The nation’s governors were hoping for good news a few weeks ago when President Bush announced his economic plans. But except for a modest proposal on unemployment insurance, they were left out in the winter cold.
With their budgets facing the most serious crisis since World War II, the governors had been lobbying hard for federal help. What they really wanted was at least a short-term resuscitation of federal revenue sharing, which ended in 1982. They would have settled for a change in the federal reimbursement for Medicaid, which could have eased some of the pressure on state budgets. They got neither. Bush instead advanced a bold stroke to restructure the federal tax system, removing even the modest $10 billion aid package for the states that his advisers had discussed. The states are left on their own with a budget hole of $90 billion, which threatens to soak up the entire short-term economic stimulus Bush proposed.
So what we’re likely to get is an economic wash and political conflict. Who’s at fault here? The feds, for failing to extend a helping hand when the states need it most? Or the states, for digging themselves into a hole and whining when Bush refused to lift them out of it?
The answer is a bit of both. If Bush truly were interested in jump-starting the economy out of its lethargy, pumping money through the states would be a quick way of doing it. But it’s clear that long-term revision of the tax code is far more important to him than short-term economic stimulus.
The states must plead guilty to having hitched their spending to the boom economy of the 1990s. They forgot “Stein’s Law,” derived by the late economist Herbert Stein: “Things that can’t go on forever—won’t.” When the economy collapsed, states found themselves hooked on spending increases they couldn’t support.
Then, at precisely the same moment revenues collapsed, health care costs exploded. Spending for doctor visits, hospital stays and, especially, prescription drugs, swelled at the highest rate in a decade. Health care expenses now constitute 30 percent of state spending. In 2002 alone, Medicaid costs rose 13.2 percent, compared with just 1.3 percent for state spending as a whole. These health cost increases have all but swamped states’ efforts to control the rest of their budgets.
The Bush tax proposals, should they become law, threaten to further aggravate the problems. State and local bonds are exempt from federal taxation, which allows these governments to borrow in capital markets at low rates. If the administration succeeds in its effort to create an exemption for corporate capital gains income as well, the advantage of investing in state bonds will decrease, and state borrowing costs will go up. And because, in the interest of tax simplification, most states have tied their income taxes to the federal code, eliminating federal taxes on capital gains would automatically eliminate state taxes on those same gains, costing state treasuries even more money.
All these forces—state spending pegged to unsustainable revenue growth, the sudden increase in health care costs and the risk of further revenue erosion from the Bush plan—threaten a profound crisis for state policy makers. Aggravating it is the projection of most economists that the U.S. economy will not grow fast enough to bail out the states anytime soon.
In the end, the states will still need some form of help from the feds to put their budgets back on a stable footing. The big monster in the states’ budgetary basement is health care: treating the uninsured, providing long-term care for the elderly and subsidizing prescription drugs. As the Baby Boomers approach retirement, all these expenses promise to grow. Without federal action to manage health costs, that budgetary problem may be beyond the capacity of even the most fiscally prudent state government to solve.
We are a long way from the salad days of federal-state relations in the 1960s and early ’70s. At that time, the feds saw state and local problems as their own. Democrats and Republicans joined together to provide federal funds to leverage state and local action. The partnership might have been paternalistic, but it shaped policy for decades.
When budget deficits hit in the late 1970s and early ’80s, federal-state ties became increasingly frayed, and they have been frayed ever since. They further unraveled last year with the Bush administration’s loosening of air-pollution regulations, which complicated the job many states face in meeting pollution standards. The current tax plan makes the situation worse.
The states can—indeed, they must—deal with some of these problems by putting their spending back into balance with a realistic view of their revenues. They need to update their tax structures. But it’s hard to see how they can solve their fundamental fiscal problems without some new partnership emerging between themselves and the federal government.