Washington and the Fiscal Crisis of the States

The strings on federal stimulus money are making it harder for states to cut spending and balance their budgets. 

By RICHARD RAVITCH

As one whose interest in public service stems largely from the conviction that government can make a positive difference in people's lives, I have found the past year a paradox. From the financial crisis to health-care reform, the federal government has taken on challenges that urgently need to be addressed. Yet despite these actions—and sometimes because of them—the states, which provide most of the services that touch citizens' lives, are in their deepest crisis since the Great Depression. The state crisis has become acute enough to belong on the federal agenda.
New York State faces a budget deficit that could climb to $8 billion or $9 billion in fiscal year 2010-11 and the state could face another deficit in 2011-12 of about $14 billion to $15 billion. The causes of the larger deficits down the road include a drop off in federal stimulus funds, an increase in Medicaid costs, and the planned expiration of a state income tax surcharge, as well as the state's underlying structural deficit.
New York is in a tough spot, but few other states are immune from large and growing deficits. According to the Center on Budget and Policy Priorities, the states have faced and will face combined budget shortfalls estimated at $350 billion in fiscal years 2010 and 2011. Past experience suggests that these deficits will continue even if a national economic recovery takes hold. Moreover, we do not know how robust the recovery will be or what shape it will take. We know only that it will not spare the states the necessity of making acutely painful fiscal choices. New York and other states face draconian cuts in public services, higher taxes, or, more likely, a combination of both.

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The federal stimulus has provided significant budget relief to the states, but this relief is temporary and makes it harder for states to cut expenditures. In major areas such as transportation, education, and health care, stimulus funds come with strings attached. These strings prevent states from substituting federal money for state funds, require states to spend minimum amounts of their own funds, and prevent states from tightening eligibility standards for benefits.
Because of these requirements, states, instead of cutting spending in transportation, education, and health care, have been forced to keep most of their expenditures at previous levels and use federal funds only as supplements. The net result is this: The federal stimulus has led states to increase overall spending in these core areas, which in effect has only raised the height of the cliff from which state spending will fall if stimulus funds evaporate.
Until recently, some people predicted that the stimulus funds would not evaporate—that instead the federal government would rescue the states once more with another stimulus bill. But the prospect of this kind of help looks doubtful as an increasing number of lawmakers in Washington worry about the federal deficit and seem intent on taking serious steps to rein it in.
If those steps include neglecting the fiscal situation facing the states, the country could be headed for fiscal problems that are larger than the ones we face now. We are in a time of extraordinary economic change and Washington is struggling with the sometimes-conflicting demands of the federal deficit and the unemployment rate. But the states' growing deficits present their own urgent national problem that the federal government must place in the balance.
Federal policy makers do not have the option of assuming that the state fiscal crisis is temporary or will cure itself without further involvement by Washington. This crisis reflects the growing long-term pressures on the states from the health-care needs of an aging population and the maintenance needs of an aging infrastructure. Moreover, the $3 trillion municipal bond markets have begun to notice the states' deficits: Moody's recently downgraded the bond ratings of Arizona and Illinois because of the deficits those states face. The rating agency says it is waiting to see whether New York will reduce its budget gaps and has warned the state against trying to do so solely through one-time actions.
It seems almost inevitable now that the states' fiscal problems will have further effects on capital markets, possibly as soon as next spring and summer. If more cracks appear in the capital markets that handle municipal bonds, the U.S. Treasury and the Federal Reserve will be faced with an unattractive set of options: They can allow those markets to deteriorate or use federal tax dollars to shore them up and thereby increase the federal deficit.
It is safe to say that one way or another events will force federal policy makers to spend money in response to state deficits. Federal officials shouldn't wait for an emergency to begin to address two questions: Which services should the federal government provide and which should the states provide? And how should the costs of these services be split among federal, state, and local tax bases?
For example, Medicare, not Medicaid, is the primary payor of health-care costs for the elderly and disabled. About 17% of Medicare beneficiaries are low-income and, thus, also receive varying levels of state Medicaid benefits. These "dual eligible" beneficiaries account for some 40% of state Medicaid spending.
For these beneficiaries, the current system is a nightmare: They disproportionately suffer from chronic diseases but must navigate two separate bureaucracies and sets of rules in order to receive care. For the states, this system is a costly burden. From the perspective of a rational health policy, the system is an anachronism. It developed when Medicare did not provide income-based aid and did not have income-based information about those it served. Medicare now provides such aid and has the information and capacity to provide these benefits more effectively, with more potential for cost containment, than the current system.
A federal takeover of services to dual eligibles would cost about $70 billion per year. For many states, a share of this amount would be the difference between chronic fiscal crisis and a chance at structural budget balance. After the Troubled Asset Relief Program and health-care reform—with the cost of the latter estimated by the Congressional Budget Office at almost $900 billion from now through 2019 and $1.8 trillion in the 10 years from 2014 through 2023—the bill for such a takeover does not seem huge or disproportionate to the relief it would provide to state budgets.
Those of us responsible for the states' budgets have the unpleasant duty of imposing greater burdens on our citizens before we can reach legitimate balance between revenues and expenditures. It is not unreasonable for us to hope that federal policy makers will treat our state deficit problems with the same seriousness with which they are now preparing to address the national deficit.
Mr. Ravitch, a Democrat, is the lieutenant governor of New York.