, which is still not that healthy, and like what's going on in Europe, in Greece. If it starts to trigger a meltdown of some of the EU economies, we're going to feel the brunt of that.

Stay tuned for Governor McDonnell's thoughts on the health-care bill and a national value-added tax.

Fool contributor Jennifer Schonberger does not own shares of any of the companies mentioned in this article. You can follow her on Twitter. The Fool has a disclosure policy.