Is It Time for a New Fiscal Balance Between States and the Feds?

In his 1982 State of the Union address, President Ronald Reagan called for sweeping changes in the partnership between Washington and the states. His proposal for a grand swap of state and federal responsibilities would have relieved states of one of the fastest-growing burdens on their budgets today.

Congress never acted on Reagan’s proposal, and his idea to fundamentally rethink the financial ties between states and the federal government went dormant. Perhaps until now.

The deepest recession in decades is inviting new scrutiny of the way power and fiscal obligations are divided between Washington and the 50 state capitals, a balance forever changed by the New Deal programs after the Great Depression. Then, the federal government vastly expanded its footprint. Today, states’ dire budget problems are prompting suggestions that it might be time to reassess who pays and who gets to set the rules in the states’ complex fiscal partnership with the federal government.

The dominant worry for states on this front is their share of the spiraling bill for Medicaid, the federal-state health insurance program for the poor. Some state officials argue that a serious discussion about changing states’ portion of Medicaid costs should get started, if not this year then before 2014, when states might have to start underwriting coverage for some 15 million more low-income Americans under proposals for national health care reform.

In Vermont, where Medicaid today accounts for 24 percent of the state’s overall spending-higher than last year’s national average of 21 percent-unchecked growth of the program “crowds out all other responsibilities of state government,” Governor Jim Douglas (R), chairman of the National Governors Association (NGA), said in a July 2009 interview with National Public Radio. Without changes to Medicaid, University of Vermont economist Arthur Woolf has projected that, in 20 years, his state’s tax dollars would cover little more than education and human services.

Fiscal experts also complain that growth in the full range of federal-state programs-from highways and education to job training and foster care-is restricting states’ flexibility, creating mountains of paperwork and crimping their financial ability to respond to local needs.

Reagan’s “swap” would have had the federal government take full responsibility for Medicaid in exchange for the states taking over food stamps and welfare. He also proposed that the federal government “turn back” to the states 40 other federal grant programs, ranging from education to transportation, with a no-strings-attached federal trust fund to help pay for the new responsibilities over a 10-year transition.

“In a single stroke we will be accomplishing a realignment that will end cumbersome administration and spiraling costs at the federal level while we ensure these programs will be more responsive to both the people they’re meant to help and the people who pay for them,” Reagan said.

Known as the “swap and turn back” proposal, it garnered national headlines and heated debate among governors, but Congress, mired in budget negotiations, failed to take up the proposal.

The ebb and flow of federalism

Under the nation’s evolving federalist system, states and the federal government have long shared costs for domestic programs. Over time, officials from the two levels of government have tussled over who pays what portion of the tab and who gets to call the shots.

In general, the federal government gradually has added more state grants-and more requirements. Power has accreted to Washington under a process in which one or more states come up with a solution to a societal problem and federal officials decide to require or entice states through incentives to adopt the same policies.

The steady shifting of authority to Washington and the increase in national policies that states must carry out-including the addition of homeland security, election reform and strict education rules under the No Child Left Behind Act enacted under Republican President George W. Bush-worry those who believe the nation needs strong state governments with the flexibility to innovate.

Certainly, federal grant programs-such as one that provides nutrition for low-income pregnant women and infants or another that assists low-income people with home heating bills-have helped state governments enhance the quality of life within their borders. And by investing some of their own funds in national programs, states are likely to be better stewards of taxpayers’ money, policy experts argue. But not all federal requirements come with enough money to cover expenses. And as rules are layered from one Congress to the next and costs grow, national programs increasingly dominate states’ budgets and set the guidelines that states must follow.

Economic conditions, courts and the proclivities of the person occupying the White House have affected the vagaries of federalism. The biggest recent move to give states more autonomy came in 1996, when then-President Bill Clinton, a Democrat, worked with a Republican Congress and the nation’s governors to overhaul the welfare system. In a move widely viewed as successful, the welfare program changed from an open-ended entitlement program with costs shared by states and the federal government, much like Medicaid, to a series of capped block grants to states that gave them wide latitude on how to spend the money. Before Clinton, Reagan and fellow Republican President Richard Nixon also sought to shrink the federal government and give more power to the states.

Unlike his Republican predecessors, Bush increased grants to states to historic levels during his eight-year tenure but also broke records for the number of federal mandates and state pre-emptions. His new welfare rules, for example, took away much of the leeway states had been granted under the Clinton administration.

Obama and federalism

The administration of President Barack Obama shows signs of both increasing federal authority and giving states more flexibility. His aggressive domestic policy agenda-including health reform, financial regulation and climate-change legislation-leads some to speculate that federal funding to states will rise and state authority will wane. But his actions so far indicate that he sympathizes with states’ concerns, said Michael Bird, federal legislative director for the National Conference of State Legislatures.

When the state fiscal crisis was emerging before Obama took office, the Democratic president-elect told an NGA gathering in Philadelphia, “If we’re listening to our governors, we’ll not only be doing what’s right for our states, we’ll be doing what’s right for our country. That’s how we’ll grow our economy-from the bottom up.”

In the first months of his presidency, as banks toppled and millions of Americans lost their jobs, Obama ordered federal agencies to yield to existing state laws when issuing new regulations, expanded federal funding of the state Children’s Health Insurance Program and repealed Bush-era Medicaid rules that had restricted state health care policies. States got nearly everything they requested from Congress, Bird said.

The $787 billion stimulus package, passed in February 2009, included the biggest transfer of federal funds to states in the nation’s history. Nearly $280 billion of economic recovery funds are expected to flow to or through states through 2016, with $135 billion going straight to their bottom lines: $87 billion for Medicaid costs and $48 billion in state stabilization funds, primarily for education.

For expedience, the American Recovery and Reinvestment Act of 2009 distributed stimulus money to states using existing formulas. The biggest chunks required states to maintain recent funding levels for critical services, such as Medicaid. A few governors complained about conditions attached to the aid, but most were eager to offload nearly 40 percent of their budget gaps to Washington’s balance sheet, no matter what the requirements.

“The federal government has attached so many conditions, strings, limits on the use of the money that it’s not going to allow us to be as creative or reform-minded or as flexible as we would have liked, and that’s disappointing,” Minnesota Governor Tim Pawlenty (R) complained in a February 2009 interview with Stateline.org . Like Pawlenty, Republican Governors Bob Riley of Alabama, Bobby Jindal of Louisiana, Haley Barbour of Mississippi, Mark Sanford of South Carolina, Rick Perry of Texas and then-Governor Sarah Palin of Alaska also bridled at some of the requirements attached to the federal funds but in the end took most of the money.

While some questioned the federal aid, political analysts say it was natural for the federal government to open its purse strings when the Great Recession hit, just as it did after the September 11, 2001, terrorist attacks and the 2005 devastation of the Gulf Coast after Hurricane Katrina.

The Obama administration drew the line, though, when California later asked for federal loan guarantees because of fears that short-term credit would be unavailable during the banking meltdown in 2009. The Golden State ultimately was able to borrow what it needed without federal help.

As the stimulus funding nears an end, most governors are declaring it a success.

“I expect we’ll look back on this period and see it as another New Deal,” said Raymond Scheppach, executive director of the NGA. “I don’t really know what states would have done without it.”

When federal-state cost sharing began

The New Deal programs of the mid-1930s rescued legions of destitute people and restarted the nation’s devastated economy. They also changed forever the fiscal relationship between states and the federal government. Until that time, Washington gave states only scant resources, primarily for road building. What little assistance was available for impoverished families, elderly people and the disabled was provided by states and localities.

But the enormity of human suffering after the 1929 financial collapse prompted Congress to appropriate nearly 10 percent of the federal budget for domestic aid programs such as Social Security, which began in 1935 and became part of what is now known as the “safety net.” Later, in the mid-1960s, when the nation was flush with cash and gravely concerned about poverty and racial inequities, Congress approved so-called Great Society anti-poverty and education funding measures, further upping the portion of the U.S. budget that went to programs previously run by states.

Today, the U.S. Department of Health and Human Services, which funds state-run programs for the needy and generally oversees the nation’s health and welfare, takes up 29 percent of the federal budget, and the Social Security Administration occupies nearly 24 percent, according to the U.S. Census Bureau. That compares to less than 18 percent for national security, which was envisioned by the framers of the Constitution as the federal government’s primary responsibility.

Medicaid and state budgets

While Washington can print money and operate on a deficit, states have limited borrowing ability and are bound to balance their budgets. As a result, the recession has led some state officials to complain that continuing to obligate states to underwrite national programs, particularly Medicaid, is unsustainable.

“We’ve been splitting the bill with a partner that’s too rich for us for far too long,” said Michael Genest, who retired January 1 as the director of the California Department of Finance. He predicted that Medicaid, if unchanged, would claim 30 percent of his state’s general fund dollars by 2030-and 40 percent by 2040-compared to about 18 percent in fiscal year 2009.

Governor Arnold Schwarzenegger (R) took the grievance even further. Facing a $20 billion deficit in his final year in office, he released a state spending plan in January that relies on $6.9 billion in new federal money that he claims his state is owed for Medicaid and other programs. He called on the federal government to work with states to change “the flawed formula that demands that the states spend money that we do not have.”

Launched in 1965 to expand state efforts to ensure basic health care for the poor, Medicaid committed the federal government to an open-ended partnership that has led to a complex array of state health insurance plans. Medicaid originally offered federal payment for about half of low-income health costs in return for states agreeing to minimum eligibility and coverage standards. Rules have changed over the years, but currently states must cover children ages 6 to 19 if family income is less than 100 percent of the federal poverty line (about $22,000 for a family of four), pregnant women and young children if income is under 133 percent of poverty levels, and elderly, blind and disabled persons who meet eligibility thresholds. Participation in Medicaid was optional, but all states eventually adopted laws to qualify for the federal money, most within the first few years.

Though state plans vary widely, what they have in common is ballooning price tags. Taxpayers in 2009 paid an estimated $335.1 billion for Medicaid, according to the National Association of State Budget Officers (NASBO), and the program’s costs are projected to spiral, with or without national health care reform.

According to a Kaiser Family Foundation report, the recession spurred Medicaid’s biggest enrollment growth in six years during fiscal year 2009, increasing spending nearly 8 percent.

Economists have cited out-of-control health care costs as a major cause of the nation’s economic woes and entitlement programs, including Medicaid, as a primary source of the staggering federal deficit. In its deliberations on a universal health care plan, Congress moved to expand eligibility for Medicaid coverage but showed little appetite to relieve states and shoulder the entire cost of the expanded public health care burden.

Still, as state revenue has been sinking, interest has risen in exploring a recalibration of fiscal tradeoffs in the state-federal realm. For now, the most tangible step is the formation by NASBO of a committee of state fiscal analysts to study the state-federal cost-sharing arrangement. Nothing like a Reagan plan has been floated, though state fiscal experts offer a couple of potential scenarios.

The portion of Medicaid attributable to the elderly could be combined with the federally financed Medicare program for seniors, reducing administrative costs and bureaucratic confusion. At least 46 percent of all Medicaid spending is for so-called dual eligibles-those over 65 who qualify for both Medicare and Medicaid and use benefits to pay for prescription drugs and nursing home care. Under this scenario, states would continue to administer and pay for their portion of Medicaid to cover low-income families and the disabled, and Washington would continue to pay about half of that bill.

Another scenario would have states taking full responsibility for education and highway funding and Medicaid becoming entirely a federal program. Based on 2009 figures from the U.S. Census Bureau, such a swap would take $135.5 billion in Medicaid spending off states’ books in exchange for states forgoing about $56.8 billion in federal K-12 education grants and some $40 billion in federal highway aid.

If states were to scale back or repeal their Medicaid laws, their fiscal worries would end. States are under no federal obligation to continue the programs. “If a letter went to Washington from all 50 governors saying, ‘We’re not going to provide Medicaid anymore,’ that would get the conversation moving,” said California’s Genest.

It is unlikely states would shirk their healthcare responsibilities entirely. Still, the recession already is forcing some states to consider shrinking their Medicaid benefits to help balance their distressed budgets.