Braving Twin Deficits

State and local leaders face a severe challenge in dealing with the short-term recession while at the same time planning for future fiscal burdens.
by | March 31, 2010

The U.S. Government Accountability Office just issued another snapshot of the long-term future for the state and local sector. It goes without saying that the short-term outlook is daunting. State and local leaders face several years of deficits before the economy fully recovers from the Great Recession. However, even when employment and consumer spending pick up to replenish hard-pressed state and local budgets, the hard choices do not go away.

Instead, like the federal government, states face a long-term future of higher spending and lower revenues stretching out for the next five decades. A good deal of the blame goes to higher health-care costs affecting states through their roles in financing Medicaid as well as health care for their own workforces. The aging of the nation also comes home to roost in terms of higher pension costs down the road and lower revenues thanks to a smaller workforce. Moreover, outdated state revenue systems geared to an industrial economy fail to tap the growth of a technocratic service-oriented economy.

This grim outlook suggests that state and local leaders face the twin challenges today of dealing with the short-term recession while at the same time trying to lower the long-term fiscal burdens faced by future taxpayers. In digging out from the unprecedented budget hole of today, elected officials need to be mindful of the effect of their decisions on the near- and long-term fiscal futures facing their governments. The shadow cast from the future on today's choices makes our current fiscal crisis even more vexing than those in previous recessions.

How should state and local leaders think about these twin fiscal challenges? For one, they should institute a scorecard that projects the medium- and longer-term implications of their budget choices today. For the most part, state and local government budgets are short-term focused. It is rare, for instance, for states to project the five- or ten-year fiscal consequences of current decisions as is routinely done in the federal budget by both the Congressional Budget Office and the Office of Management and Budget. The federal government has recently been producing projections that go out as far as fifty years to raise awareness of the long-term effects of our decisions.

Second, it means that state and local governments should make their near-term choices with an eye to the future. Where possible, they should make their spending cuts and revenue increases in a way that promotes a sounder footing for long-term finances, and avoid taking short-sighted actions that only deepen the long-term hole they will face.

The following chart illustrates a spectrum of choices for revenues and spending based on their long-term fiscal effects:

One only needs to scour recent news reports on state and local strategies to find examples across this spectrum. On the positive side, some state and local leaders subscribe to the view that a fiscal crisis is a terrible thing to waste. In this spirit, states are reducing their prison costs by reexamining sentencing policies. On tax reform, 15 states are in the process of enforcing actions to collect sales taxes for goods sold over the Internet. States like Michigan are consolidating state agencies to improve efficiency and reduce costs. Each of these initiatives promises to not only reduce short-term deficits but reduce long-term fiscal gaps as well.

On the negative side, state and local governments have reached for solutions that may help resolve near-term cash imbalances but at the expense of digging the long-term fiscal hole even deeper. Arizona's plan to sell and leaseback government-owned assets like office buildings qualifies as among the most short-sighted strategies. While private developers provide a handsome short-term cash payoff to the state, the taxpayers and state budget officials are on the hook to pay off what amounts to a new mortgage over periods as long as 40 years.

The Arizona Republic reported that Arizona received $735 million and will have to pay back $1.1 billion. Unlike a mortgage, however, future taxpayers will not obtain a new asset. Rather the state will simply refinance assets originally built by government through lower tax-exempt bond rates at higher private sector interest rates.

Plans by certain states, like Connecticut, to cut contributions to pension funds are another example of short-sighted budget strategies that only borrow trouble for the longer term. Virginia and other states have followed suit, but have balanced out the long-term impact by reforming pension obligations to reduce their long-term fiscal commitment. Of course, it is understandable that public officials would reach for debt-financing schemes when faced with cuts that seem in the short term to be politically and economically unpalatable. Most of us would borrow to keep the lights on if this were the only strategy available to keep our families secure. And our banker might approve a loan under the condition that our future prospects were bright enough to ensure repayment.

In fact, there have been times in our public finances when short-term fiscal gaps were just that -- short term. We could afford to shift deficits forward because we knew that the economy and the budget would be stronger down the road. One thinks of World War II as a case in point -- fiscal borrowing reached all-time highs as a share of the economy. However, borrowing was appropriate not only because the economy was too fragile to pay for the high costs of war from current funds, but also because we had a young, vibrant and growing economy in the postwar period that would enable us to easily repay these obligations.

Facing the prospects of long-term structural imbalances, states have no such assurances coming out of this Great Recession. This is all the more reason to question the wisdom of short-term borrowing and other strategies that will only worsen the longer-term budgets down the road. These budgets have to pass stricter tests than those in previous downturns. And states need to get started in developing models and projections that will enable us all to more clearly see the long-term implications of our choices.

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