INDIANAPOLIS | Fixing a broken unemployment insurance system. Streamlining local government. Taking -- or not taking -- the next step toward amending caps on property tax bills into the state constitution.

Those are some of the contentious issues state lawmakers are likely to wrestle over in the four-month legislative session that starts Jan. 7. But the only thing they are required to do -- enact a new, two-year state budget -- is likely to be their biggest challenge given a recession that's already taken a big toll on Indiana's economy and pocketbook.

Gov. Mitch Daniels already plans $767 million in cuts to the current budget that expires June 30 in hopes of keeping it balanced, and he and legislators expect to have little new money to work with as they draft a spending plan.

Leaders in the Democrat-controlled House and Republican-ruled Senate are showing a spirit of cooperation -- at least for now -- as they brace for the challenge of passing a budget that does not spend more than the state expects to take in.

"We've had recessions before, but this one looks deeper and longer," said House Speaker Patrick Bauer, D-South Bend. "I don't think anyone wants to be perceived as playing games with this problem."

Indiana is in better financial shape than many states despite a grim fiscal forecast. The state has $1.4 billion in its main checking account and reserves -- a cushion Daniels wants to preserve -- and there is no talk of major teacher layoffs or a general tax increase to ensure the next budget will be balanced.

"There is panic among policy leaders in other states," said House Minority Leader Brian Bosma, R-Indianapolis. "There's no panic here. We'll get through this."

As usual, lawmakers will make funding for public schools a top priority. Bauer hopes legislators can find enough money to provide an overall spending increase for K-12 education, but Senate Appropriations Chairman Luke Kenley, R-Noblesville, has said it might only be possible to keep funding at current levels.

Daniels, who will be sworn in for his second term on Jan. 12, already has suggested that two of his top education proposals -- expanding full-day kindergarten and creating a new college scholarship program -- may have to wait. And he said simply preserving funding for schools at current levels would be a "great victory."

But he says the state can move forward in other ways.

Daniels wants lawmakers to approve proposals to streamline local government, including eliminating Indiana's system of counties having three-member boards of commissioners in favor of single county administrators. He also will push for school districts with fewer than 1,000 students to combine their central operations with another district unless they already are part of a countywide district.

Daniels said creating a top county executive would be a starting point for many of the other local government changes suggested last year by a state panel led by former Gov. Joe Kernan and Indiana Supreme Court Chief Justice Randall Shepard.

He also wants to transfer the duties of township governments to counties. He said the changes would reduce local bureaucracy, eliminate confusion and save taxpayers money.

"I'm sure there are people who will say, `Oh my gosh, the budget is all we can do,' and I'll be arguing to the contrary," Daniels said. "These are changes that don't cost money. As a matter of fact, they will save money or allow the money to be spent more for the benefit of the public."

But Bauer says lawmakers should concentrate on more pressing priorities, such as the budget and what he calls a broken unemployment insurance trust fund. Several years ago lawmakers raised benefit payments for the unemployed and lowered premiums employers pay into the system, which has drained what was once a huge surplus in the fund.

The state recently asked the federal government for a loan of up to $330 million so it can make payments through at least January, but the imbalance between benefits and employer payments remains at a time when the unemployment rate in Indiana is 7.1 percent. The Daniels administration, key lawmakers and groups representing business and labor have been discussing ways to fix the system, which Bauer and the governor say must be dealt with this session.

Daniels and fellow Republicans in the House and Senate also want to advance efforts to amend caps on property tax bills into the state constitution by passing a resolution a second time. Doing so this year or next would put the measure before a statewide vote in November 2010.

Under a law enacted last session, property tax bills on homeowners in 2009 are limited to 1.5 percent of their home's assessed value, with 2.5 percent limits on rental property and 3.5 percent on business property. In 2010, the caps on homeowner bills would drop to 1 percent of assessed value, 2 percent for rental property and 3 percent for business property.

The phased-in caps are projected to save taxpayers an estimated $229 million in 2009 and $524 million in 2010. But that is money school districts and local governments won't collect, although lawmakers steered an extra $120 million to schools over the next two years to soften the blow.

Senate President Pro Tem David Long, R-Fort Wayne, worries that the resolve to amend the constitution might weaken unless lawmakers pass the resolution a second time in 2009. Putting the caps in the constitution would prevent judges from striking them down and make it more difficult for future legislatures to undo them.

"We think it's important to move forward and press forward immediately and not wait and listen to the hues and cries of the local governments because there is some belt-tightening going on throughout the state," he said. "We understand that and we knew that was coming, and so did they."

Bauer said lawmakers should wait until 2010 to consider passing the resolution a second time to allow time to gauge the caps' impact on local governments and the services they provide.