No Help From Higher-Ups

The states can expect to bear the fiscal burden of major changes in federal taxes and domestic spending.
January 2005
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

As state and local governments enter into the budget process, they have their hands full, but only in the figurative sense. Yes, states are seeing recovery of revenues from the lows of 2003, but those collections are at 1990s levels. Plagued by worm-eaten tax systems and relying on jury-rigged revenue-enhancers, many states are stuck with borrowing to deal with so-called "structural" deficits.

But not all the problems--nor, for that matter, the biggest ones--are to be found "down on the farm" of the individual states. No, it is in Washington, D.C., that the biggest fiscal worries for states and localities are cropping up. To stanch the outflow of the huge deficits it is running up, the federal government is moving to curb domestic spending, a component of which is aid to state and local government. In addition, President George W. Bush wants to overhaul federal taxes to encourage private savings and promote the ownership society. That reform looks like it will depend on removal of the deductibility of state and local taxes--worth about $45 billion a year in forgone revenues--to help finance the desired changes.

Put together, these initiatives represent a major transformation in fiscal federalism. They are also the cutting edge of a broad movement flowing from the recent election that is intent on rebalancing national priorities--leveling the playing field when it comes to the private sector and governments and abandoning the notion that governmental activities are inherently meritorious and deserving of special treatment.

What does this mean for states and localities? Federal budget cutbacks mean that most aid programs not only will not grow but that cuts are required. Individually, the slices will be small, but they will add up. Federal domestic discretionary spending is scheduled by the administration to be capped at a growth rate of 1 percent a year. Since the nation's population is growing at that rate, that means overall spending in real (price-deflated) terms will shrink at the rate of inflation. But those cuts will hardly make a dent in the deficit, which is propelled by the major entitlement programs, Medicaid and Medicare. Nobody knows for sure, but the growing federal deficits projected in the future will likely push up inflation rates and interest rates. As the deficit swells, so will the annual cost of financing the federal debt.

Loss of state and local tax deductibility from federal income taxes presents something of an irony. Almost 20 years ago, as part of the 1986 tax reform, the sales tax lost its deductibility from federal income tax. However, tax "itemizers" retained the ability to deduct property and income taxes on their federal returns. Just last October, a federal corporate tax cut bill was signed into law that restored the deductibility of the sales tax from federal taxes for the eight states where no income tax is levied. Now, a couple of months later, all state and local tax deductibility is at stake as the notion of a federal flat tax moves up on the administration's reform agenda.

Loss of deductibility would help realize a vision of fostering full- blown tax competition among the states and, of course, between state and local government and private providers of services. For starters, it is likely to strengthen resistance to state and local taxes. For higher-income taxpayers, such taxes will be more expensive on an after-tax basis. This likewise will encourage the provision of services by the private sector as an alternative. If you are among those fed up with oppressive government and its burdensome taxes, then that is a pretty attractive result.

The sizing back of federal aid to the states and localities will help bring federal tax changes into bold relief. No one believes that the federal government can continue to provide the level of intergovernmental transfers it is now providing the states (currently about $400 billion). Of that amount, 45 percent represents Medicaid, the fastest-growing item in state budgets. With Medicaid such a big- ticket (and growing bigger) item, other aid programs cannot be sustained at current levels of federal taxation. The fact that federal taxation is at its lowest level as a percentage of GDP in over two generations appears irrelevant. Making the four recent federal tax cuts permanent (or incorporating those cuts into a new "revenue- neutral" tax system) will force ongoing cuts in domestic programs.

One need not be wild-eyed to see that there are seismic changes taking place in the way the nation both views and finances government and that this new vision extends to all levels of government. In a nutshell, the emerging vision sees fewer areas where governments have a constructive role to play, with priority to national defense and homeland security (and perhaps a little pork for the faithful in Congress). That leaves out a lot to which we have been accustomed. The next few years will determine if the majority of voters believe, when faced with a rapidly changing economy as well as a dangerous world, that is enough of a mission for government at all levels.