The Effect of Federal Budget Cuts on States and Localities

When the federal government starts reducing its deficit, watch out below!
by | January 2011
 

The electorate made it clear in November: Congress should cut up the federal credit card and restore fiscal sanity. Road maps on how to do that were seldom mentioned. And it’s no wonder, since getting to a balanced budget will be exceedingly painful.

Right now, the federal deficit runs around $1.4 trillion dollars. A big share of that -- $1 trillion -- is cyclical and caused by the Great Recession and accompanying stimulus spending and tax cuts. The remainder -- $400 billion -- is structural or “built-in” to the budget. With the current economy recovering slowly, the federal government raises in current revenues about 57 cents to 63 cents for every dollar it spends. Even in good times, it raises only 90 cents for every dollar spent. Given the existing tax system and the way Medicaid, Medicare and Social Security are designed, that structural deficit is destined to increase steadily. So we’ll have to cut spending, raise taxes or a combination of both.

But what programs do we cut and what taxes do we raise? The answers unleash a political fight too large for this humble column to take on. But we know one thing: State and local governments are deeply tied to federal finances, and they will feel the pain from federal cost cutting and revenue increasing.

In fiscal 2010, $654 billion in federal grants went to states and localities -- an amount that equaled 26 percent of all state and local spending. A big chunk last year represented funding from the American Recovery and Reinvestment Act, payments from which have peaked and are rapidly phasing out, reducing annual payments to state and local governments to about $60 billion. But that reduction in temporary federal outlays does not figure into reducing the “structural deficit.” The $400 billion gap still must be closed. The billions in federal programs directed toward state and local governments -- and the multitude of tax preferences that benefit them -- will provide fertile grounds for filling the deficit hole.

Let’s look at grants, one of which is Medicaid. More of the Medicaid load might be shifted to states, which now annually contribute $150 billion of their own funds to match federal grants of $220 billion. The feds might save $35 billion by making that cost match 50-50 across the board. Meanwhile, federal grant programs for education send $80 billion per year to the states; and another $200 billion to income security, transportation and community development programs. If the feds reduce all grants by 20 percent, a $100 billion revenue hole would be created in state budgets -- but only 25 percent of the federal structural budget gap would be closed.

That’s not even the major danger. Via their taxpayers, states and localities receive indirect benefits through federal tax deductions and credits. These “tax expenditures” (foregone revenues because of preferential tax treatments) amounted to $73 billion last year, including the deductibility of state and local property, income and sales taxes ($51 billion), and the exemption of the interest on state and local bonds and interest from federal income taxation ($22 billion). These preferences are on the chopping block, and their loss or reduction would prove costly to state and local governments whose citizens would find their tax burden increasing.

Finally, there are indirect cost-cutting or tax-increasing measures. Under federal tax laws, homeowners now write off their mortgage interest costs. Over the years, this favoritism has driven up housing prices. Real estate values, now in very bad shape, serve as the foundation for local property taxes. But the feds lose $100 billion or so from the interest deduction. That makes it an attractive target for reducing the federal deficit. But such a step might permanently bend down future growth in housing prices and accordingly, the property tax base.

And there’s more. Expanded use of user charges and sales taxes to enhance federal revenue would mean intense intergovernmental competition for revenues. For example, raising the federal motor fuel tax by 25 cents to reduce the deficit would mean $30 billion in added federal revenues. But that would curb the ability of states to raise such taxes, even in the event of declining revenues. Ultimately all tax collectors go to the same well for water.

State and local officials must prepare for the fiscal Armageddon. This admonition may come as a shock to newly elected governors and state legislators who rode into office astride promises to cut back government. They are likely to find that that job will be done in Washington. Overnight, they may have a lot less money to spend and more needs to spend it on.

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