Schwarzenegger Seeks The Right Bailout

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Next month, California's governor plans to ask Washington for another bailout to help close his state's $21 billion budget gap for the next fiscal year. This request comes with an appealing twist, though: it wouldn't cost federal taxpayers a dime.

Instead of asking for more money, Arnold Schwarzenegger is expected to ask Washington to release California from rules that inhibit budget cuts. Schwarzenegger would use this leeway to cut spending by as much as $8 billion. Details are expected next month, but the bulk of the cuts will likely be in school aid and Medicaid.

Last year's American Reinvestment and Recovery Act (popularly known as the stimulus package) extended hundreds of billions of dollars in aid to the states, but with strings attached-they had to maintain existing service levels in programs getting stimulus support, or in some cases increase them. This placed high-service states like California at a disadvantage, as they must maintain already-high baselines that do not apply to other states.

On education, the stimulus bill forbids states that take stimulus money from cutting state education spending below fiscal year 2006 levels, near the peak of the economic boom. However, despite a substantial temporary increase in income, sales and motor vehicle tax rates, California's independent Legislative Analyst's Office anticipates that fiscal 2011 general fund tax receipts will be 6% below 2006 levels.

California's revenue situation is so dire that the stimulus restriction puts a higher floor on education spending than the state's usually-stringent Proposition 98 education funding formula. To maintain stimulus eligibility, California must devote an ever larger share of its revenues to education or further increase taxes, even as public school enrollment declines.

Similarly, stimulus rules box California into its relatively generous Medicaid eligibility rules. Californians with dependent children are eligible for Medicaid if they earn up to 106% of the federal poverty line, the 14th highest level among the fifty states. California also covers many optional add-on services within Medicaid, including acupuncture, chiropractic treatment, and non-religious components of faith healing.

As a result, California has 18% of America's Medicaid participants with just 12% of the population, and per-capita Medicaid spending of more than twice Nevada's. But if California were to reduce eligibility to match Nevada levels, it would forfeit stimulus dollars.

On both education and Medicaid, California is punished for its past generous spending. The stimulus package enshrines a status-quo bias, where high-spending states must maintain their programs but low-spending states do not have to grow theirs. If Medicaid at 106% of the poverty line is a federal priority in California, why not in Nevada or the 34 other states that do not provide it?

In both education and health spending, the President has significant leeway to waive stimulus penalties. Obama should agree to Schwarzenegger's request to do so, giving California a freer hand to dig itself out of its fiscal hole. This would be in line with the purpose of federal aid to states during recessions.

In a recession, when tax revenues drop, it is desirable to run a budget deficit to reduce the need for economically damaging tax hikes and spending cuts. But states are generally prohibited by their own constitutions from borrowing to pay for current operations. By borrowing money and giving it to states, the federal government provides backdoor deficit financing.

But aid to states is less useful when the federal government simultaneously mandates certain spending. By prohibiting cuts in certain areas, the federal government reduces a state's options to close budget gaps not covered with stimulus dollars.

This may lead states to undertake anti-stimulative actions. In California's case, that could include further increases in the state's already uncompetitive income tax (fourth-highest top rate) and sales tax (second-highest average rate). Instead of dictating from Washington, the federal government should let states determine what budgetary courses of action are most appropriate for their circumstances.

The Obama Administration has previously blocked Schwarzenegger efforts to rationalize the state's budget, including a threat to withhold stimulus money over a proposed cut in pay for home health care workers. But Schwarzenegger has been a key White House ally on issues including cap and trade, putting him in a better position than most Republicans to ask for help.

Spokesman Bill Burton says the White House is taking a look at aiding California. With projected federal budget deficits exceeding $9 trillion over the next 10 years, the White House should find Schwarzenegger's proposal appealing, because it is free.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute.

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