Digging Out, Planning Ahead

Feb. 17, 2009, was a historic day for the economic relationship between the federal government and the states. The American Recovery and Reinvestment Act, signed into law that day, constituted an effort of unprecedented scope by the federal government to keep states and localities in the business of providing services and to prevent state budget cuts from dragging down the economy.

This step was needed because states and localities generally have to balance their operating budgets no matter what economic conditions prevail, while the federal government can and should run deficits during economic downturns. The new law is sending hundreds of billions of dollars to cash-strapped states and localities. Some of the money is earmarked for very specific purposes, like highway spending or environmental investments. But much of it is relatively flexible aid to keep education, health care, public safety, and other key functions going. From sheriff's deputies in Virginia to child-care providers in Arizona, hundreds of thousands of Americans whose work is financed with public dollars are staying on the job because of the Recovery Act.

Thanks to the Recovery Act, not only have hundreds of thousands of jobs been saved, but millions of Americans have kept their health insurance and the economy is starting to recover. But the crisis has been so severe that the states' fiscal trauma threatens to last longer than Washington's help. The money will run out before state and local governments have fully recovered from the impact of the recession. In fact, as governors and legislatures recently began writing their budgets for next fiscal year -- with projected revenues still far below needs -- the scheduled expiration of Recovery Act funds was their biggest concern.

More fundamentally, the approaching expiration of the Recovery Act's state fiscal aid raises the question of whether the federal government is finally ready to begin treating states and localities like full partners in the business of serving the American people.

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From Hurting States to Helping Them

To appreciate the change of direction that the Recovery Act represents, it's worth a short trip down memory lane to the first half of the George W. Bush administration. Then, a somewhat milder recession was undercutting state revenues and core functions. Two-thirds of the states cut aid to school districts; 76,000 state employees lost their jobs.

But in the Bush era, Congress and the administration took several steps that actually made things worse. They terminated a seven-decade-old arrangement that allowed states to keep a portion of federal estate-tax revenues. They passed new corporate tax breaks that undermined state tax bases. They enacted a No Child Left Behind law that mandated major improvements to local schools but provided insufficient new funding. The major exception to the trend was a onetime, $20 billion dose of state fiscal relief in 2003, which (among other things) averted cuts in state health-care programs that would have cost over 1 million Americans their health coverage. That important step, however, was swamped by the others. All told, the actions and inactions of Congress and the administration cost states $175 billion between 2002 and 2005 -- three times as much as the states spend on higher education in a year. By 2008, federal grants to states outside of Medicaid had fallen 9 percent in per-capita terms from their 2003 peak, after adjusting for inflation.

On the bright side, states' own tax revenues were growing, thanks in large part to a real-estate boom -- which turned out to be a bubble. When the bust came in 2007 and 2008, state revenues started tumbling.

Job losses in every state reduced income-tax collections. Hard-hit consumers cut their spending, causing sales-tax revenues to plummet. Declining home values depressed local property-tax collections. Total state tax revenues in 2009 were between 10 percent and 15 percent below levels in the previous year and even further below the level needed to maintain current services adjusting for inflation and population growth.

Faced with collapsing revenues, rising demand for services, and the legal requirement that they balance their operating budgets, states had few good options. They first turned to their "rainy day" reserve funds, which states had built up to record levels during the expansion, but this was far from enough. By early 2009, governors and legislators were exchanging their budget scalpels for hatchets. Half the states announced cutbacks in health care, two-thirds cut higher education, and three-fourths cut back on their work forces.

These cuts didn't just weaken core public services. They also cost jobs. When states cut spending, they lay off workers, cancel contracts, and reduce purchases -- setting off a ripple effect that further weakens demand. As much as possible, for the good of the economy, the country needed state and local governments to keep operating as normal.

So when Congress and the Obama administration put together the Recovery Act, they included a healthy dose of temporary funding to help support ongoing state spending. This included more federal Medicaid funding and additional funding for education and other services in the form of a new State Fiscal Stabilization Fund.

By July, less than five months after the bill's enactment, states already had spent about $30 billion in fiscal aid. The money not only saved the jobs of teachers and police officers but also supported the earnings of nonprofit service providers, businesses that sell to government, and private-sector health-care professionals whose employers depend on government spending. Without it, last summer states would have laid off more workers and cut even more spending to vendors and others, further damaging the still-weak economy.

Combined with other elements of the act, this infusion of state fiscal aid worked as intended to boost consumer and government spending quickly, helping save the economy from free fall and carrying it through to a fragile recovery. The nonpartisan Congressional Budget Office estimates that the Recovery Act saved as many as 1.6 million jobs by September 2009. Leading private-sector economic forecasters agree that the recession would have been significantly worse without the act.

However, the federal money only closed about one-third of states' budget shortfalls. So states still are cutting jobs and services -- just not as fast as they otherwise would have. The nonpartisan Government Accountability Office surveyed school districts and found that 32 percent were planning to cut jobs, though not as deeply as most would have without the federal aid.

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Unfinished Business

The states' fiscal crisis will not be easily dispatched. Due to falling tax revenues, states faced $110 billion in operating budget gaps for fiscal year 2009, which they addressed with a combination of spending cuts, reserve-fund drawdowns, some tax measures, and the first $30 billion or so in Recovery Act dollars. The gaps for the current fiscal year have been even larger, approaching $200 billion; even after taking into account the increased federal aid, the gap is nearly $125 billion, the largest ever recorded.

State revenues won't return to normal until after the job market recovers, which could take years. At the same time, the need for health care, food stamps, and other state assistance remains high. In some parts of Texas, people needing food stamps have had to wait as long as three months to schedule application interviews, even though federal law says benefits must be processed in 30 days. Plus, more people across much of the country are enrolling in community colleges to improve their job skills because so few jobs are now available, increasing higher-education costs. For all these reasons, state budget shortfalls next fiscal year could reach $180 billion, almost as much as in the current year.

And federal aid will soon run out. The expanded Medicaid support is scheduled to disappear at the end of December, right in the middle of most states' fiscal year. Many states also will have spent most of their extra federal education funding by that time. State legislatures are considering spending cuts that could hit the brakes on the national recovery, based on whether they think Congress will allow the Recovery Act assistance to end as scheduled or phase it out more gradually. Without more aid, there will be more cuts.

States have already slashed their spending in sometimes severe and shocking ways, often harming those already left vulnerable by the recession. Tennessee has stopped signing up new kids in its Children's Health Insurance Program. Hawaii public schools are cancelled on most Fridays this year due to teacher furloughs. The University of California raised tuition by a third and cut enrollment by thousands. Alabama, Florida, and Massachusetts have cut back home-based services for seniors. The cuts will only get deeper.

Meanwhile, many states will also raise fees, excise taxes, and other revenues that hit low- and middle-income families the hardest. Over 30 states have already raised taxes. Responsible state policy-makers will balance spending cuts with tax increases weighted toward the wealthiest households. Though spending cuts and tax increases both reduce economic demand, tax increases targeted to the rich have less of an impact because much of the revenue they generate would have been saved rather than spent. And certainly the wealthiest Americans can afford to pay somewhat higher taxes, given the explosion of income they've enjoyed over the last two decades. Still, the budget gaps that states now face are going to be too large to close with progressive tax increases alone.

Especially to the extent that they rely heavily on spending cuts, state budget actions could cause big problems for the nascent economic recovery. Indeed, investment bank Goldman Sachs cites states' responses to their revenue problems as a key reason why it expects the economy to slow in 2010.

Unfortunately, it won't be easy to convince Congress to extend federal recovery funding, for several reasons. The unemployment rate, only starting to surge when the Recovery Act was enacted, continued to rise in subsequent months, a fact that opponents have used effectively to mislead the public about the act's effectiveness. This will make it harder for Congress to spend even more federal money to follow a course that is working but that many Americans mistakenly believe isn't.

A number of policy-makers have also expressed concerns about the Recovery Act's impact on the deficit. Certainly the act has driven up the deficit in the short term, but its impact on the longer-term deficit is negligible because the measure is temporary. Almost the entire projected deficit over the next 10 years is attributable to three causes: the economic downturn, tax cuts enacted and not paid for under the Bush administration, and the wars in Iraq and Afghanistan. The entire $787 billion Recovery Act accounts for just 3 percent of the long-term deficit.

Another challenge is that many who normally would favor dramatic government action on behalf of the economy and state and local services have done little to defend the Recovery Act, particularly its state aid provisions. Some liberal organizations have focused on the act's shortcomings rather than all the good the stimulus has been doing. Striving for perfection has been the enemy of the good here.

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A Permanent State-Federal Partnership

Politics aside, the debate over extending Recovery Act funding needs to take place in a larger context. This nation needs a permanent partnership between the states and the federal government that kicks in automatically when the economy begins to decline.

As noted, states are required by their constitutions to balance their operating budgets; they can't print money. At the same time, they have to deal with the cruel irony that in bad economic times, the need for what they provide goes up at the same time that available resources go down. The cost of "countercyclical" aid that states provide to struggling families, like emergency income assistance, food assistance, shelter, and health care to the newly unemployed, is designed to increase during downturns. Other state services, like education and transportation, remain important investments for states' long-term economic well-being and are problematic to curtail. Asking states to do the most at times when they have the least isn't good for anyone.

In this recession, the aid to states was enacted about a year after states began to experience serious revenue shortfalls and fiscal problems. In the previous recession, at the beginning of the decade, a much smaller amount of assistance wasn't enacted until nearly two years after the recession had officially ended. Although the need for federal assistance to states during an economic downturn is evident, a lot of political considerations can get in the way of actually providing that assistance.

A better way would be to guarantee states a boost in federal aid when the economy turns down. No more haggling in Washington while the economy sinks and joblessness rises. For instance, the federal share of Medicaid costs could adjust automatically to reflect changes in unemployment so that when joblessness rises, the federal government picks up a bigger share of the cost -- as long as states maintain the program at roughly current levels. Since Medicaid is now the third largest revenue source for states -- just behind sales and income taxes -- this change alone could make a significant difference in how states weather downturns. Federal grant formulas for education and human services also could be adjusted to increase during recessions, with a quid pro quo that states use the money to keep overall expenditure levels roughly intact. Such strategies would protect jobs and services and would have a stabilizing effect on the economy.

And as the economy continues what will likely prove a long, slow march to full recovery, the federal government can take other steps to help state education, health, transportation, and public-safety investments recover. For instance, Congress could change federal law on the taxation of Internet sales, so that states could receive billions of dollars in revenue that are owed in principle but not collected.

States themselves have a role to play here, too. They could stockpile even bigger rainy-day funds and other reserves during expansions, and they need to be a lot more cautious about enacting big tax cuts like those of the 1990s that turned out to be unaffordable. Some states also need to address structural problems in their budget processes such as formula-based revenue limits, caps on rainy-day funds, and an absence of multi-year budgets, all of which hinder state planning for downturns. Such reforms could make it harder for Congress to withhold help in a future recession by claiming that states caused their own problems.

Throughout American history, crises have prompted institutional changes designed to keep them from happening again or to minimize the harm if they do. As bad as this recession has been, it would have been much, much worse without timely federal action. Now, with troubled times still fresh in mind, we should put in place a system that recognizes the importance of maintaining state services in a crisis -- so we're ready next time.

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