Federal Stimulus Dollars, State Deficits -- and Federalism

The American Recovery and Reinvestment Act of 2009 (ARRA) provided a significant infusion of federal funding to states that already has had some positive effects. Namely, the money released so far has helped limit state budget cuts and tax increases, which in turn has had a positive economic impact.

Despite this, the depth and extent of the downturn is continuing to adversely affect overall state fiscal positions. Unfortunately, the best estimate of state shortfalls over the next three years is now between $200 billion and $250 billion.

To avoid exacerbating the fiscal pressures on states and help speed economic recovery, the federal government should carefully analyze any policy changes that affect state finances before they are implemented.

The ARRA provided a total of $787 billion in stimulus funds, $246 billion of which is going to states or through states to individuals. This places states and governors on the frontlines in partnering with the federal government to make the ARRA work.

About $135 billion of the $246 billion is in the form of countercyclical funds that provide states with flexibility in spending. These funds are divided between two categories. First is an approximately $87 billion federal increase in Medicaid funds, which will allow states to reprogram their state matching funds to meet other high-priority needs. Second is $48 billion in the state fiscal stabilization funds. Most of this must be used for elementary, secondary and higher education, but a portion may be used for other purposes as well. Because education represents about 30 percent of state spending, this assistance provides considerable fiscal relief for states.

As for the rest of the stimulus funds going to states, states have little flexibility in how to spend these because they are intended for a specific purpose. Most will either be provided through existing state-federal programs such as highway construction and weatherization or in safety-net programs such as food stamps and unemployment insurance. Although the countercyclical funds will have an immediate positive economic impact in states, the remaining funds will take longer to have an effect because they will be spent out over the next two years.

From both a state and economic perspective, the recovery package has been positive on three fronts:

  • The $135 billion in flexible funds has allowed many states to defer some of the most drastic budget cuts or tax increases, which would have further weakened the economy. The Medicaid payments retroactive to Oct. 1, 2008, were particularly helpful in allowing states to offset shortfalls and postpone planned cuts.
  • The recovery package was well-targeted to protect education and health care for low-income individuals-governors' two highest priorities. During the last several economic downturns, governors have tried hard to protect these two budget categories.
  • Since the economy has not yet bottomed and stimulus funds are being spent, the package will be helpful over the next year both in limiting the downturn and perhaps helping the economy turn the corner. Unlike most previous economic stimulus plans, the ARRA was timely. Most previous packages enacted by Congress were too late to mitigate the downturn.

Despite help provided under the ARRA, the fiscal outlook for states remains tenuous over the next few years. For fiscal 2009, state spending fell about 2 percent, and governors' recommended budgets for 2010 reflect another decline of 2.6 percent in spending. Throughout 2009, 41 states were forced to reduce previously enacted budgets by $31.6 billion. States also enacted fee and tax increases of another $6 billion in 2008 and 2009 and have recommended revenue increases of $23.9 billion for 2010.

State end-of-year balances in 2009 and 2010 were down to 5.6 and 5.4 percent, respectively. When balances begin to approach 5 percent, a states' bond rating could be affected, which in turn can affect its ability to finance projects. Therefore, most states try to maintain higher balance levels.

In addition, states estimate they still are facing shortfalls of $183.3 billion over the 2009-2011 period, and many states indicated they will continue to have shortfalls in 2011 but were unable to make a specific forecast. Adjusting for this, the best estimate of state budget shortfalls for the three-year period is between $200 billion and $250 billion. This is a huge number, given the fact that total general fund revenues for all states are estimated to be about $644 billion in 2010.

It is important to note that the year after the recession is declared over is always the most difficult year for states, primarily because of the explosion of Medicaid spending late in the cycle. Unfortunately, since spending cuts have prevailed over the last two years, it may be that revenue increases might be more important over the next several years in eliminating the projected shortfalls because the majority of states have already eliminated most non-core spending.

Because of the fragile fiscal position of states, it is important over the next few years for the federal government not only to work with states to promote economic recovery, but also to be very mindful of the potential fiscal impact executive orders or legislation could have on states. This includes any unfunded mandates as well as both direct, and even indirect, pre-emption of state revenue sources.

States have particular concerns regarding potential costs associated with major federal legislative initiatives such as health care reform, a cap-and-trade system for climate-changing gases and business activity taxes, as well as with ongoing state costs to implement federal mandates under REAL ID, which dictates new security measures for state driver's licenses. Any additional such costs to states could only be accommodated by further tax increases, which could hamper economic recovery.

Raymond C. Scheppach, Ph.D., is the executive director of the National Governors Association. The views expressed here are those of the author and do not necessarily represent those of the National Governors Association.