Dire States

Deep in debt, most governors will have to either raise taxes or cut spending— exactly what not to do when recovering from a recession.

By Megan McArdle

Three years after the stock market cratered in 1929, American schools suffered their own crash. School districts had managed to ride out the early years of the Great Depression; in fact, because many districts depended on property taxes, which didn’t crash as fast as income taxes, more than a few managed to increase spending.

But in the 1932–33 school year, many districts ran out of funds. With more than one in five workers unemployed, many households didn’t have the money to pay property taxes, so all of a sudden, the school boards didn’t have enough money to pay their bills. Some 2,200 schools in 11 states closed entirely—in Alabama, schools in 50 out of 67 counties shut down. Many more districts cut services or sharply reduced their hours; thousands of districts in the Midwest and South shrank the school year to fewer than 120 days.

When we talk about government response to economic crisis, we tend to focus on the federal government; for one thing, it’s big, and it’s right there in Washington, where it’s easy to keep track of. But economic contraction is often felt most keenly by state and local governments, which deliver highly visible services like schools and police and fire departments.

Unlike the federal government, almost all states have to enact budgets that are nominally balanced. A recession may be the worst time to raise taxes, but it is also the worst time to cut services. Unfortunately, states have to do one or the other. And sometimes, as in those Depression-era school districts, they’re forced to do both.

This may be one of those times. State revenues collapsed in 2009, and though they’re now slowly recovering, the Rockefeller Institute reports that they are still 15 percent below where they were two years ago. At their current pace, receipts will take more than five years to recover to their 2008 levels. Some states, such as Alaska and Texas, had accumulated substantial rainy-day funds before the crisis, but most have relied on federal aid and budget gimmicks to stave off radical cuts. This year, the stimulus money will run out, and the new Republican majority in the House of Representatives is unlikely to allocate more—particularly since many of the worst problems are in blue states like California, New Jersey, and Illinois.

California has forced people to pay estimated taxes early, while giving IOUs to many of its suppliers. Illinois simply isn’t paying its suppliers at all. New Jersey’s new governor has already gotten into a bruising fight with the teachers union, and recently announced that he was scrapping an $8 billion second rail tunnel to New York City.

Such fiscal problems have been building for a long time. Politicians love to bestow goodies on their constituents, especially retirement benefits for public-sector workers—largesse that some future sucker ultimately has to pay for. Decades of this kind of behavior have left a lot of states with growing structural deficits. Many states have tried to paper over these shortfalls by issuing bonds or raiding special funds such as pensions; as a result, the overall debt of state and local governments has risen from $1.7 trillion in 2004 to $2.4 trillion in 2010, a 40 percent increase. The unfunded liability of the pension systems should also be added to that figure; according to economists Joshua Rauh and Robert Novy-Marx, that liability is more than $3 trillion, just for the states alone. Even when tax revenues eventually recover, this problem will not go away.

The economist Herb Stein famously said, “If something cannot go on forever, it will stop.” States with a permanent mismatch between taxes and spending will not be able to squeak by on budget gimmicks and backdoor borrowing forever; either they’ll find a way to bring their budgets into balance, or they’ll run out of money and default on their obligations. The path they choose will make a big difference in the future of the states, and of their citizens—and in the life of the nation as a whole.

Andrew Cuomo, the newly elected governor of New York, seems determined to build a career as a budget hawk. His campaign platform included admirably detailed promises on how to end the state’s budget imbalance, including a pledge to not raise taxes. Even before he was sworn in, the governor-elect was sending a blunt message to the state legislature. This is “about numbers,” Cuomo said. “There’s no Democratic or Republican philosophical dispute here. The numbers have to balance, and the numbers now don’t balance … It’s painful, but it is also undeniable.”

New York could have used federal aid from the stimulus to restructure its spending and make it more sustainable, but instead the money went mostly to shore up the old structure. Now any cuts will be deep, sharp, and much more traumatic than they had to be. And they will be opposed by an army of union workers and community activists who wield outsized influence in the Democratic primaries—a key consideration in such a deep-blue state.

In the past, notes E. J. McMahon, a senior fellow at the Manhattan Institute’s Empire Center for New York State Policy, governors who tried to cut the state’s health-care system were attacked with hard-hitting ads like one that portrayed a woman running down the street with a sick kid in her arms, only to find the emergency room locked. “‘Tell Governor Pataki not to kill Grandma,’” McMahon intones dryly. “And the ads work! Pataki caved after passing a few tough budgets.” Cuomo himself has described the process thusly: “The governor announces the budget; unions come together, put $10 million in a bank account, run television ads against the governor. The governor’s popularity drops; the governor’s knees weaken; the governor falls to one knee, collapses, makes a deal.” Perhaps unsurprisingly, over the past decade, New York’s spending has grown almost twice as fast as personal income.

Many states have what you might call a “Don’t kill Grandma” problem: spending creates dependent—and stubborn—constituencies. At least New York doesn’t have the legislative gridlock of California, where ballot initiatives have mandated spending and prevented tax increases, and a two-thirds-majority requirement to pass tax increases has resulted in a stalemate between free-spending Democrats and tax-averse Republicans. New York’s local economy hasn’t been devastated by the collapse of a primary local industry, as have those of Michigan and Nevada, where unemployment tops 12 percent. It does not, like New Jersey, have a history of underfunding its pensions.

True, the state is no repository of fiscal virtue. As Josh Barro of the Manhattan Institute says, “They’ve made their pension payments on time because state courts have essentially ordered them to make their pension payments on time—if the legislature had had the option to misbehave, I’m sure they would have.” But its vices aren’t excessive. Barro says that New York’s budget woes are probably worse than the average state’s, but not as bad as those of California, Illinois, or New Jersey.

Even so, New York State faces a $9 billion shortfall in its budget next year, a deficit of about 6.25 percent. And if it properly accounted for its liabilities, that budget hole would look a lot worse. A recent report from the Empire Center says that the state and local governments in New York have an unfunded liability of about $200 billion for retiree health care—benefits that the governments have promised workers without setting aside the money to pay for them. Meanwhile, Barro thinks that the state’s own pension projections are too optimistic. Using more-conservative assumptions, he contends that the major state pension plans are only about two-thirds funded.

The state’s retiree problem may be among the fastest-growing, but in pure size, Medicaid poses an even bigger fiscal headache. Roughly one in every four citizens of the state is on Medicaid; in New York City, that figure is closer to one in three. And New York’s per-­enrollee payments were the second-highest in the country, almost twice the U.S. average. Indeed, New York State, with about 6 percent of the nation’s population, accounts for more than 10 percent of total Medicaid spending.

According to a sobering report by the previous Lieutenant Governor Richard Ravitch, total spending on New York State’s Medicaid program by federal, state, and local governments in fiscal year 2009–10 topped $50 billion, more than a third of the state’s budget. That is projected to increase 27 percent by 2013—with the state’s share of the spending increasing much faster, as federal stimulus aid expires.

When health-care reform takes effect in 2014, the problem will get even worse. Few people realize that more than half of the health-care bill’s expansion of coverage comes from adding people to Medicaid. While the federal government will pay fully for newly eligible beneficiaries in the early years, by 2020 it will pay only 90 percent, and even less for people who were already eligible for Medicaid but not enrolled.

It’s hard to see how Governor Cuomo is going to cover gaps like this without raising taxes. His state’s feisty public-sector unions enjoy extremely favorable laws governing their collective bargaining. Under one provision, if a collective-bargaining agreement expires, the provisions of the old contract stay in effect until a new one is negotiated, including “step up” provisions that automatically increase wages. This means the unions have no incentive to agree to a contract less lucrative than the one they already have.

But the problem with government spending is not just that it creates powerful political constituencies; it also creates large groups of people who have planned their lives around jobs, or programs, that suddenly disappear. Sudden cutbacks—the kind that New York must now contemplate—may leave them worse off than if the program had never been created.

If fixing the state’s problems without tax increases seems hard, consider the prospect of actually raising taxes. New York is already one of the most highly taxed states, particularly when you consider how many of its residents are in the top federal brackets. Many jurisdictions have hefty local taxes as well—the combined top marginal tax rate for New York City residents is already near 10 percent.

Barro thinks the state may have finally hit its fiscal capacity, with businesses fleeing and the beginnings of a tax revolt in the New York City suburbs over property taxes and school costs. This has happened before—top personal-income-tax rates went up to 15 percent in the 1970s, and the result was an exodus of businesses, driven as much by middle managers outraged at their tax burdens, as by top executives incensed at the business taxes. But the governors and legislators who brought spending under control the last time around didn’t have the magnitude of pension and health-care burdens now facing the state.

According to Kenneth Adams of the Business Council of New York State, many of his members would love to expand in the state, but they can’t afford to, because the tax burden is too high on their businesses and their employees. East Coasters eagerly awaiting the opening of the next Wegmans supermarket in their area should perhaps give a silent thanks to New York State’s legislators; the hugely popular chain no longer seems to be opening stores in its home state, which now ranks dead last on the Tax Foundation’s annual State Business Tax Climate Index.

The situation is far from hopeless: as Barro notes, if the state closed just half the gap between its per capita Medicaid expenditures and the national average, it could lop $5 billion off its budget deficit. But that would mean a lot of unhappy Medicaid beneficiaries and health-care providers. Is Cuomo really willing to kill Grandma—or at least, the funding of Grandma’s home health-care aide?

In 1933, despite cuts, Arkansas could not stay solvent; it defaulted on $146 million worth of transportation bonds, a traumatic process that haunted the state for years. That was the last time a U.S. state defaulted on its bonds, but some economists are starting to worry again. “In California and New York,” says John Hood of the John Locke Foundation, “the fiscal crisis flirts with bankruptcy.”

According to Matt Fabian, a managing director at Municipal Market Advisors, “In the analyst community, there’s currently very little fear of default. It’s not like the industry is split—people who do municipal credit for a living just aren’t that worried.” Of course, very few mortgage-bond professionals expected house prices to collapse and drag the country down with them, and in both cases the experts’ logic is somewhat the same—it hasn’t happened since the Great Depression. But assuming Fabian is right that states won’t default on their debt, how will they get their financial affairs in order?

Raising taxes when the economy is still fragile would probably depress growth. Of course, so could cutting spending, because cuts would also throw thousands of state workers into a job market that already holds too few jobs. And cuts in benefits might end up being catastrophic for at least some beneficiaries.

But as McMahon notes, we’re not really talking about killing Grandma, or even abolishing Medicaid. We’re talking about holding spending to the levels that prevailed in, say, 2000, when I can personally attest that a lot of lively grandmothers were walking around the state.

There is no painless way to do this, especially with all the pressure about public-sector pensions that must be paid, but it needn’t be catastrophic. If politicians can muster the will, they can trim the state’s extremely generous Medicaid reimbursements, steer new state workers toward defined-­contribution plans rather than traditional pensions, and pare back retiree health benefits (which are not necessarily subject to collective bargaining). And if states like New York can get themselves back on a fiscally sustainable path, they won’t just make the accountants happy; they’ll make themselves more attractive to residents and businesses that will help grow the tax base—and improve everyone’s standard of living.

Of course, it’s easy to talk about mustering political will from a comfortable chair in a magazine office; it’s a lot harder to do in the face of television ads accusing you of grandmatricide. But states like New York have no choice. Neither taxpayers nor bondholders will fund ever-increasing spending. It can’t go on forever; it will stop. Cuomo’s challenge—the challenge facing most of our state governments—is to apply the brakes early, rather than letting the car come to an abrupt halt when it runs into a wall.

This article available online at:

http://www.theatlantic.com/magazine/archive/2011/01/dire-states/308330/