Welcome to Fend for Yourself Federalism

Our 2017 fiscal policy panel examined a future in which more responsibilities devolve to states backed up by the type of uncertainty and unpredictability only the federal government can provide.  From the September-October 2017 edition of Fiscal Focus.

When President Trump released his budget earlier this year, some used the phrase “shock and awe” to describe the proposed cuts and the change in the federal/state relationship it represented.  Even though Congress is likely to temper these cuts through its own budgeting and appropriations processes, it’s clear the major push for tax relief combined with the federal government’s challenges in funding its own existing and massive health care and retirement responsibilities is likely to have big ramifications for federal support for state and local government.

What does the current federal budget debate suggest with respect to future state and local government budgets?  What services are most exposed?  What are states doing to prepare for what is coming?  And to what degree are states’ own self-inflicted fiscal problems likely to make the impacts of federal cuts worse?  This was the focus of our 2017 fiscal policy panel, moderated by American Public Media’s senior economics contributor Chris Farrell.  Panel participants were Donald Boyd, Director, Fiscal Studies, Rockefeller Institute of Government; Natalie Cohen, Managing Director and Head of Municipal Research, Wells Fargo; Myron Frans, Commissioner, Minnesota Management and Budget;  and Robert Zahradnik, Principal, State Fiscal Health and Economic Growth, Pew Charitable Trusts.

Reactions to the Other Side of the Ledger

Because of the panelists’ extensive state and local government finance expertise, each was asked to first offer their own thoughts on the tax reform debate and the issues the morning’s first panel raised.  Don Boyd echoed the comments of Lindholm and others in contrasting and juxtaposing the highly detailed, serious, and studious reform effort of 1986 with the vague, imprecise, goalpost-shifting effort of 2017.  In sharp contrast to nine pages of ambiguity, the 1986 effort featured “two thick volumes from the U.S. Treasury on every issue you can imagine” with accompanying arguments for and against various options.  President Reagan supplemented that with his own analysis, which, albeit a bit more political, was nevertheless a very serious presentation of the issues detailing the rationale and reasoning behind their proposals.  Everything was put on the table and vetted, not just politically expedient and actionable items.

Boyd continued by expanding on the ramifications of eliminating state and local tax deductibility, noting that states that would feel the greatest impacts also happen to be the states the federal government relies on most to support its own large redistributional efforts.  He concluded by noting that there are potentially real consequences for state budgets whether tax reform eventually materializes or not.  That’s because even debates about taxes can change behaviors.  He provided the example of deferring dividends and capital gains based on expectations of future tax relief – evidence of which may be unfolding right now.

Natalie Cohen also reflected on the shifting motivations behind tax reform – from a sense of principle to what now appears to be a pursuit of political expediency.  The result, she argued, is that states need to be “on guard” with respect to what smaller items get included and to think of the cumulative and interactive effects of various measures on both the tax and spending side.  Bob Zahradnik observed one of the primary outcomes of federal tax reform would be to elevate the already high levels of uncertainty and exposure surrounding state budgets.  States must actually balance their budgets and are already buffeted by risks of general economic conditions plus uncertainties surrounding federal revenue streams.  Federal tax reform interjects yet another element of unpredictability making the jobs of state and local budget officers just that much more difficult.

Defining the Fiscal Uncertainty

The federal budget outlook is beset with even more ambiguity and uncertainty than that plaguing tax reform.  As of this writing, the House budget includes $4.5 trillion of health care, other mandatory program, and domestic discretionary spending savings over 10 years, but includes budget reconciliation instructions for a proportionately modest $203 billion of actual spending cuts in 2018.  The Senate is even less specific – $4.6 trillion in mandatory and discretionary savings but instructions for only $1 billion in cuts in 2018.  In addition, the Senate budget doesn’t even allocate that $1 billion to authorizing committees and leaves $2.2 trillion unallocated to specific budget functions.1

So what is the big picture and what sort of responses do states consider in this type of environment?  Commissioner Frans began by commenting that the current degree of uncertainty and risk “is about as high as it can get,” presenting a tremendous challenge for state forecasting.  The state is looking most closely at the federal budget because tax reform is so vague and uncertain at this time.  He offered some examples from the Department’s April estimates of how the Trump administration’s budget would cut federal support for several state departments:

  • Agriculture – 21%
  • Commerce – 16%
  • Education – 13%
  • Health and Human Services – 17.9%
  • Pollution Control Agency – 12%
  • Department of Labor and Industry – 3.8%
  • Transportation – 13%

This does not include health care delivery associated with “repeal and replace” which the state estimated could cost the state $2 billion in FY 20-21.

The big picture for Natalie Cohen is a future where lots of responsibilities and decisions are pushed down to the state level with both foreseen and unseen consequences.  “Block granting” – a major theme this year – may offer states more flexibility but would also mean less money over time.  Moreover, “flexibility” functionally translates into having to make very difficult and potentially contentious political decisions at the state level about eligibility thresholds and support levels.

Cuts may also end up being a crash course in government for taxpayers as Cohen identified several “sleeper” issues that could have compounding effects.  As an example she highlighted the U.S. Department of Agriculture, where cuts might sound harmless but the department is where food stamps and school lunch program funding resides.  When combined with potential cuts in federal education funding itself, the result is a compounding effect on state department K-12 funding and school district budgets.  Similarly, while the public may associate Medicaid spending with health care for low-income households, the public may learn to its surprise that the program supports 60% of nursing home residents.

Bob Zahradnik emphasized how states need to prepare and plan for contingencies, noting on average one-third of state budgets are reliant on federal funds (Minnesota is 29.4% on an all funds basis) with Medicaid, transportation and K-12 education being the most influenced spending programs.  He remarked it is in the states’ best interest to understand these federal flows and plan for them, describing two examples of best practice in this area.  Utah developed a federal funds study commission to analyze how federal dollars directly and indirectly impact the state.  Meanwhile Virginia, one of the states most dependent on federal dollars, has established a federal funds reserve fund.  He complimented Minnesota Management and Budget on its efforts to understand the influence of revenue volatility and tying it to general fund reserves, noting he has used Minnesota as an example of best practice across the country.  Arguing that ultimately citizens care about whether services are provided and not where the money comes from, Zahradnik maintained the political argument “it’s not our fault” won’t work; the burden is shifted to the states to better prepare.

Donald Boyd classified federal spending into four areas – direct payments (dominated by Social Security and Medicare), procurement (dominated by defense spending), state grants, and employee compensation.  Although the direct payments and procurement are the biggest targets, they are the least likely to get cut.  The bullseye will be state grants dominated by Medicaid, highway money, support for other social services, and education and training.

Boyd zoomed in on the elephant in the federal grant room – Medicaid.  Even if block grants commence without cuts and grow at something resembling population plus inflation, the change could still dramatically impact state behaviors for two reasons.  First, it would change the price of delivering Medicaid services because anything more a state may want to spend over the block grant must come dollar for dollar from state or local government budgets (unlike under the current partial federal reimbursement design).  Second, while the federal government can finance larger enrollment costs in recessionary periods through deficit spending, states lack that flexibility because they operate under mandatory balanced budget requirements.  If the state and local tax deduction is eliminated or capped, that further increases the price of Medicaid services – or for that matter infrastructure and any other general fund supported service.

Implications for State Economic Development

Much of the math justifying the tax and spending proposals being debated is based on expectations that greater economic growth will result.  Yet the relationship also works in the other direction since government spending pays for a wide variety of necessary public goods and services supporting state economic activity, growth, and innovation.  Are there implications for important economic development issues we should be cognizant of?

Panelists agreed that states will be challenged to strategically reexamine their workforce training and development programs – and potentially to rethink and redefine the problem itself.  Highlighting some of Minnesota’s demographic and labor market challenges, Commissioner Frans argued we will need to “step up our game” and develop the kinds of education and training opportunities that respond both to the new realities of labor markets and the competition for resources that would come with federal spending cuts.  Observing that mobility – dramatically down since the Great Recession – is an underappreciated and influential factor in workforce shortages, Cohen noted that next generation economic development spending may require creative programs to help address workers’ inability to relocate and get to where the jobs are.  Zahradnik reflected one “benefit” that might arise out of the introspection created by new levels of federal austerity might be states’ revisitations of the billions spent on economic development and tax incentives to see if they are actually getting their money’s worth.

With respect to infrastructure, in the words of one panelist, “you are on your own” but then again most government infrastructure is state and locally owned.  While the public may have high expectations of an infrastructure plan based on public statements during the 2016 election campaign with big accompanying numbers, Cohen argued the idea that the federal government will spend new money on infrastructure is a “myth that needs to be dispelled”.  She noted that all the talk so far has been about financing mechanisms like public private partnerships and not about spending actual federal dollars.  Even the $305 billion Fixing America's Surface Transportation (FAST) Act of 2015, the first federal law in over a decade to provide long-term funding certainty for surface transportation infrastructure planning and investment, was paid for largely by a Federal Reserve surplus which was, in Cohen’s words, “kind of a gimmick.”  Commissioner Frans reported that $3.5 billion in bonding requests for 2018 have already been sent to the governor, which will be trimmed to $1.0 - $1.5 billion before being submitted to the legislature.

Self-Inflicted Wounds

As Chris Farrell pointed out, we are in the ninth year of economic expansion, with very low unemployment and stock market records being set seemingly daily.  All this would suggest we should be having discussions over what to do with relative plenty rather than stressing over looming austerityThe question arises whether states are ready to embrace a new era of “fend for yourself federalism”.  The answer appears to be “no” for a number of reasons – some largely out of states’ control, others self-inflicted.

Boyd observed that in spite of the economy, there has not been much of a recovery in state and local finances.  Zahradnik concurred noting by Pew’s count 22 states had tax revenues in 2017 totaling less than their inflation-adjusted peak at the end of the Great Recession, signifying a lot of non-recovery.  The reasons, according the panel, are many.  Sales tax revenues lag growth in disposable income and taxable consumption due to both the difficulty of e-commerce collections and the shift to irregularly taxed services.  Income tax receipts are growing more slowly relative to historical standards influenced in part by income disparities, investors’ decisions to postpone realizing capital gains on the expectations of lower rates in the future, and a wide variety of preferential tax treatments provided to the fastest growing demographic – seniors.  Cohen concluded “every one of the classic taxes that state and local government collects is in a state of transformation.”  Zahradnik agreed saying, “Smart states will rethink how they are taxing.”

But states have also abetted the problem with their own fiscal mismanagement, and in no place is that more evident than in public pensions.  Zahradnik remarked there is a growing understanding that the assumptions underlying public pensions are unsound.  This leads to chronic underfunding of these plans and major redirections of state and local resources away from actual public services and into paying for legacy costs.  Don Boyd concurred saying the system of reporting and funding is “deeply, deeply flawed – dangerously flawed,” and “the Government Accounting Standards Board (GASB) hasn’t fixed it at all.”  He presented a map which recalculates unfunded liabilities relative to the state economy, saying “on this map red is very, very bad and green is just bad.”  Noting that Minnesota can take pride in being modestly bad, according to his analysis public pension contributions nationwide would have to go up $120-140 billion each year just to tread water (between $300 and $500 per capita in Minnesota).  Commissioner Frans highlighted the pension reform attempted earlier this year, saying he believes there is an opportunity to make incremental gains on the problem.

Is there a role for the federal government on this issue?  Boyd maintained there is a national interest in this topic rooted in retirement security, the fiscal risk to states, and well functioning debt markets.  However, federal government intervention is tricky because of sovereignty and moral hazard issues.  He argued the federal role consists of the applying “rules of road and signage.”  “There are no police,” he said and GASB rules are one of many things that have helped create this situation.  “They didn’t fix it and they are not going to fix it, and the actuaries themselves are unlikely to fix it.”  The first and probably only real role for the federal government is perhaps to put GASB under the auspices of the SEC (like FASB) or otherwise set the accounting and funding rules similar to what the private sector must abide by.

Any Glimpses of Sunshine?

After this frank assessment and discussion, meeting attendees might have been excused if they half-expected the ten plagues of Egypt to subsequently break out.  If there are positives to take away on this issue, according to the panelists, it’s the political fact that history tells us spending never gets cut as much as gets talked about.  They observed that despite the foreboding budget offered by President Trump early this year, in the most recent continuing resolution a lot of line items actually went up, not down.  And there is a lot of positive work and innovation going on in state and local government across the country that gets lost in the national news headlines.  That’s good news, because our laboratories of democracy will apparently need to concoct many new policy recipes for a long time to come.

Footnotes