Jan | Feb 2014


A Marriage of Money

By Anne Stauffer, Director of Fiscal Federalism at The Pew Charitable Trusts
and Former Federal and State Budget Official
The relationship between federal and state finances is complex, not well understood and vital to almost every aspect of Americans’ lives. Federal and state tax dollars jointly support schools, roads, health care, public safety and other key programs. This partnership, however, is under pressure from the enormous fiscal challenges of the past several years and the ongoing fiscal uncertainty at the federal level. An informed conversation using real data on the state impact of federal policies could help policymakers make the tough choices required to put all levels of government on a path to fiscal stability.
A dialogue is critical because federal and state finances are closely intertwined. Federal grants for health care, education, transportation and other programs make up roughly a third of state budgets, ranging from 24 percent in Alaska to 49 percent in Mississippi in 2011, the last year for which complete data are available.
Beyond that, total federal spending levels in states—on grants, contracts, salaries and direct payments to individuals for programs such as Social Security—are significant relative to the states’ overall economies, equivalent to between 12 percent of state gross domestic product in Delaware to 36 percent of state GDP in New Mexico, in 2010. In addition, many state-level fiscal policies piggyback on federal policies.
Thirty-seven states, for example, use a federal definition of income to calculate state income taxes. This means federal spending and tax code changes affect state economies and budgets, which states try to anticipate and prepare for.
The multiple and varied links between federal and state finances mean the ongoing federal budget stalemate creates uncertainty at all levels of government. Even though the Budget Control Act of 2011 put in place mechanisms to reduce the federal deficit through the 2021 fiscal year, until Congress agrees on a full-year budget for 2014, it is unclear which programs will be cut to achieve the required savings.
Disagreements over federal budgets are nothing new. Congress has not enacted a budget by the start of the fiscal year since 1997. But this year, uncertainty about the federal budget has reached a new level. Prior to implementation of the sequester in March, federal agencies and states received little guidance on how the cuts would be made, making it hard for them to plan. Indeed, the Office of Management and Budget did not finish issuing official guidance on sequester implementation until after the sequester took effect. For certain programs, such as the U.S. Forest Service’s Secure Rural Schools payments, federal funding was distributed to the states before the sequester, and the Forest Service subsequently told states to return a portion of that funding.
For the 2014 fiscal year, the story has not changed. Congress once again could not agree on an overall spending plan through the regular appropriations process. Indeed, uncertainty ratcheted higher during the government shutdown. As of mid-October, it remained unclear when the shutdown would end and whether funds would be provided on a temporary or full-year basis. States may not know what level of federal funding to expect until well into their budget year.
This leaves most states in a bind because their own fiscal years started July 1. Unlike the federal government, states have to balance their budgets every year. They’ve already made difficult choices in balancing revenue and spending priorities. If the federal funding they expect falls short, states will need to make another round of tough decisions. As one state budget director put it, the ongoing uncertainty at the federal level leaves states flying blind when it comes to managing their current-year budgets and making plans for the next fiscal year.
All of this uncertainty comes as states and their local governments are especially vulnerable to changes in federal spending. State revenues have been slow to recover from the Great Recession of 2007-09. And, although states are replenishing their rainy day funds, on average they are still well below their peak in 2006. Local governments are also feeling fiscal pressures, as property taxes and state aid dropped simultaneously in 2010, for the first time since 1980, and remain below prerecession levels.
During this period of fragile economic recovery and heightened federal budget uncertainty, a dialogue between the federal government and states is needed to help promote fiscal stability at both levels of government. In the past, there were formalized intergovernmental conversations through a federal advisory committee, agency offices and congressional committees—all of which helped inform federal-state relations on an ongoing basis. These have mostly been disbanded or diverted to other responsibilities.
Recent history suggests that a formal process for a dialogue can be helpful during periods of uncertainty. The federal government coordinated with the states to respond to the perceived threat of Y2K computer problems at the end of the 20th century and to implement the American Recovery and Reinvestment Act of 2009. There are also coordination mechanisms in place for disaster response such as that used in the aftermath of Hurricane Sandy in 2012. But those coordination efforts were project-focused and of limited duration.
Going forward, state and federal officials need to come to a neutral table equipped with information on how federal policies affect state budgets and economies, and how state and federal policies could be better coordinated to achieve mutual goals.
Our current fiscal and economic challenges shine a spotlight on the federal-state relationship in ways that could lead to innovation and improvement. Pew seeks to provide clear analyses of the federal-state fiscal relationship to promote informed decision-making on the federal budget and tax policy that takes the impact on all levels of government into account and supports long-term fiscal stability.