Volatile budgets and state debt from increased Medicaid expenses wreck fiscal federalism---that prevents effective state governance

While it may be premature to draw strong inferences about a general softening of the U.S. state/local budget constraint, the recent experience of substantial federal assistance to state and local governments to backfill budgetary shortfalls does not bode well for the future of U.S. fiscal federalism. The availability of substantial federal relief during times of fiscal crisis softens the obligation that state and local governments face to keep their fiscal houses in order. The risk is that, despite state constitutional provisions requiring a balanced budget, states will pursue de facto deficit spending and simply offload the costs to the federal government during the next fiscal crisis. To date, most federal assistance to the states has not had an explicit “bailout” frame, proceeding instead under the guise of general fiscal relief. A more severe crisis, however, could easily prompt emergency federal intervention. As economist Kenneth Rogoff recently noted, “‘[i]f we ran into a situation where one state got into trouble, they’d be bailed out six ways from Tuesday.’”21 Other commentators have called for a more comprehensive federal “rescue” of the states in the form of advances that would be charged against future federal transfers.22 This type of action, though perhaps warranted in the short-term to avert catastrophe, must be evaluated against the risk of eroding the incentives for subnational fiscal discipline over the long run. An important object in the design of U.S. intergovernmental fiscal policy going forward should be to minimize the likelihood of future demands for state fiscal relief during economic downturns.

Third, fiscal crises compromise the ability of state and local governments to serve a useful countercyclical function during economic downturns. It is well recognized that service demands on state and local governments increase during a recession.23 For example, state Medicaid expenditures increased significantly during the most recent recession, with an additional 3.7 million seeking program benefits in 2009 alone.24 Yet the existence of a fiscal crisis necessarily impairs state and local governments’ ability to meet those service demands; in fact, fiscal crises may prompt the opposite strategy — i.e., a reduction in state and local services. In order to preserve the ability of state and local governments to play a constructive role in countercyclical policy, the federal government may wish to adopt certain policies design to minimize the likelihood of future fiscal crises.25 In other words, it is in the federal government’s interest to minimize, to the extent possible, having state and local governments in budget crisis mode during the next economic downturn.

B. The Role of Revenue Volatility in State Fiscal Crises

There is a growing consensus among commentators and policymakers regarding the adverse effects of revenue volatility on state and local budgeting. In the years preceding the two most recent recessions, state and local tax revenues surged, permitting an expansion of government services and tax cuts.26 These boom-year fiscal policies generated political expectations regarding the level of services and taxes going forward. With the onset of each recession, however, state and local governments faced yawning gaps between expenditure levels and tax receipts — prompting demands for federal assistance. In other words, volatility played two separate and equally important roles in creating the conditions for fiscal crisis — surging tax receipts during the boom years stimulated demand for new programs and tax cuts, while plunging tax receipts during the bust years made continued satisfaction of those demands impossible. The implicit counterfactual here is that more stable revenue levels across time would have translated into more consistent and realistic public service demands, thereby minimizing the likelihood of (or at least reducing the severity of) budget imbalance in the down cycle.