States Adjust to a More Frugal Washington

As a new power dynamic takes hold in Washington, one thing is clear for cash-strapped states: Whether they think of federal aid money as an essential economic boost or a wasteful bailout, the help is over.

For states that have leaned heavily on federal stimulus dollars to balance their budgets during their worst fiscal crisis in generations, Washington's more austere attitude will come as a big change. But the really interesting question for 2011 is whether the state-federal relationship may change in more fundamental ways than Congress simply turning off the spigot of emergency budget aid.

Already, the Republican takeover of the U.S. House of Representatives is shifting the conversation in a new direction. House Republicans have pledged to cut $100 billion from the federal budget, a job that almost certainly would require cutting funding for some programs that states rely on. They also have promised to stop "earmarking" federal dollars for specific pet projects and floated other ideas, such as turning Medicaid into a block grant program and allowing the most fiscally desperate states to declare bankruptcy.

President Obama and a U.S. Senate controlled by Democrats are likely to balk at many of these proposals. Whatever comes of them, however, states can expect Washington to increase its scrutiny of the way they spend federal dollars — and plan on having fewer of them to spend.

"We have a $13 trillion national debt," says Oregon's new governor, Democrat John Kitzhaber. "I don't think we're looking at a whole lot of new money going down to the states from the federal government."

The stimulus ends

State leaders were well aware that the federal stimulus money would eventually run out. But architects of the package figured states wouldn't fall off that funding cliff until they were already well on their way to recovery. That's not going to happen. While state tax revenues recently have ticked upward, revenues in most states remain well below pre-recession levels.

One of the biggest buckets of stimulus funds, federal assistance to help pay for Medicaid, will get smaller each month this year until it finally disappears entirely at the end of June. Overall, states and localities have collected $186 billion in federal stimulus funds since 2009 but expect to get just $23 billion in fiscal 2012 and $14 billion in fiscal 2013.

One of the harshest critics of sending stimulus money to the states is the new House Speaker John Boehner. "Last year … Democrats borrowed nearly $100 billion to bail out state governments and education shortfalls," the Ohio Republican says. Boehner laments that such actions "only make state governments more dependent on the federal government and more vulnerable when the federal funding explosion disappears."

Stimulus money, however, represents only part of the flow of money from Washington to the states. Federal funds support state programs to pay for highways, K-12 education, health care for people with low incomes, and many other programs. Even before the stimulus program began, federal dollars accounted for about 30 percent of state revenue. It's these funds that are likely to become a prime target if Congress is serious about pinching pennies.

Republicans have promised to try and roll back most federal spending to levels of 2008, excluding defense and certain senior entitlement programs. That translates to a $100 billion cut in federal spending, although the $100 billion figure is already shifting to $60 billion since the federal fiscal year has already started. "We don't know where the cuts will be," says Michael Bird, senior federal affairs counsel for the National Conference of State Legislatures.

Data from the National Association of State Budget Officers suggest where the biggest potential targets lie. The biggest pot of money the feds give states is Medicaid, accounting for nearly 43 percent of state spending from federal funds. Elementary and secondary education follows with 12 percent. Transportation is the next largest category with 8 percent.

Marcia Howard, executive director of the nonpartisan Federal Funds Information for States, says she expects Congress will try to consolidate the array of state grant programs that fund various educational, community development and environmental programs. "They'll collapse and broaden, but fund them less," she says. President Obama has indicated this was an idea he favors. In last year's budget, for example, he proposed folding 38 educational programs into 11 funding streams.

Some federal spending reductions could come from doing away with earmarks, which is another idea that the Obama administration supports. Even some of the most ardent backers of allowing members of Congress to insert money for special projects into spending bills grudgingly admit that the practice has become an emblem of government inefficiency.

Earmarks account for only about 1 percent of federal spending, so ending them won't do much to erase the federal deficit. But an earmark ban would hit a handful of states harder than others , notably Hawaii, Mississippi, North Dakota, Vermont and West Virginia. As Stateline reported last month, these states have been receiving more earmarks per capita than any other state because they have had senior lawmakers on key congressional committees.

A block grant for Medicaid?

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Republican House Speaker John Boehner has called federal stimulus money given to states to balance their budgets a bailout. He laments that emergency aid makes state governments "more dependent on the federal government and more vulnerable when the federal funding explosion disappears."

A more sweeping idea to rearrange federal-state finances comes from Republican U.S. Rep. Paul Ryan and former Clinton administration budget director Alice Rivlin. They have proposed switching Medicaid away from the current structure, in which the federal and state governments pay an equal share of the cost. They would replace it with a fixed federal block grant to states, similar to the way federal welfare funds are provided. 

"Let's cut the strings, give them the money so that they can reform this," Ryan told Fox news after the election. While a similar proposal died during the Clinton administration, he says, "This is not the 1990s. We've got fiscal pressures that are dictating these kinds of things. And let's let these governors … experiment."

Ryan's new position as chairman of the House Budget Committee may give the block grant idea new momentum. The National Conference of State Legislatures also has a task force looking into the idea. Medicaid is one of the fastest growing programs at both the state and federal levels. Recently, the program passed K-12 education as the most expensive item in state budgets.

Critics argue that block-granting Medicaid is a bad idea for states and the poor. "It would shift costs and risks to states, low-income beneficiaries, and health care providers," says Edwin Park in a new report for the Center on Budget and Policy Priorities. Park says the idea also would likely unravel the health reform law, which envisions exapanding Medicaid even further to cover many Americans who currently lack health insurance.

Of course, House Republicans and many of the nation's Republican governors want to overturn the health care law. Short of that, Republican governors are pressing Washington for flexibility in how they cut Medicaid costs. All 29 Republican governors who will hold office this year signed a letter to President Obama and congressional leaders asking them to drop requirements in the stimulus and health care laws that prevent states from cutting Medicaid enrollment.

In a statement related to the letter, Texas Governor Rick Perry, chairman of the Republican Governors Association, said, "Now is the time for the federal government to restore states' flexibility to craft Medicaid programs tailored to their specific needs."   

Allowing for bankruptcy

An even more controversial idea being circulated among conservatives would allow states to file for bankruptcy in much the same manner as cities can. Letting states file for bankruptcy would allow them to shed some of their obligations, including contracts with public sector employees, possibly even allowing states to renegotiate existing pension benefits that states are woefully behind in paying. 

They might not have to actually declare bankruptcy to gain some negotiating leverage. In New York City in the 1970s, it was the threat of bankruptcy that forced unions that represented city employees and financial institutions that loaned money to the city to make concessions.  

Similar groups do not have the same incentive to work with the state today, Richard Ravitch, who brokered the deal, said in a recent forum at the Nelson A. Rockefeller Institute of Government.

Ravitch, a real estate developer who was until recently New York's lieutenant governor, has questioned whether a bankruptcy plan would be constitutional if applied at the state level. In a recent Wall Street Journal interview, he said he doesn't see a way out of the state budget mess unless "people stop lending money and enabling politicians to have cash to spend." Only then, he says, "people will face up to the miserable, Draconian choices we have."

University of Pennsylvania law professor David Skeel calls state bankruptcy the "best option for avoiding a massive federal bailout." That's particularly true for states such as California and Illinois, where the states already have piles of IOUs and yet still face massive budget deficits, he wrote in a Weekly Standard article.

A bill that may serve as a precursor to state bankruptcy legislation was introduced by Republican Congressman Devin Nunes of California. This legislation would require states and municipalities to provide greater disclosure of their public pension liabilities, or risk losing the ability to sell tax-exempt bonds, a crucial financing vehicle that states rely on heavily.

The view back home

Outside of Washington, state lawmakers are bracing for tough budget talks, both in their capitals and on Capitol Hill. "It is clear that Washington will, increasingly - and appropriately - be focused on deficit reduction," says Jay Kaufman, a Massachusetts Democrat who is the House chair on the Legislature's Joint Committee on Revenue.

Kaufman seriously doubts there will be any additional relief from Washington this year, but he worries the promised frugality will leave states on the chopping block. "We want to make sure states are at the table" when Congress and the Obama administration start trimming, Kaufman says.

Across the country and political spectrum, Colorado state Senator Greg Brophy hopes Congress will balance the federal budget by reducing spending, which he says he knows will mean reduced federal money to the states. But Brophy, one of the most outspoken fiscal conservatives in the statehouse, says he mostly wants Congress "to listen to the Tea Party." He wants Congress to "honor federalism by working only on things that the federal government should, leaving the rest to the states."

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