Stimulus aid to states seen delaying ‘day of reckoning’

A debate is raging over whether stimulus funds are actually helping states weather the recession or simply enabling them to postpone matching a record drop in tax revenues since 2007 with badly needed spending reforms and cuts.

President Obama wants to provide the states with an additional $50 billion in health and education funding, on top of $135 billion in such stopgap funding provided in last year’s $862 billion stimulus bill. That amount, which the president insists is essential to prevent the layoff of thousands of teachers, police and firefighters, would plug about 40 percent of an estimated $125 billion in budget gaps the states collectively face this year.

Congress so far has balked at extending such a generous state aid package. It appears in trouble in the Senate, where legislators are increasingly concerned about the federal government’s own severe budget problems.

But 30 states have adopted budgets that depend on Congress approving at least $24 billion in extended funding for Medicaid, the low-income health care program, which ballooned in size during the recession as many jobless people became eligible for the free medical care.

State officials warn that they will have to slash payments to doctors, limit medical care for people in need, and impose other large spending cuts if Congress doesn’t come through with the funding. Some heavily indebted states like California, New York and Illinois have nearly exhausted all alternatives and could face financial instability and funding pressures that have already prompted a handful of cities and towns to consider bankruptcy.

But while lingering unemployment continues to weigh heavily on state budgets, analysts say most states also have failed to recognize and deal with the fact that the nearly 10 percent drop in revenues they experienced during the recession will not be fully recouped any time soon, and they will have to find ways to bring spending in line with their reduced revenues.

“It’s the day of reckoning,” said Bob Williams, co-founder of the Evergreen Freedom Foundation and former auditor at the Government Accountability Office. With few exceptions, the states got used to rapid growth in both revenues and spending during the economic boom and now must relearn how to live within their means, he said.

While the drop in revenue from property taxes, and income and sales taxes during the recession did impose hardships on the states, that revenue loss pales in comparison to the boom in revenues most states experienced during earlier economic expansions, he said.

According to the National Association of State Budget Officers, state spending grew by nearly 60 percent to $1.5 trillion between 2000 and 2008, a period when revenues came flooding in, particularly as a result of the housing boom.

“They are artificially propping up a level of spending that can no longer be supported by the economy,” Mr. Williams said. “Rather than fundamentally reshaping government to reflect declining state revenues for some time to come, they are relying on accounting gimmicks, one-time funds, and federal stimulus money to balance the budget.”

The White House and its allies have encouraged states to postpone major spending cuts not only by luring them with a stream of supposedly “temporary” federal funding, but by urging states to first eliminate tax loopholes, raise fees for services and impose “sin” taxes on such items as alcohol and tobacco.

That strategy led to record state tax increases totaling $24 billion last year, but even ardent state advocates now acknowledge that they cannot keep raising revenues on balking citizens in a weak economy.

“There is a sense that people have maxed out on tax increases,” said Raymond C. Scheppach, executive director of the National Governors Association. “Most of the rest will come out in the spending side.”

While the federal stimulus spending has been a major prop for states seeking to avoid spending cuts, many also put off rigorous spending reforms by going deeply into debt — sending total state and local borrowing soaring to a record $3 trillion.

Congress and the Obama administration helped states in their trek into heavy indebtedness by creating a Build America bond program in the stimulus bill last year, which enables states to issue taxable bonds for small investors who cannot take advantage of the complete exemption from federal taxation enjoyed by wealthier investors in municipal bonds.

That program proved so popular that it is expected to account for about one-third of state borrowing this year. The Treasury subsidizes the states in the program by paying the increase in the interest rates they pay on the taxable bonds, over and above what they usually would pay on tax-exempt debt.

The resulting huge buildup of debt recently prompted billionaire investor Warren Buffett, among others, to question whether an unsustainable bubble is developing in the state and local bond market akin to the one last decade in the mortgage market.

“There will be a terrible problem” five or 10 years from now, he predicted at a congressional hearing this month, “and then the question becomes, will the federal government [bail them out]?”

“The biggest threat to the economy is a mountain of sovereign debt that cannot possibly be paid,” said Bill Wilson, president of Americans for Limited Government. “As seen in Europe, when governments spend far beyond their means, bad things happen. And yet, Obama wants to sustain the states’ unsustainable spending levels.”

During the housing boom, he said, states came to expect and rely upon rapid increases in property values to finance ever more spending and borrowing. “It was a bubble in which state politicians made the same bad bet investors of mortgage-backed securities made — that property values would never come down,” he said.

“When the housing bubble popped in 2007, the drop in state revenues was entirely predictable,” he said. “Nonetheless, state spending still grew by about $100 billion in 2008 … The states simply refuse to cut the additional spending from the boom years.”

Harvard professor Linda J. Bilmes said the states cannot be blamed for the huge drop in revenues, jump in joblessness and other devastation caused by the housing and financial crisis, which has left them with substantial spending burdens and debts.

She said states already have slashed spending substantially despite the federal stimulus. Because of balanced-budget requirements, spending was slashed by 6.8 percent last fiscal year after a 4.3 percent overall cut in state spending the previous year, she said, and states have laid off 212,000 workers during the recession while furloughing many others.

The cuts in spending at the state and local level were large enough to essentially neutralize the stimulus effect of Mr. Obama’s spending bill on the economy last year, she said, urging Congress to come through with further aid this year to try to limit the effect of further state cuts on the weak economy.

But Ms. Bilmes did attribute one major part of the state spending dilemma to “past mismanagement”: overly generous health care and pension benefits for state employees that many states adopted to attract workers from the private sector. Now, with baby boomers retiring, states are having to pay out on those benefits, and that has become a significant drag on their budgets, she said, with state pension plans overall underfunded by at least $1 trillion.

In exchange for any further aid, she suggested Congress should require states to demonstrate that they have a plan to close the enormous deficits in their long-term pension obligations.