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Fiscal policies and a weak economy fray U.S. federal When the federal government tries to both cut taxes and wage war it squeezes the states. BY ROBERT AGRANOFF The war with Iraq and the “war” against terrorism internationally have lowered the visibility of a domestic economic situation that cuts at the very core of the United States federal system. At the federal level, the Bush Administration has proposed large tax cuts to stimulate the economy, a return to deficit spending and revamping of health care programs. The states are facing a combined $30 billion shortfall this fiscal year, and an anticipated combined deficit of $82 billion in the fiscal year that begins in July. Since virtually all states are constitutionally prohibited from running non-capital fund deficits, their only recourse is to reduce services and raise taxes. State fiscal policies are closely tied to federal actions in taxing and spending and state governments have to meet the costs of federal program requirements. And so state governors have sought federal help. making the Michigan Governor Jennifer Granholm: tough times, hard choices. “temporary” 2001 tax cuts permanent. The administration estimates that federal revenue would shrink about $1.8 trillion seeking reductions in other areas, along with deficit spending. through the year 2013. Historically about one-third of the The Bush administration is hoping that the combination of low federal budget pays for all domestic discretionary programs interest rates and large budget deficits will provide a huge (education, disability services, housing, transportation); one-boost to a slow economy. third so-called “entitlement” programs (social security, Medicare, Medicaid) and one-third is allocated for defense Federal tax changes hit statesspending. Given the current international situation defense Among recent federal actions that have had a big fiscal impact spending cuts are unlikely so the federal government is on the states was the repeal of the federal estate tax. About 35 states have been using a “pick-up” provision where their Robert Agranoff is Professor and Associate Dean Emeritus, tax on estates or inheritance is a payment taken as a credit School of Public and Environmental Affairs, Indiana University against the federal payment, a revenue source for the states of Bloomington and is Chairperson, Research Committee on about $6 billion in 2000. Federal repeal means that states must Comparative Federalism, International Political Science Association. Federations Vol. 3, No. 2, May 2003 “decouple” their receipts and pass new tax laws or these receipts will disappear by 2004. Most states with an income tax use the federal definition of adjusted gross income for purposes of simplification. The proposed elimination of federal taxes on capital gains would automatically eliminate state taxes in that arena. State and local bonds are exempt from federal taxation, which allows the states to borrow for capital programs at low rates. If corporate capital gains income taxes are Governor Gray Davis (California): “Recession has forced us into the red.” eliminated, there will be less advantage in investing in state bonds, and state borrowing rates will increase. The well-respected Center on Budget and Policy Priorities estimates that 11 of the administration’s tax cut proposals will cost the states up to $64 billion in revenues over the next 10 years. Between 1990 and 2001, a booming economy led to annual state general fund spending increases of over 5 per cent, twice the rate of inflation and faster than federal spending. States expanded big-ticket programs such as education and Medicaid options, and broadened eligibility for many social programs while enacting tax cuts. The current deficit situation is triggered not only by the economic slowdown, but by the collapse of the stock-market peak and rising health care costs. State tax revenues in the fiscal year ending June 30, 2002, proved to be far lower than estimates: sales tax, $147.6 billion, 3.2 per cent lower than projections; personal income tax, $187.7 billion, down 12.8 per cent and corporate income tax $21.6 billion, at 21.5 per cent lower than expected. The first round of relatively easy onetime spending cuts and funding shifts have already been made, and the “rainy day” reserve and tobacco settlement trust funds are virtually depleted. As is the situation with most states, after California meets its obligations to school districts, colleges and universities, local governments, and health care providers, it has committed about three-quarters of its budgets. In its fiscal year 2003 budget of $79 billion, California has only $18 billion to fund state agencies and programs other than its obligated funds according to Governor Gray Davis. The state is facing a $35 billion deficit, which obviously cannot be met by marginal cuts here and there. In fact, only three states – New Mexico, Arkansas and Wyoming – expect their fiscal ledgers to balance next year. Kids with disabilities and defending the homeland State responses have mainly come in the form of across-the-board spending reductions. Some 30 states have cut spending, targeting health care, education and prisons. Kentucky has released lesser-offense prisoners up to one year early. Oregon cut their school year by one month. Forty-nine states Federations Vol. 3, No. 2, May 2003 long-term care services. About half of the states are considering higher taxes, particularly on cigarettes and alcohol. Medicaid was not the only federal concern on the governors’ minds at their midwinter meeting. They focused on three additional federally mandated programs that they say present significant underfunding challenges. First is the cost of homeland security programs, for which state and local governments bear the bulk of implementation costs. The $3.5 billion proposed by the administration will cover only a small fraction of the actual costs. Second are special education requirements for children with disabilities. The federal government has committed itself to paying 40 per cent of the cost of these programs, but have actually provided only 17 per cent. Third is the “No Child Left Behind” education law, for which the governors claim that only half the promised amount of money is budgeted. The states report great frustration with federal rules for testing and accountability, which have constrained state policies along with driving up costs. Combined, the cost of these three program requests is $21 billion. The governors hope the federal Congress will agree to fund at least half of that amount. Getting on Bush’s agenda Federally-mandated and program-generated costs, particularly the Medicaid behemoth and the impact of federal fiscal policies, increasingly bring the governors and other associations of state and local officials to the president and Congress for redress. Normally the governors do not meet in formal negotiation sessions with the president, like the first ministers conferences in Canada and Australia. Also, unlike Spain, where the regional presidents periodically testify before Federations Vol. 3, No. 2, May 2003 the Cortes on matters of autonomous community concern, and have powers of legislative introduction, United States governors rely on the National Governors Association, other associations of state officials, and staff members and lobbyists. There have been two attempts at “Federalism Summits” of governors and state legislative associations. The first, in 1995, focused on ways for states to control and even block federal actions and to enforce the Tenth Amendment to the Constitution, which reserves powers to the states. The second, held in 1997, focused on federal mandates and preemptions. An eleven-point plan, designed to enhance the idea of federalstate partnership, included recommendations calling for Congress to justify its constitutional authority to enact a given bill, limit and clarify federal preemption of state law and federal regulations, streamline block-grant funding, and prohibit conditions of federal aid not tied to the aid purposes. This intergovernmental agenda calls attention to the grievances that the states feel, and forms the strategic backdrop for their national meetings and lobbying. The Bush tax and spending cuts, which are sure to be somewhat modified by congressional action, once again raise the issue that governments may be in different boats, but are subject to the same tides. The states want recognition and relief regarding the increasing number of national actions that impact them in financing and in programs, many of which were originally parachuted on them by Washington. Hard times plus underfunding and nonfunding These conditions hardly threaten the existence of the United States as a federation, but they shake at its core. As is the case for the majority of the world’s federations, the combined forces of communication, industrialization, welfare state programs, and global and international connections have brought state and local governments closer together with the United States government. It is also true that like most federations, degrees of centralization in the general government are coupled with forms of decentralization throughout the system. However, when times are difficult, such as with the current threats to internal security and economic downturn, along with the need to finance war efforts, their attendant costs put inevitable strains on multi-level systems. The states may have created some of their own problems by their tax cutting and spending decisions of the 1990s, but the federal government bears a large share of the culpability, for which the states want fiscal redress. The situation of underfunding and nonfunding in hard economic times poses a real test of the federal-state relationship, weakens the “bargain” related to federal movement into state policy arenas, and threatens the states’ ability to meet their requirements and produce constitutionally required balanced budgets. If these conditions continue for some time, it is possible that some federal “reweaving” will occur through changes that reposition the states in the American federal system. Federations Vol. 3, No. 2, May 2003