States Are the Canary In the Fiscal Coal Mine

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Last week, Moody's released guidance stating that the US and UK Aaa bond ratings are at risk. Debt levels are rising rapidly to levels where those ratings cannot be maintained, and avoiding that outcome will require "fiscal adjustments" -- read, spending cuts and/or tax increases -- that are likely to "test social cohesion."

For a clue about how federal officials might make these fiscal adjustments, we can look to state governments. While Congress and the President have the luxury of postponing fiscal realignment for years or decades, states have limited leeway to run budget deficits. When a gap opens between revenues and planned expenditures -- as has happened in 48 of 50 states over the last two years -- officials must take action to raise taxes and/or cut spending.

The National Association of State Budget Officers recently released a survey of state budget actions in Fiscal Year 2010. They found that the 50 states faced budget gaps totaling $109 billion, and have acted to close them by $90 billion to date. Of those closures, $24 billion were achieved with tax increases. Another $8 billion consisted of other "revenue actions", some of which are properly classed as tax increases and others as accounting gimmicks.

Meanwhile, as of Fall 2009, 36 states had achieved $56 billion in savings by cutting spending below baseline levels, with several states left to complete further cuts. Combining these numbers, states have resolved their FY 2010 budget gaps with an approximately 2:1 ratio of spending cuts to tax increases.

Tax increases have taken a wide variety of forms, but some themes are apparent. Since 2008, eight states have enacted or raised a "Millionaire's Tax," an income tax specifically targeted at people with high incomes. Only two (California and Delaware) have raised income taxes on a broader swath of the population, while Ohio cancelled a scheduled income tax cut. A handful of states raised sales taxes, while many pursued subtler changes, like expanding the sales tax base or raising excise taxes on cigarettes or other "sin" goods.

One upshot for federal policy is that taxes on unpopular minorities -- such as smokers and wealthy people -- are much more politically palatable than broad based tax increases. On the other hand, when states did enact broad-based tax hikes, they tended to do so through the sales tax, not the more-progressive income tax.

This is consistent with the choices Congress made in the recently-passed health reform bill: it relies mostly on payroll tax increases specifically targeted at wealthy people, and also includes a gimmicky tax on indoor tanning. Last year, when Congress expanded the Children's Health Insurance Program, it raised the cigarette tax to finance the new spending.

But while the federal government can raise some additional revenue with narrow-based taxes, any tax-heavy approach to closing the fiscal imbalance will require higher broad-based taxes that hit the middle class. If states' preference for raising sales taxes provides an indication, look for Congress to eventually impose a VAT rather than higher income or payroll taxes on the middle class.

States' experience may also provide hope that a federal fiscal restructuring will weight spending cuts more heavily than tax hikes. But it is important to note a key political difference between federal and state spending that could make spending cuts harder at the national level.

The largest components of the federal budget are Social Security, defense, Medicare, Medicaid, and net interest. Interest spending is fixed; Social Security and Medicare are wildly popular middle-class entitlements; defense spending is politically difficult to touch. While broad-based tax increases are likely to inspire a political outcry, so are major spending reductions at the federal level.

State budgets are not politically easy to cut, either. But the two largest segments of state budgets -- aid to school districts (which is most important to low-income districts) and Medicaid -- are of greater concern to the poor than the middle class. States also have greater ability to cut their budgets by furloughing employees and cutting payroll, actions with limited effects on voters who work in the private sector.

As such, many middle class voters perceive state budget cuts as a problem for "other people," which makes them politically easier than tax increases. At the federal level, that calculus may reverse, with broad-based tax hikes winning the day over fundamental reforms in Medicare.

When both the Moody's and NASBO reports came out, I was attending the Kauffman Foundation's second annual Economics Bloggers Forum where the long-term fiscal imbalance was a hot topic. Participants (who came from both the left and the right of the political spectrum, but tended toward the right) discussed the nature of the fiscal imbalance and likely resolution.

Despite political differences among the participants, there was a remarkable degree of consensus about the likely policy path -- and the consensus was not an optimistic one. There were three beliefs held by most attendees at the conference:

1. Taxes will rise as part of any effort to close the gap.
2. Significant health care entitlement savings will also be necessary.
3. Politicians will delay taking these actions until another crisis -- likely, another deep recession, this time spurred by high public debt levels -- forces their hands.

Despite these areas of agreement, participants differed on the mixture of tax increases and spending cuts that would make up the fiscal adjustment. Some argued that the United States would end up with a "more European" tax code -- with a substantially higher share of GDP collected in federal taxes, but in a less progressive manner than today. Others (a minority) argued that the political environment is so hostile to tax increases that the adjustment will fall mostly on the spending side.

The difficulty with this sort of political evaluation is that, in the end, politicians will be forced to do something that is massively unpopular. So, it is difficult to look at today's political environment and declare certain actions "politically impossible," as they may become significantly more palatable in a debt-spurred crisis. Indeed, look at Greece, where a Socialist government is simultaneously raising taxes and sharply cutting government benefits and employee wages.

The key to promoting a spending-side solution to the federal fiscal imbalance will be convincing the public that they are better off with lower middle-class entitlement spending than with higher middle-class taxes. Unfortunately, this is likely to be a tougher sell than it has been at the state level.

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

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