Video: Testimony of Iris J. Lav on "Economic Recovery: Options and Challenges"

PDF of testimony (10pp.)

October 20, 2008

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Hearing Titled: “Economic Recovery: Options and Challenges”

  • There are 29 states that closed shortfalls of $48 billion in enacting their fiscal year 2009 budgets (for the year beginning July 1, 2008 in most states). The shortfalls equaled 9 percent of these states’ general fund (operating) budgets.
  • Since fiscal year 2009 budgets were enacted, budgets have fallen out of balance producing new, mid-year deficits in 22 states and the District of Columbia that total more than $11 billion or 4 percent of budgets.
  • The latest revenue collection numbers suggest that the situation is rapidly worsening. Third quarter 2008 sales tax and income tax revenue are coming in well below prior year levels and well below states’ initial projections in most of the states that have released figures. These latest figures have not yet been taken into account in most states’ budget forecasts.

At least 16 states have announced that they are expecting deficits for state fiscal year 2010 that so far total $18 billion, but that number is very low because it is very early in the year for most states to make such a projection and because revenue collections continue to weaken. Deficits during the downturn in the early part of the decade reached $75 billion and $80 billion in the second and third year of that fiscal crisis, and economic conditions are now projected to be significantly worse than they were then. Judging from the rate at which revenue is deteriorating and the history of prior recessions, the 2010 gaps are likely to be in the $100 billion range.

These state deficits are particularly problematic because, unlike the federal deficit, they lead directly to spending cuts and tax increases that reduce demand, which further harms the economy.

Whenever the national economy stagnates or falls into recession, state revenues also stagnate or decline. This happens just at the very time that states face upward pressure on their budgets as residents lose jobs and income and health insurance and become eligible for Medicaid or other safety net programs. This produces deficits.

These state deficits are not like the increase in the federal deficit that typically also occurs during a recession. This is because all states but one have a requirement to balance their general fund (operating) budgets. States with flagging revenues cannot provide even the normal level of services — let alone meet the increased demand for services and supports.

Under balanced budget requirements, states have three primary actions they can take during a fiscal crisis: they can draw down available reserves, they can cut expenditures, or they can raise taxes.

Most states do keep “rainy day funds” and other reserves to try to anticipate this problem. States entered this period of economic weakness with the largest reserves they have ever had, totaling $69 billion or 10.5 percent of their general fund budgets at the end of fiscal year 2007. But those funds are on the road to being depleted for the purpose of budget balancing — and that was before the events of the last four weeks that undoubtedly have weakened fiscal conditions in the states.

The other two options states have to meet their balanced budget requirements are tax increases and budget cuts. These options both are pro-cyclical. That is, they intensify the economic downturn rather than help the economy recover.

The spending cuts and tax increases states make when they must balance their budgets under conditions of falling revenue can further slow a state’s economy during a downturn and contribute to the further slowing of the national economy, as well. When states cut spending, they lay off employees, cancel contracts with vendors, eliminate or reduce payments to businesses and nonprofit organizations that provide direct services, and cut benefit payments to individuals. In all of these circumstances, the companies and organizations that would have received government payments have less money to spend on salaries and supplies, and individuals who would have received salaries or benefits have less money for consumption. This directly removes demand from the economy.

Tax increases also remove demand from the economy by reducing the amount of money people and businesses have to spend.

In contrast to the states, the federal government can run a deficit, and it does not have to take the actions damaging to the economy (and to low- and middle-income families needing state services) that state balanced budget requirements force on states during recessions. Thus, one of the best ways to stimulate the economy in a downturn is for the federal government to provide short-term, additional funding to states.

You will recall that in 2003, you enacted a $20 billion fiscal relief package for states. It provided two types of assistance to states: 1) a temporary increase in the federal share of the Medicaid program; and 2) general grants to states, based on population. Each part was for $10 billion.

While extremely important, the 2003 fiscal relief package was not enacted until after 1 million people lost eligibility for Medicaid because of state cutbacks, and deep cuts had been made in K-12 education, child care, state workforces, and a variety of other areas. In the best of all worlds, it would have been enacted before those demand-reducing cuts were made.

States already have begun cutting their budgets; about half of the states have made cuts in public health programs, services for the elderly and disabled, K-12 education, or universities and colleges. At least 18 states have cut their workforce. And states are on the verge of making far more drastic cuts as they deal with their mid-year deficits and begin to enact fiscal year 2010 budgets.

There is the opportunity to prevent many of these damaging actions through providing fiscal relief. Preventing these pro-cyclical state actions is among the best forms of stimulus you could provide, because it both prevents budget cuts to programs that are needed by people who are losing jobs and incomes in this recession, and prevents state actions from worsening the economy.

This time around, however, it seems that much more than $20 billion in relief will be necessary.

  • To stop the most damaging of the budget cuts, fiscal relief of approximately $50 billion would be needed. This would be about one-half of the expected deficit for state fiscal year 2010 (or less than one-third the combined deficits for state fiscal years 2009 and 2010).
  • The majority of the fiscal relief ($30 billion to $35 billion) would be most effective as an increase in the federal share of the Medicaid program (FMAP), accompanied by a ban on states reducing eligibility in that program and thereby driving up the ranks of the uninsured. Without such assistance, the number of uninsured in this country could rise to 50 million.
  • The remainder of the relief could be made available to prevent cuts in education and other critical state programs, as well as to lower the likelihood that states will cut aid to localities.

Federal fiscal relief of $50 billion would provide a substantial stimulus by averting that amount of pro-cyclical actions by states that otherwise would be inevitable.It would be sufficient to prevent many of the state budget cuts that would be most harmful to low- and moderate-income households, including the newly unemployed. But, relative to the size of the deficits, it would not create a “moral hazard” that could in any way induce states to be less responsible with their own finances. The need to amass substantial “rainy day funds” and other reserves during strong economic times would remain.

I would stress that the payments to states would be temporary. States should be allowed to use fiscal relief over a 15 month or 18 month period after enactment.

The hallmark of a good stimulus is that it is well-targeted, temporary, and timely. Federal fiscal relief to the states fits well on all of those dimensions. For these reasons, a number of economists have called for fiscal relief to the states to be a key part of a stimulus package, including Mark Zandi, Paul Krugman, Lawrence Summers, Jared Bernstein, and Alan Blinder, among others.

Click here to read the full-text PDF of testimony (10pp.)

End Notes:

[1] This includes states with deficits that were closed in enacting their fiscal year 2009 budgets, states with mid-year gaps, and three states (Kansas, Oregon, and Washington) that did not have fiscal year 2009 deficits but are projecting deficits for fiscal year 2010.

 

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