State government choices lay out two potential paths forward for federal deficit reduction

Jon Ward Contributor
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State governments are beginning to choose one of two directions to dig out of deep budget deficits, and the resulting clash of visions between raising taxes or cutting spending has some conservatives salivating at the contrast between liberal and conservative philosophies of how to create economic growth.

“The test has been run many times. Texas is growing, California and [New York] are shrinking. How many times do we need to get liberals to recognize that jobs and industry goes to low tax environments?” said Allan Meltzer, a leading free market economist at Carnegie Mellon University. “Why do you think the South boomed while the North declined?”

Now it is Illinois that is raising taxes and New Jersey that is in the midst of a tough multi-year austerity plan, which has gained Republican Governor Chris Christie acclaim from conservatives across the country.

“I don’t think there’s a national figure that I’ve looked at since Ronald Reagan and said, ‘You know what? That’s the type of leader I want,’” said Joe Scarborough, host of MSNBC’s “Morning Joe,” last week.

Illinois Gov. Pat Quinn, a Democrat, has become the face of the liberal approach, signing a 66 percent income tax increase into law on Thursday.

So far, the early signs are that in traditionally liberal states like California – where Democrat Jerry Brown was elected governor for the second time in his career – are going more with the Christie model than the Quinn approach.

Brown is proposing to cut $1.5 billion from welfare programs, $1.7 billion from the the Medi-Cal system that provides health care for the poor, $500 million each from the University of California and California State University systems, $750 million from services for the developmentally disabled, and $200 million from various “reorganizations, consolidations and other efficiencies.” He also plans to raise tuition fees for state university students, close state parks with low attendance rates, cut $30.4 million from public libraries, and shrink his own office’s budget by 25 percent.

Brown also wants to raise personal income taxes by a quarter of a percentage point, increase the sales tax one percent, and raise the state tax on vehicles. But he wants to hold a special referendum in June so voters can approve the tax hikes.

And yet, while there are clearly parallels to the federal government’s increasingly perilous fiscal situation, conservative and liberal economists warned against drawing too many straight lines between the two.

“It is really important to recognize the fundamental differences – statutory and constitutional requirements to balance the budget, capital budgets, etc. – that make the states very different from the Feds,” said Douglas Holtz-Eakin, a former top economic adviser to Sen. John McCain’s presidential campaign, now at the American Action Forum. “Having said that, I agree that it will be interesting to see how they manage their finances.”

Holtz-Eakin was referring to the fact that every state but Vermont has some sort of balanced budget provision. Thus, while President Obama and Republicans and Democrats in Congress bluster about the need for action to deal with the nation’s deficit and debt, the Federal Reserve has been printing hundreds of billions of new dollars to finance much of the federal government’s spending.

But because of their balanced-budget requirements, governors do not have such a luxury.

And despite reports of a mild economic improvement, things are actually getting worse for state governments. They are set to face the biggest budget deficits of the current economic recession in the fiscal year that starts in July.

Much of this is because federal government stimulus aid – which helped them overcome large shortfalls in the past three years – has about run out. The total budget shortfall for all the states that will have to be paid out of state house coffers will be $134 billion for the 2012 fiscal year that begins in July for most states. That’s more than the $101 billion for the current fiscal year, more than the $123 billion from the 2010 fiscal year, and significantly more than the $79 billion in the 2009 fiscal year, according to a December report by the Center for Budget and Policy Priorities.

In the 2010 fiscal year, the total state deficits amounted to $191 billion, much more than the $140 billion in deficits for the upcoming fiscal year. But in 2010 there was $68 billion in federal stimulus aid, compared to only $6 billion this year.

But in addition, continued high unemployment means state governments will get less income tax revenue, and there will be increased demand for aid programs like Medicaid. Declining home values means they will have less property tax revenue.

The tax agreement between Obama and congressional Republicans in December – allowing businesses full expensing of investments – will cost states an estimated additional $11 billion, according to the CBPP report. The same report said states would lose billions in aid if Republican plans to cut $50 billion in spending become law.

And most states have or will have depleted their reserve funds.

“Historical experience and current economic projections suggest that due to declining federal assistance fiscal year 2012 will be more difficult than 2010 or 2011,” the CBPP report said.

That means it’s time to cut spending or raise taxes.

“Desperate times call for desperate measures and those measures will vary across states,” said Alex Brill, a research fellow at the conservative American Enterprise Institute who recently advised the president’s fiscal commission on tax policy. “Governors will be pressed to try new approaches – perhaps some more ‘market-based’ than others. It will take time before we can fairly measure the consequences of different strategies.”

“The states will be a natural experiment where policymakers can learn what works and why,” he said.

But Brill cautioned against viewing the matter through a purely conservative versus liberal prism.

“There are a lot of variables. What is needed and what will work in [California], [Nevada], [Arizona] or [Florida] where housing was a real crisis, is different than what is needed to improve state budgets in, say, the northeast where home price declines were less severe and other factors were at play,” Brill said.

Jim Rickards, a senior manager and market analyst with Omnis Inc., agreed.

“It’s not simply a matter of ‘red’ versus ‘blue’ or Democrat v. Republican, but a matter of new good ideas versus the same old failed solutions,” Rickards said. “This will come in areas such as ‘smart’ budget cuts, asset sales, privatization, tax policy, pension reform, government union contracts, etc.”

“The results will be measured in bond ratings, job creation and migration of people from ‘failed’ states to ‘successful’ states,” he said.

Michael Lind, who directs the economic growth program at the nonpartisan New America Foundation, said that “the refreshing thing about state and local politics is that is less ideological.”

“Sure, conservatives can call for cutting public employee pensions and liberals can fight to preserve funding for various state and local welfare programs,” Lind said. “But all state and local politicians have pretty much the same menu of options when it comes to keeping their states solvent in hard times and economic development in good times.”

But experts also agreed that one of the major drivers of unsustainable budget deficits is commitments made to public employees and their unions, in the form of guarantees for pay, health care and retirement pensions.

“The inability of states to curtail their pension obligations is going to be a real choke point,” said Brill.

Lind said that taxpayers should bail out the public employees. He admitted that would be a “politically hard” fix, but that is likely a vast understatement given the intense opposition to such an idea by conservatives and many rank and file taxpayers.

But, Lind said, such an idea is “a no-brainer.”

“State contracts should be honored, so the federal government, which can borrow more easily, should bail out state pension plans on condition that henceforth all public employees are enrolled in social security, plus perhaps the same 401ks that some private workers get,” he said.

But at a time when the talk in Congress is of cutting spending, a bailout of public employee pensions would – apart from the questions of fairness – be an enormous undertaking. The Pew Center for the States estimated a year ago that states had only $2.35 trillion set aside to pay for the $3.35 trillion they owed in promised benefits to public employees.

Orin Kramer, a Democrat who formerly ran New Jersey’s pension fund, told The Financial Times that states were in the hole by $2.5 trillion.

California’s unfunded pension liabilities exceed $700 billion all by themselves.

“We can’t fix the budget without reducing public employee retirement benefits,” said a piece in Tuesday’s Los Angeles Times by Marcia Fritz, president of the California Foundation for Fiscal Responsibility.

“Although the public employee union bosses will fight to retain them, financially unsustainable pension benefits must end,” Fritz wrote.

This article originally identified Holtz-Eakin as affiliated with the American Action Network.

Will Rahn contributed to this report.

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