The economy
A Clash of WillBoost, says Washington. Sorry, reply the states, how can we?
Oct 25th 2001| washington, dc

FISCAL stimulus is the rage in Washington these days, as Democrats and Republicans fall over themselves with proposals to revive the economy. On October 24th the House of Representatives passed $100 billion of (mainly corporate) tax cuts. Top senators want to spend money on unemployment benefits and subsidies for health-care premiums. There is argument about how best to do it, but no one doubts a big budget loosening is on the way.

In virtually every state capital exactly the opposite is happening. The slowing economy is pushing many state budgets into the red as tax revenues plummet. But, unlike the federal government, all but one of the states are legally bound to balance their books. With deficits forbidden, state politicians are being forced to cut spending and even raise taxes. In effect, they are being required to undermine what the people in Washington are trying to do.

The states are an often forgotten but essential part of America's fiscal system. Together they spend around $1 trillion a year, just over half as much as the federal government, while employing considerably more civilians. For most of them, revenues come primarily from two sources—income taxes and sales taxes. As the economy has stalled, these revenues have been hard-hit. Between April and June, state tax revenues grew at their slowest pace for eight years. Although the final numbers are not yet available, they probably fell between July and September. At the same time, a slower economy pushes states into spending more, particularly on Medicaid, the health-care programme for poor people. Already ten states say their Medicaid spending is above budget. It will rise much more as unemployment increases.

Things have got even worse since September 11th, and virtually every state has revised its budget figures downwards in recent weeks. Scott Pattison, of the National Association of State Budget Officers, reckons that the states face a joint deficit of at least $14 billion in this fiscal year (which for them ends next June 30th). Others reckon it could easily reach $20 billion.

New York, for instance, now expects a deficit of $3 billion, or 7% of its general fund. Hawaii, accessible only by air and relying on tourists for a quarter of its GDP, is in dire straits and has been put on credit watch by bond-rating agencies. Its governor has called a special session of the legislature to deal with what he calls the worst crisis in the state's history. Florida, which has no income tax and relies on sales taxes to pay for 70% of its operations, is also in trouble as tourists stay away. The Florida legislature began a special session this week to decide how to plug a $1.3 billion hole in its $48 billion state budget. Even states that were in good shape only a few months ago are looking ropey. Maryland, which ended fiscal 2001 above budget, now has a big shortfall.

The states have three main ways of dealing with this red ink. They can raise taxes, dip into their “rainy day” funds, or cut spending. So far, most of them have not raised taxes (though North Carolina, which was in trouble long before September 11th, recently approved several tax increases, including a temporary rise in the sales tax as well as more tax on alcohol and satellite televisions).
The states' rainy day funds amount in total to around $30 billion, more than enough to cover this year's likely deficit. In Ohio, the governor wants to draw down $300m of a $1 billion fund. But with huge uncertainty about the length and severity of the economic downturn, most states are loth to spend too much of their reserves.

That leaves spending cuts, and most states are concentrating on those. Cutting capital spending is an obvious place to start: Washington state has frozen $400m in public-works projects as part of its effort to slice $1 billion from a $12 billion discretionary budget. But in most cases the cuts go much further, and mainly hit education and social services for the poor. More than half of Florida's $1.3 billion budget cuts are likely to come from schools and colleges.
Unfortunately, spending cuts are the most contractionary form of budget belt-tightening, since they result in a direct loss of economic activity. (When taxes are raised, people may reduce their saving, rather than cut their spending.) Moreover, state spending cuts tend to hit poorer Americans hardest: exactly the people whom the federal government is trying to persuade to spend more.

Besides, the federal government's stimulus policies could actually make things worse, by reducing states' tax revenue even further. As Iris Lav of the Centre on Budget and Policy Priorities points out, the stimulus package passed by the House of Representatives contains provisions to boost corporate investment by allowing firms to count a share of their investment costs as expenses. These provisions could reduce state revenues by $5 billion a year for the next three years, because 44 of the 45 states that have corporate income taxes use the federal rules to calculate their own tax bills.

Things do not have to be this way. Washington's budgeteers could easily include in their stimulus packages policies that helped the states. Richard Nathan, director of the Rockefeller Institute of Government, suggests temporarily reintroducing an old revenue-sharing arrangement through which the federal government distributed money to states and local governments between 1972 and 1986. In effect, the federal government would simply send a one-off cheque. Ms Lav suggests increasing the share of Medicaid costs paid by the federal government. This would be administratively easy and would allow states to shift money elsewhere.

Alas, few in Washington seem to care much about state finances. Republican law makers in particular seem far keener to cut taxes than to spend more money, whether on the states or anything else. Unfortunately, this myopia will mean a less effective federal stimulus and a lot of unnecessary fiscal pain for the states