Revised August 18, 2004

PASSING DOWN THE DEFICIT:
FEDERAL POLICIES CONTRIBUTE TO THE SEVERITY OF THE STATE FISCAL CRISIS
By Iris J. Lav and Andrew Brecher

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Executive Summary

The state fiscal crisis has been deep and prolonged.  States have struggled to close deficits that have totaled approximately $190 billion over the past three years.  And, as states debate and enact budgets for fiscal year 2005 (which, in most states, begins on July 1, 2004), they are facing deficits of roughly another $40 billion for that year.

Federal policies, which have reduced state revenues and imposed additional costs on states, have played a significant role in enlarging these deficits and are impeding states’ fiscal recovery.  These federal policies have contributed significantly to the need for states and localities to make expenditure cuts and enact tax increases to bring their budgets into balance.

• Federal policies have cost states and localities more than $175 billion over the four-year course of the state fiscal crisis, from state fiscal year 2002 through fiscal year 2005.

• These costs have averaged 8.4 percent of total state general fund budgets during that time, a large amount.

• The federal government provided $20 billion in federal fiscal relief to the states in  2003.  This $20 billion helped states avoid some budget cuts and tax increases, but it pales in comparison to the magnitude of the state fiscal crisis and to the more than $175 billion in state costs and forgone revenues over the 2002-2005 period that are attributable to federal policies.  (See Figure 1.)

In seven states, the net cost of these federal policies — the total cost less the offsetting fiscal relief — exceeds $5 billion over the course of the fiscal crisis.  The states with the largest net losses from federal policies are California ($23 billion), New York ($13 billion), Texas ($12 billion), Florida ($11 billion), Illinois ($6 billion), Michigan ($6 billion), and Pennsylvania ($5 billion).

The net loss relative to the size of state budgets varies substantially by state, from a low of 1.4 percent of the general fund budget in Alaska to a high of 13.3 percent in Florida.  The 11 states in which federal policies have imposed the greatest net costs, averaging at least 10 percent of their general fund budgets over the course of the fiscal crisis, are Florida, Nevada, Missouri, Mississippi, Louisiana, Arkansas, Colorado, South Carolina, Texas, Oklahoma, and South Dakota.

• The states bearing the greatest relative cost of federal policies tend to be among the least affluent states in the country, as measured by per capita income and poverty rate.  Arkansas, Louisiana, Mississippi, Oklahoma, and South Carolina are among the ten states with the lowest average per capita incomes and highest poverty rates in the country.  They also are among the states most harmed by federal policies.

• Eight of the 10 poorest states  —  Arkansas, Mississippi, West Virginia, Louisiana, Alabama, Oklahoma, South Carolina, and Arizona  — are among the 20 states with the most severe losses resulting from federal policies.

• States that have a relatively heavy reliance on federal funding for their budgets also are among those that have been hardest hit.  Of the 11 states with the greatest losses as a share of their budgets, six — Missouri, Mississippi, Louisiana, Arkansas, South Carolina, and South Dakota — are among the 20 states that derive the highest proportion of their revenues from federal funds.

• States that are most reliant on raising revenues through a sales tax are another group that is bearing a high cost of federal policies.  Among the 11 states with the greatest loss from federal policies relative to their budgets, Florida, Nevada, Mississippi, Texas, and South Dakota are also among the 10 states with the greatest reliance on sales taxes for revenues.   As described below, federal policies that bar states from levying or effectively collecting sales taxes on certain items or transactions are among the most costly of the federal provisions affecting states.

• Finally, five of the 11 states with the greatest relative loss from federal policies have lost a significant amount of revenue as a result of the federal tax changes of the past three years.  Florida, Missouri, Louisiana, Colorado, and Oklahoma all fall into this category due to their failure to decouple their tax codes from these federal changes.

  At least five areas of federal policies have contributed to these monetary losses and to the fiscal distress of the states: federal tax policy, federal preemption of state and local taxing authority, the failure of Congress to address Supreme Court rulings that prevent states and localities from collecting taxes owed to them, mandates that require states to spend funds for particular purposes, and federal Medicare and Medicaid policies that have become expensive for states.

• Some of the federal tax cuts enacted in 2001, 2002 and 2003 are reducing state revenues because of linkages between the federal and state tax codes.  While some states have “decoupled” their tax systems from some of these federal tax cuts, others have not.  The states that have not decoupled are losing approximately $9 billion during the four-year course of the fiscal crisis.

• Federal policies bar states from imposing normal state taxes on certain types of transactions.  One example is the federal Internet Tax Freedom Act, first enacted in 1998, which bars states from placing taxes on the access fees that people pay for their Internet service.  Just this one preemption of state taxing authority is costing states over $4 billion during the fiscal crisis.

• Two Supreme Court cases prevent state and local governments from collecting sales taxes on most items that their residents buy through catalogs or over the Internet, even though sales taxes apply when the very same items are purchased in retail stores.  The Supreme Court noted that Congress has the authority to enact legislation that enables states that elect to do so to exercise their normal authority to impose sales tax on such purchases.  Although federal legislation has been introduced to correct this problem, it has not garnered significant support from Congress or the Administration, and its passage is not expected anytime soon.  Research suggests that state and local governments are losing at least $61 billion during the fiscal crisis as a result of the federal government’s lack of action to resolve this problem.

• The federal government has placed an assortment of demands and requirements on state and local governments without adequately funding them.  These so-called unfunded mandates or underfunded obligations include requirements in the areas of election reform, education of disabled children, and the No Child Left Behind law.  Total funding for these programs is $73 billion below promised funding levels.

• Finally, there is the failure of the federal government to cover the cost of prescription medications for low-income elderly and disabled individuals who are eligible for both Medicare, which is a federal program, and Medicaid, a program for which states bear an average of 43 percent of the costs.   For all other services covered by both Medicare and Medicaid, Medicare is the primary payer.  Nevertheless, the federal government for many years failed to act to cover prescription drugs under Medicare — despite enormous shifts in medical practice in recent decades that have made drug therapies central to the provision of health care.

This has been a particular problem for states during the fiscal crisis, during which time the cost to Medicaid of providing prescription drugs to the population eligible for both Medicare and Medicaid has been rising at double-digit rates each year.  As a result, states (and the few localities that contribute to Medicaid) are spending about $28 billion in state and local funds during the course of the fiscal crisis to provide prescription drugs to low-income elderly and disabled beneficiaries who are eligible for both Medicare and Medicaid.[1] 

In addition to the negative impact of specific federal policies, there is the question of whether the federal government has taken sufficient action to alleviate the severity of the state fiscal crisis.  The federal government is the only level of government that can — and arguably should — run temporary deficits during an economic downturn.  It makes sense for the federal government to use this power to run temporary deficits to stimulate the economy when it is weak, and to do so by — along with other steps — providing sufficient temporary fiscal assistance to states to avert some of the more severe types of measures that states have had to institute in the past few years to balance their budgets.  Congress did provide $20 billion in fiscal relief to states in 2003, and that relief has proved important to states, but it pales in comparison to the size of the problem.  Even after taking fiscal relief into account, the cost to states of federal policy has averaged 7.4 percent of total state general fund budgets since the fiscal crisis began.

If the federal deficit were not mounting at an alarming rate in part because of costly tax cuts heavily geared toward high-income households, the federal government could afford to do more to help states avert substantial cuts in education and health care and significant state tax increases.  Such actions by states have constituted a drag on a weak economy and also can have decidedly negative human consequences.

Table 1
Total Costs and Net Costs of Federal Policies
In Millions of Dollars

	Total Costs	% of budget	Net costs	% of budget
Florida	12,177	14.4%	11,229	13.3%
Nevada	1,207	13.8%	1,102	12.6%
Missouri	3,721	13.4%	3,345	12.0%
Mississippi	1,835	13.2%	1,625	11.7%
Louisiana	3,058	11.6%	2,749	10.4%
Arkansas	1,634	11.6%	1,458	10.4%
Colorado	2,568	11.4%	2,329	10.3%
South Carolina	2,300	11.4%	2,044	10.1%
Texas	13,345	11.2%	12,067	10.1%
Oklahoma	2,122	11.2%	1,904	10.0%
South Dakota	433	12.0%	361	10.0%
Wyoming	353	12.1%	286	9.8%
Alabama	2,391	10.7%	2,126	9.5%
Vermont	413	11.6%	330	9.2%
Tennessee	3,426	10.4%	3,003	9.1%
North Dakota	390	11.0%	318	9.0%
West Virginia	1,190	9.9%	1,065	8.9%
Kansas	1,693	9.6%	1,539	8.8%
Arizona	2,569	9.9%	2,224	8.6%
Nebraska	955	9.0%	847	8.0%
Kentucky	2,546	8.8%	2,270	7.9%
New Hampshire	480	9.5%	396	7.8%
New York	14,827	9.1%	12,663	7.8%
New Mexico	1,433	8.5%	1,297	7.7%
Washington	3,810	8.3%	3,409	7.4%
Georgia	4,997	8.1%	4,479	7.3%
Utah	1,148	7.9%	1,031	7.0%
Michigan	6,200	7.7%	5,545	6.9%
California	23,426	7.6%	20,987	6.8%
Illinois	6,890	7.5%	6,120	6.7%
North Carolina	4,416	7.6%	3,864	6.7%
Idaho	599	7.5%	514	6.4%
Indiana	3,093	7.2%	2,718	6.3%
Pennsylvania	6,228	7.3%	5,328	6.3%
Maine	764	7.3%	649	6.2%
Virginia	3,290	6.6%	2,875	5.8%
Iowa	1,222	6.6%	1,037	5.6%
Ohio	5,767	6.2%	4,996	5.4%
Oregon	1,284	6.5%	1,068	5.4%
Wisconsin	2,738	6.1%	2,385	5.3%
Maryland	2,539	5.9%	2,206	5.2%
Rhode Island	665	6.0%	564	5.1%
Hawaii	849	5.5%	768	5.0%
Minnesota	3,048	5.6%	2,686	4.9%
Montana	323	6.2%	250	4.8%
New Jersey	4,720	5.0%	4,159	4.4%
Connecticut	2,352	4.8%	2,102	4.2%
Delaware	441	4.3%	367	3.5%
Massachusetts	3,780	4.1%	3,231	3.5%
DC	597	3.9%	504	3.3%
Alaska	206	2.2%