The Economy, the Stimulus Package and the States

The best estimate, though likely a conservative one, is that states will face budget gaps of about $250 billion over the next 2.5 years, through fiscal 2011. Because of balanced-budget requirements, states on their own would have no alternative but to cut budgets and raise taxes to close this gap.

Both of these actions, however, would only make the nation’s economic downturn longer and more severe. Most economists agree that providing federal money so states can defer these actions is one of the most effective ways of stabilizing the economy.

So, what are the prospects that the $275 billion being sent to states by the American Recovery and Reinvestment Act, the $787 billion stimulus package signed by President Obama last month, will help plug the states’ shortfall and also turn the nation’s economy around?

Three questions are important in determining the answer: First, what is the federal stimulus’ effectiveness in offsetting proposed tax hikes or spending cuts by states? Second, does the new federal money flowing to or through states have the appropriate mix? Third, can states meet the goal of stimulating the economy while also maintaining the efficiency of programs?

States get the most flexibility to help avoid spending cuts or tax increases from two categories of funds that total about $135 billion. The first is an estimated $87 billion extra in Medicaid health-care dollars that will allow states to re-program some of their own previous matching funds to other areas to offset planned budget cuts. The second is $48 billion in a state fiscal stabilization fund that can be used to offset planned education cuts.

This $135 billion can be used to offset states’ projected $250 billion in shortfalls through fiscal 2011. The new dollars are an appropriate amount that will help stabilize the economy and offset the most draconian cuts, but still will keep the pressure on states to continue to consolidate, streamline and downsize state government. The money already is having a positive economic impact as more and more states are postponing planned cuts.

The allocation across states could be better targeted. But the Medicaid formula does account for economic stress, and therefore many of the states with the worst underlying economies get a larger allocation of funds. Essentially, there are only a few small states-generally those that produce energy-that may receive funds above their needs. For most states, these flexible federal funds are far short of need. Still, with respect to the first question, the economic recovery package is effective in offsetting potential steps by states that would only prolong the downturn.

There are also two other major categories of federal stimulus funds going to states. First, the package contains a little less than $100 billion for existing state grant programs, from $27.5 billion for highways to $1 billion for community-services block grants to $3.1 billion for state energy grants. Many of these are formula grants while others are discretionary or competitive, which in total include about 50 programs. States have little flexibility here and in most cases will need to obligate and spend funds quickly to create jobs.

The other category directs about $40 billion into safety-net programs (not counting the $87 billion for Medicaid mentioned above), such as increased food-stamp benefits and eligibility as well as increases for welfare and childcare. The package also increases benefits and extends eligibility for unemployment insurance.

All these funds are part of the short-run stimulus portion of the federal law. The act also includes funds in four areas intended to establish a foundation for long-run economic growth: broadband, health IT, alternative energy, and research and development.

The mix of funds spreads out the economic impact of the $275 billion over the next 2.5 years and seems appropriate. The $135 billion in Medicaid and education dollars allows states to immediately postpone cuts and therefore will have a large, short-run positive economic impact but also will make a contribution over the next three years. The grants for highways and the like, on the other hand, will take six months before spending takes place but will make a major contribution in 2010 and 2011. A much stronger safety net is appropriate and will both protect individuals and families and stimulate the economy over the entire three-year period. This is particularly important given that we will likely lose an additional 3 million jobs over the next two years.

The major challenge for states is to spend the money quickly to maximize job creation while also maintaining program stability and efficiency and filling a budget gap that will last at least three years. Three years is based on the assumption that it will take two years for GDP to return to the 2008 level and a third year, based on historical observations that the year after a recession is generally the most difficult fiscal period for states. Given that all of the economic stimulus funds are temporary, it will be extremely difficult for states to spend funds quickly, fill a three-year budget gap and maintain program stability and efficiency.

Given the fact that the $135 billion in Medicaid and education funds will have an immediate positive economic impact, the focus of the grant programs should be more on stimulating the economy over the next two years. This will give states more flexibility to strike the right balance between job creation, filling their budget gaps and maintaining program efficiency.

Raymond C. Scheppach, Ph.D., is the executive director of the National Governors Association. The views expressed here are those of the author and do not necessarily represent those of the National Governors Association.