The Bleak Outlook for Our Intergovernmental Fiscal Future

We need a forum for our state, local and federal governments to collaborate on the fiscal challenges they all face. But in today's fiscal climate, it's hard to see that happening.
by | October 23, 2013

The Congressional Budget Office recently issued its latest long-term federal budget outlook, making clear once again that on our current path Washington's fiscal future remains unsustainable over the next several decades. The state and local partners in our federal system will surely be affected by the fiscal ill winds blowing in from Washington. After all, states now rely on federal grants for 30 percent of their revenues. And states face their own fiscal tsunamis, thanks to the same forces -- an aging society and the continuing growth of health-care costs -- that are tearing at the federal budget.

While long-term fiscal changes by definition take time to unfold, it is not hard to find their effects today. Normal fiscal downturns become exacerbated thanks to the growing long-term fiscal pressures that impinge on state and local budgets. The George Mason University State and Local Leadership center just released reports on cities facing the prospects of bankruptcy. These reports reveal that long-term commitments are already having disproportionate effects on those jurisdictions with the weakest economies and budgets, reflected in pension costs that have crowded out other priorities in cities desperate for investment in infrastructure and human capital.

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What is clear is that, crippled by its own fiscal pressures, the federal government will no longer be able to play a significant role in the fiscal futures of states and localities. Indeed, in the next fiscal year the spending caps and sequesters agreed to by President Obama and congressional Republicans in 2011 will lower federal discretionary spending for domestic purposes to their lowest levels in postwar history.

The news isn't all bad. Grant programs to states have escaped the worst effects of sequesters so far. While nearly 70 percent of grant programs are affected by the current sequester, only 35 percent of grant dollars are reduced, thanks to the protection of Medicaid and highway funds from these across-the-board cuts.

And in recent years federal officials have been able to respond counter-cyclically by ignoring their own deficits to help states and localities get out of their own recession-induced fiscal holes through the stimulus program. With over $300 billion in federal assistance, the federal government became part of the state and local fiscal solution, just like they draw it up in textbooks.

However, this pleasant intergovernmental fiscal interlude can't and won't last. Hard-pressed federal officials searching for spending cuts and new revenues are bound to end up in the state and local fiscal backyard. Discretionary and entitlement spending, as well as tax expenditures, will all eventually be on the table. For instance, long-sheltered state and local tax deductibility and tax-exempt bonds have already been targeted by two federal deficit-reduction commissions, most notably Simpson-Bowles. The Domenici-Rivlin task force recommended a national value-added tax which, if not designed properly, could significantly intrude on state and local consumption taxation.

One wishes that these fiscal pressures might induce a new era of intergovernmental cooperation. There are some choices where all levels of government might gain. One example might be in the area of health reform, where cost controls and new incentives might very well drive down health-care costs across all levels of government.

And strange as it may seem, the prospect of a national consumption tax might be another area in which fiscal collaboration could produce a win-win outcome for federal and state governments: States might realize significant new fiscal room by joining with national officials to piggyback on a national consumption tax with a broader base than the shrinking retail sales tax.

However, I am sad to say that scenarios such as these are extremely unlikely. National, state and local governments all are entering a new era of constraints characterized by zero-sum games in which limited resources inspire conflict and cost-shifting, not sharing and collaboration.

As if this weren't enough, partisan polarization has served to heighten intergovernmental conflict and ill will. In fact, it is now increasingly difficult for states to speak with one voice on any issue in Washington. Even when it may not be in their interest, some state officials take positions driven less by near-term fiscal interests and more by party-based ideological positions. Thus, half of the states are holding out on the federal health-reform law's Medicaid expansions, even though participation would give them all fiscal windfalls.

I for one still harbor a fond wish for a new national intergovernmental commission that could become a new platform for fiscal collaboration. Australia and Germany are two federal systems that have active consultation forums that prompt real collaboration on joint fiscal and service-delivery projects.

National leaders in this country need such a forum, since they still vitally depend on states and localities to deliver on most key domestic policies, as health reform once again illustrates. And state and local leaders might find these forums to be a vital new channel to bring about truly national collaborative partnerships. It is, however, difficult to envision the political formula that would bring about such collaboration in our system today.

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