The Check is in the Mail

If the economy turns down this year, will the feds rescue the states the way they did in 2003?
January 2007
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 budgeteers plan for the next fiscal year, they are faced with remembrances of times gone by. When there is an economic downturn, state finances are less than stable, and recent figures show such a slowing is visible in several areas. Housing construction, in particular, comes to mind.

While the slowing may be just a "pause that refreshes," the fiscal bottom may again fall out, leaving state finances vulnerable. In part that's because their tax systems are leveraged so highly on bases that are sensitive to economic changes. For example, the general sales tax base is riddled with exceptions and exclusions that tend to make revenue from the tax hyperventilate with changes in discretionary spending. So, when home buying slows, people spend less on furniture, fixtures and the types of big-ticket items that weigh heavy in the shrunken tax base. Similarly, state income tax systems tend to rely on the biggest earners when they are earning the big bucks. But those revenues wither when capital losses replace gains. Also, states over the years have turned to lesser charges that are cyclically sensitive, such as levies on deeds and property transfers.

But the other vulnerability is on the spending side--Medicaid in particular. This health insurance program for the poor has been the fastest growing segment in state budgets for several years. Recent reports suggest a slowdown this past year--Medicaid spending fell by 1.4 percent in the first nine months of 2006, the first decrease in spending since the program began in 1965. But that change doesn't alter the basic working premise behind Medicaid: When recessions hit and the unemployment rate goes up, the number of eligible persons increases. Between 2001 and 2002, Medicaid enrollments nationally went up by 8.6 percent at the same time that state tax revenues were falling by 7 percent. It is estimated that each newly unemployed person led to an added $300 or so in Medicaid expenditures, on average, during the 2001-02 slowdown.

So, what to do if cyclical economic pressures come calling again? In 2003, the federal government took unprecedented steps to lessen the recession's fiscal blow to the states by passing, as part of a tax cut package--the Jobs Growth and Tax Relief Reconciliation Act--some $20 billion in grants for the states. The assistance was apportioned at $10 billion for Medicaid and $10 billion for general assistance. That $20 billion went a long way in closing the roughly $50 billion in estimated state budget deficits.

Will this benevolence be repeated the next time around? With the long-term declining condition of federal finances, state folks are not holding their breath. Besides, arguments against federal counter- cyclical aid to states are well understood. First, the single-shot appropriation process leads to both delays (which have the assistance arriving after the recession) and divergences. For example, the $10 billion in general fiscal assistance that was adopted in 2003 was allocated on a per-capita basis with the small states getting a floor payment. As a result, states that had high unemployment and weak revenues often got less on a per-capita basis than states that were doing better. A second argument suggests that once the states come to expect a federal handout, they will save less in balances and rainy- day funds.

There are good arguments on the positive side. If the criteria are set right, states can avoid cutbacks in spending--cuts that hit the poor the hardest--or tax increases that stifle recovery. There is a glimmer of interest in counter-cyclical financial aid and much to be said for reviewing the role of counter-cyclical assistance to soften the impacts of a decline.

One thing that has changed over the past 20 years is the states' role in providing health care to dependent populations. Changing demographics and a riskier economy intensify this role, and the costs of delaying or denying basic health care can be both socially dispiriting and personally deadly. With the steady retreat of private health insurance coverage and the slippery footing of lower-income workers, the next slowdown could be worse.

Voters, sensitized to the vagaries of an economy that seems beyond their individual reach and understanding, may support more affirmative actions by governments to address their insecurities. That attitude might be good news for states, which are stuck in the middle of an intergovernmental system where they pick up the tab for costs over which they have little control, using revenue systems designed to rely on continuing growth.