Commentary: Why States Will be a Drag on Recovery

By Howard Gleckman

What the feds giveth, the states may soon take away. As Washington struggles to boost the sagging economy, cash-strapped cities and states are facing enormous budget cuts and tax hikes that could drag it back down. States may be looking at a shortfall this fiscal year of up to $50 billion. And that could neutralize as much as a third of any tax cuts and new spending in a Washington stimulus package.

Hard times hammer states because governors, unlike the President, must balance their books every year. As a weak economy slashes revenues and boosts costs for safety net programs, states must cut other spending or jack up taxes. Making matters worse, proposals in Washington to speed up corporate tax write-offs for capital investment could drain up to $5 billion from state coffers.

Add to that the domestic war on terrorism, which has busted public-safety budgets. West Virginia Governor Bob Wise says his state police ran up 1,900 overtime hours in just one month. Even the state's one bomb dog is exhausted. "Her sniffer is wearing out," frets Wise.

In different circumstances, added spending might be a boost. After all, those state troopers are getting a lot of extra money to spend. But with states in a fiscal crunch and the feds not reimbursing security costs, every dollar for anti-terrorism must come from other programs.

MAKING DO. Governors and mayors need a helping hand. Nobel Prize-winning economist Joseph E. Stiglitz suggests the feds simply send checks to the states. Another idea: temporary grants to cover the direct costs of homeland security and recession-induced layoffs. Even conservatives, who doubt added spending can boost the economy, agree that Washington should pay for some additional security costs. "There's a reasonable argument for that," says Chris Edwards, fiscal policy director at the libertarian Cato Institute.

The news for states hasn't been this grim since the 1990-91 recession. According to the National Conference of State Legislatures, 44 states report lower-than-expected revenues, and at least 19 face higher-than-expected costs. Massachusetts is confronting a $1.4 billion deficit. Governor Jeb Bush is battling a $1.3 billion shortfall in Florida. And with revenues in California more than $1 billion below forecast, Governor Gray Davis has asked state agencies to trim budget requests by 15%.

For now, most states are trying to make do with modest spending cuts, asset sales, and rainy-day funds. But if the economy continues to stagnate, the budget ax will fall. On the likely hit lists: school and road construction and aid to the poor. And while few states are talking about raising taxes yet, several, including Florida and Massachusetts, are mulling delays in scheduled tax cuts.

The program causing some of the biggest headaches is Medicaid, which provides health care for the poor and many seniors. Washington pays about half the costs, and states pick up the rest. This year, Medicaid accounts for roughly 20% of state budgets.

Rising unemployment is sharply boosting demand for Medicaid. Costs were expected to increase by nearly 11% even before the slump. And the Urban Institute, a Washington think tank, figures a one-percentage-point rise in jobless rolls will throw 1.5 million more people onto the program.

In Ohio, officials expected 39,500 new Medicaid patients in the July-to-October quarter, but more than 67,000 signed up. Ohio Medicaid chief Barbara Edwards says the state may have to trim services or eligibility. One way to forestall such cuts: Persuade Congress to raise temporarily the federal share of Medicaid.

Shipping cash to states is not very popular in Washington, which itself is again looking at the prospect of fiscal red ink. But by ignoring the problems now festering in the heartland, Congress and the White House will end up diluting the fiscal stimulus over which they are battling so hard.

Gleckman covers fiscal policy from Washington.

    Before it's here, it's on the Bloomberg Terminal.