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Congressional Stalemate May Trim State Aid While Shielding Munis

Nov. 22 (Bloomberg) -- Congress’s inability to craft bipartisan steps to reduce the nation’s deficit paves the way for billions of dollars in automatic cuts to state aid while preserving tax breaks for municipal bonds.

The impasse also protects Medicaid, which is exempt from automatic cuts triggered by yesterday’s failure of the 12-member supercommittee, charged with brokering a deficit-reduction agreement. Gridlock between Democrats and Republicans in Congress also removes a more immediate threat to municipal-bond tax breaks that hold down the cost of public-works projects.

While automatic cuts, set to begin in 2013, would affect dozens of categories including schools, the mandate exempts programs accounting for about three-quarters of state aid, said Marcia Howard, the executive director of Federal Funds Information for States. Medicaid, the jointly underwritten medical-insurance system for the poor, is the biggest single budget item for most states.

“They have a little more certainty here,” said Howard, whose organization was created by the National Governors Association and the National Conference of State Legislatures. “They know what set of programs is likely to be affected and they can take the worst-case scenario.”

November Deadline

Under an accord that raised the federal debt limit in August, the bipartisan supercommittee had to reach a deal by Nov. 23 on ways to cut at least $1.2 trillion from the deficit through the next decade. Without such an agreement signed into law, automatic savings of the same amount would be imposed, with about half coming out of defense spending.

Congress may change the law before any cuts occur, as some legislators have suggested, to protect military budgets. Reductions affecting contractors and force levels would weigh on defense-heavy states such as Virginia, Hawaii and Alaska.

Still, given the barriers to cutting Medicaid and a related program for children, the process known as sequestration may mean states and local governments will fare better than they otherwise might have, Standard & Poor’s said yesterday in a report.

“It excludes the most important area of fiscal integration between states and the federal government, which is Medicaid,” Gabriel Petek, a San Francisco-based S&P analyst, said by telephone. “The sequestration cuts have some of the fewest credit implications to state and local governments,” he said.

Markets Shrug

Bonds issued by states and local agencies and governments were little changed yesterday as it became clear the supercommittee had failed. Yields on top-rated 10-year tax-exempt bonds declined to 2.20 percent from 2.21 percent on Nov. 18, a Bloomberg Valuation index shows. A similar 30-year muni index rose to 3.9 percent, up from 3.88 percent Nov. 18. Yields on 10-year Treasuries slumped to about 1.96 percent from 2.01 percent at Nov. 18, trading near six-week lows.

Teachers union officials said the failure of the supercommittee may have difficult consequences for schools.

“The absence of a deficit deal will lead to drastic across-the-board cuts to vital programs that help our students,” Randi Weingarten, president of the Washington-based American Federation of Teachers, said yesterday in a statement. “The Congressional Budget Office projects that education will suffer a 7.8 percent cut, forcing massive reductions to education programs for our most disadvantaged students and those with disabilities.”

300,000 Jobs Lost

Those cutbacks follow years of actions that have cost more than 300,000 educators their jobs, Weingarten said.

Many states and cities are still grappling with budgets squeezed by the 18-month recession that ended in June 2009.

States and municipalities got $630 billion in federal aid in fiscal 2010, U.S. Commerce Department figures show. Before yesterday, governors from both parties had expressed concern that Congress may reduce their funding to lessen the federal deficit, leaving them saddled with responsibilities such as Medicaid. The National League of Cities also pressed supercommittee members to avoid removing the tax exemption for municipal-bond income, which drives down the returns investors demand to buy the debt.

Industry groups remain vigilant regarding the tax status of municipal bonds as well.

Watching Tax Policy

“We will continue to watch this process to ensure that our members and the many state and local governments that benefit from lower financing costs are not harmed by an unprecedented change in tax policy,” Kenneth E. Bentsen Jr., executive vice president for public policy for the Securities Industry and Financial Markets Association, said yesterday by e-mail.

Cuts triggered by the stalemate would take about $11 billion out of state aid in fiscal 2013, which begins in October, or a 6.1 percent reduction from estimated current levels, affecting such areas as education, housing, urban development, public safety and some transit services, according to an analysis by Howard’s group. She said decisions regarding the 2012 and 2013 budgets will affect the exact amounts.

Michael Bird, a Washington lobbyist for the legislatures group, said protections for some programs provide scant solace.

“States get saved on the Medicaid side while they get punched in the face on education, transportation, energy, environment, labor and all the other programs,” including some that must obey federal mandates, he said.

Credit Concerns

For mayors, the chief concern is whether Congress’s failure, or steps taken later to prevent the automatic spending reductions, may cause bond markets to push up borrowing costs or trigger a cut to the U.S. credit rating, according to Lars Etzkorn, who handles federal relations for the National League of Cities in Washington. S&P said the supercommittee’s failure wouldn’t change its credit rating on federal debt, which it cut to AA+ Aug. 5 with a negative outlook.

Cities have the wherewithal to deal with the mandatory spending cuts the stalemate may bring, he said.

“They don’t decimate the partnership that we have with the federal government,” he said. “They’re manageable.”

New York Governor Andrew Cuomo said his state stands to lose $5 billion over the next decade through the automatic cuts.

“These events, combined with a stagnant national economy and the expanding fiscal crisis in Europe that has led to a sudden and severe decline in revenues for the state, have dramatically changed the fiscal course” for New York, he said yesterday in a statement.

“The failure of the committee will mean that thousands of jobs that would have been created will just go without being created,” New York Mayor Michael Bloomberg told reporters yesterday on Staten Island. “Thousands of men and women who would have gotten back to work will remain unemployed.”

The mayor is founder and majority owner of Bloomberg News parent company Bloomberg LP.

To contact the reporter on this story: William Selway in Washington at

To contact the editor responsible for this story: William Glasgall at

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