October 31, 2008

October 31, 2008 | Commentary on Taxes

Don't Bail Out the States: Spendthrifts Made Own Mess

New York's Gov. Paterson was in Washington yesterday, testifying before Congress on why Washington should send him some help. Indeed, state governments from New York to California are begging Washington to bail them out of a combined $48 billion budget shortfall estimated for 2009. And the Democratic leaders of Congress are reportedly considering including a state bailout in the $300 billion economic-stimulus package now scheduled for debate after Election Day.

It's a terrible idea, on several counts.

For starters, it's a shell game. Sending federal aid to states wouldn't save taxpayers a dime because state taxpayers are also federal taxpayers. Hiking federal taxes to keep state taxes from rising is like running up your Visa card to keep the Mastercard balance from rising. Either way, you'll pay. All that changes is where you send your payment.

Governors typically respond that a federal bailout is preferable because it could be funded with deficits rather than new taxes - an option that 49 states with balanced-budget requirements lack.

But nobody forced these states to enact balanced-budget requirements. And they're free to repeal them anytime they can convince their voters to go along.

Furthermore, the inclusion of such a bailout in an economic "stimulus" package makes little sense. State spending doesn't suddenly become stimulative if it's funded by Washington instead of state governments. Either way, all spending "injected" into the economy must first be taxed or borrowed out of the economy. It doesn't matter which level of government is doing the taxing, borrowing or spending.

Congress already sends $467 billion a year to state and local government - up 29 percent after inflation since 2000. This is well beyond what's needed to reimburse states for federal mandates (and Washington has imposed few new unfunded mandates on the states since 1996).

The feds continue to give heavy subsidies to state health, education and transportation programs. But apparently that's not enough.

You'd think that, being so dependent on income-tax revenues - which are very volatile - states would build rainy-day funds during booms to cushion the inevitable recessions.

Instead, states keep responding to temporary revenue surges with permanent new spending programs. Between 1994 and 2001, states flush with new revenues shunned rainy-day funds and instead expanded their general-fund budgets by 6.2 percent a year.

All booms eventually end, and these free-spending states left themselves totally unprepared for the 2002-2003 economic slowdown. Yet instead of sufficiently paring back their bloated budgets, the states demanded - and got - a $30 billion bailout from Washington in 2003.

Bail out someone who's behaved irresponsibly, and you encourage future misbehavior. And that's just what happened: After the 2003 bailout, states went right back to spending - with annual budget hikes averaging 7.2 percent over the next four years. (Some also built up their rainy-day funds - but not enough.)

So, here we are again. Another economic slowdown, another round of bailout calls.

How will states learn to budget responsibly if they know they can keep returning to the federal ATM?

The biggest losers from a federal bailout are taxpayers who live in fiscally responsible states. They played by the rules and resisted extravagant new spending programs - and will be rewarded with higher taxes to bail out states that went on unaffordable spending sprees.

That is simply unfair. And it encourages responsible states to be less responsible next time. (After all, it's better to get a bailout than to have to help pay for one.)

The right answer is for the states to face facts: Set priorities, make trade-offs and reduce unnecessary spending. States that insist on deficit spending will have to reform their balanced-budget laws. Any federal aid to state governments should come in the form of loans to be fully repaid (with interest) within three years.

Don't hold your breath, though. Expect to pay for an expensive federal bailout - which will set up more bailouts in the next recession.

Brian M. Riedl is Grover M. Hermann Fellow in Federal Budgetary Affairs at The Heritage Foundation (heritage.org).

About the Author

Brian M. Riedl Grover Hermann Fellow in Federal Budgetary Affairs
Thomas A. Roe Institute for Economic Policy Studies

First appeared in the New York Post