Federal aid to the states has been a topic of tremendous interest and considerable debate in recent months, as Congressional leaders and the incoming President negotiate a massive economic stimulus bill.  It has also been a subject of controversy in Wisconsin after Milwaukee County Executive Scott Walker said in early January that he would not submit a list of local projects to be considered for federal assistance.

This article looks at several questions relating to federal aid:

The Federal Role in State Fiscal Crises

Recessions put states in a tremendous bind – economically, fiscally and politically.  They are squeezed between falling revenue and the rising need for safety net services, such as unemployment benefits and BadgerCare Plus. 

Unlike the federal government, states are constitutionally required to balance their budgets.  If a state raises broad-based taxes during a recession, it takes dollars out of the economy – especially if the taxes fall more heavily on low and middle income residents – and that could exacerbate the economic slump.  The alternative of cutting state spending will generally produce an even greater drag on the economy because spending cuts quickly translate into state or local job losses and/or cuts in private contracts. 

Paul Krugman, a columnist for the New York Times and a Nobel Prize winning economist, recently drew an analogy to the early 1930s when Herbert Hoover insisted on a balanced federal budget as the national economy slipped further into the Great Depression.  Krugman wrote that “even as Washington tries to rescue the economy, the nation will be reeling from the actions of 50 Herbert Hoovers — state governors who are slashing spending in a time of recession, often at the expense both of their most vulnerable constituents and of the nation’s economic future.”

The federal government doesn’t operate under the same constraint as the states in needing to balance its budget every year.  As a result, in the post-Hoover era the federal treasury is generally seen as the place to go when the economy is heading into or has already begun a downward spiral.

Economic “Bang for the Buck”

Although most politicians agree that deficit spending at the federal level is appropriate during a recession, they sometimes disagree on whether the emphasis should be on tax cuts or on federal spending, such as aid to the states.  However, among economists there appears to be a growing consensus that in a deep recession like the current one, federal spending will produce a far greater and more rapid benefit.

Mark Zandi, chief economist and cofounder of Moody’s Economy.com and an unpaid economic adviser to John McCain during his presidential run, testified before the Senate Budget Committee in mid-November 2008 on the importance of an economic stimulus package.  He presented the results of economic modeling of the effectiveness of various options for trying to jumpstart economic growth.  Table 1 shows Zandi’s estimates of the “bang for the buck” of different spending and tax cut alternatives.  The bang for the buck represents the estimated dollar change in gross domestic product (GDP) within the next year for each dollar in federal tax cuts or increased spending.(1)

Zandi concluded that a temporary increase in food stamps would produce the greatest return on investment, with an increase of $1.73 in GDP from each $1 increase in food stamp spending.  Permanent tax cuts had the smallest bang for the buck among the options he consider, except for temporary accelerated depreciation, which would only yield an estimated 25 cents of economic growth for each $1 of tax cutting.

Although Zandi’s analysis focused on federal tax cuts and spending (including aid to the states), it isn’t specifically a list of state-level options.  Nevertheless, the payoffs from state tax cuts or spending uppers would be much the same.  One significant difference is that states like Wisconsin that have little or no reserves in a rainy day fund can’t cut taxes without decreasing spending, and can’t increase spending without increasing taxes (or an infusion of federal aid).  As a result, a state tax cut would have a negative net impact – at least in the short run – because the modest positive effect of the tax cut over the next year would be more than offset by the negative effect of decreasing spending. 

Two highly respected economists, Nobel Prize winner Joseph Stiglitz of Columbia University and Peter Orszag, who was recently nominated to head the Office of Management and Budget, wrote during the last recession that cutting spending during an economic downturn could actually be more harmful for a state’s economy than increasing taxes.  They wrote that state spending cuts and tax increases are both detrimental during a period of economic distress, but they concluded that “tax increases on higher-income families are the least damaging mechanism for closing state fiscal deficits in the short run."(2)

The House Stimulus Plan

As this article is being written, the House has just passed an $825 billion economic recovery plan that was put together by leading House Democrats along with the Obama Administration.  It includes tax cuts, infrastructure spending to create jobs, and increased funding for things like temporary increases in food stamps and unemployment insurance benefits.  We will summarize the bill on our website after both houses have worked on it, but here are some of the key portions of the House bill that relate to fiscal relief for states and local government, followed (in parentheses) by estimates of what Wisconsin’s share of the funding would be:

Wisconsin’s share of the proposed aid to state and local governments could be as much as $4 billion.  Although a significant portion of that funding could help reduce the state deficit, large chunks of it must be spent for specific purposes that preclude using the funds to plug budget holes.

Wisconsin’s Share of Current Federal Spending

The aid in the economic recovery bill is intended as a short-term stimulus and will probably end after two years.  With that in mind, states must be careful to avoid creating large structural deficits after the temporary aid has been used.  To the extent that a state uses the funds for continuing costs, it will eventually have to find sustainable revenue sources or make deeper cuts. 

To help balance the state budget and improve Wisconsin’s economy, one option our state needs to pursue is increasing its share of federal aid on an ongoing basis.  WCCF recently analyzed data on federal spending by state, using 2007 spending statistics released by the U.S. Census Bureau last fall.  Table 2 compares federal spending per state resident in Wisconsin and Minnesota with the national average.  As the table shows, Wisconsin ranked 47th in total per capita federal spending in 2008, 18.3 percent below the national average.  Minnesota, which is similar demographically to Wisconsin, received $885 (13%) more per person from the federal government in 2007 than Wisconsin.

Table 2: Per Capita Federal Spending in Wisconsin & Minnesota (FY 2007)(3)

Wisconsin’s low ranking in federal dollars spent within the state’s borders reflects a significant fiscal and economic problem for our state.  Wisconsin is average nationally in total state and local spending per capita, but less of that spending comes from the federal government, which helps explain our state’s greater reliance on state and local tax dollars.  And just as federal funds can help stimulate economic growth in the states during a recession, the redistribution of federal revenue from Wisconsin to other states puts Wisconsin at a severe economic disadvantage.  Consider the following:

It should be noted, however, that most federal spending is for things like Social Security and Medicare benefits that state policymakers cannot influence.  That is generally true as well for procurement spending and federal outlays for salaries and wages.  On the other hand, states have some capacity to increase their share of grants and federal aid, such as Medicaid spending.  In 2007, per capita Medicaid spending in Wisconsin was 23 percent below the national average, whereas Minnesota was only 1 percent below the national average.

Although state and local grants and aid comprise only one-fifth of federal spending in the states, increasing Wisconsin’s share of that spending could yield huge dividends: 

Capturing More Federal Revenue

Wisconsin needs to be poised to capture its fair share of funding in the economic recovery package that will be passed by Congress early in 2009.  But even more importantly, our state cannot hope to preserve quality public services and grow our economy unless we do a better job of getting our fair share of current federal funding streams. 

Although most federal spending is governed by distribution mechanisms that state policymakers cannot influence, there are a number of things Wisconsin could do to increase its very low share of federal expenditures.  The following is an initial list of suggestions for generating more federal revenue and guarding against the erosion of federal funds the state currently receives: 

• Maximizing Medicaid funding – Many health and human service programs that are delivered by counties or within schools have a Medicaid component, but the local entities don’t necessarily identify the spending as a Medicaid-eligible item and fail to capture the 59 percent federal share.  Wisconsin has enlisted the help of local governments and has gotten more active in identifying health care spending that could capture Medicaid matching funds.  However, staff cuts at the state and local level could undermine efforts to be more diligent in maximizing federal dollars.  The state needs to protect positions that will more than pay for themselves by increasing Wisconsin’s share of federal matching funds.

There are probably many other ways Wisconsin could do a better job of getting its fair share of federal funding.  We will continue to collect ideas and share them with policymakers.   

Conclusion

Economists generally agree that the most effective way to stimulate economic growth quickly is to increase spending.  Boosting expenditures has a greater economic return than broad-based tax cuts because much of those cuts will go into savings accounts rather than being spent in ways that will yield near-term economic growth.  With that in mind, Congress is developing an economic recovery plan that will rely more heavily on spending than tax cuts to try to pull the economy out of its tailspin. 

A key component of the economic recovery plan will be aid for states and local governments.  That aid should help Wisconsin reduce the size of the spending cuts and tax increases that would otherwise be needed, and that’s important to avoid exacerbating the recession.  Although the federal aid will be extremely welcome news for state budget writers, it won’t fill the full deficit and is only a short-term budget fix.  There will need to be a mixture of state tax increases and spending cuts or freezes to supplement the federal aid and address the state’s longer-term budget challenges.

One of the other things Wisconsin needs to do to get more money flowing through the state economy is to increase our state’s share of federal spending.  Wisconsin ranked 47th in 2007 in total federal spending per capita, more than $1,500 per person (or 18 percent) below the national average.  If Wisconsin had reached the national average in just the category of grants and aid, our state would have received an additional $1.55 billion in federal funds in 2007, which would have been a huge boost for the state economy.  For Medicaid spending, which is a subset of grants and aid, reaching the national average, or even Minnesota’s aid level, would have generated more than $811 million in additional federal spending within Wisconsin in 2007.

The hospital assessment proposed by Governor Doyle is a very effective way of leveraging additional federal funds for Wisconsin and would be a good place to begin reducing the large disparity that serves as a drag on the state’s economy.  As state-level policymakers put together the next budget bill, we hope they will look carefully at the sorts of suggestions we have made for increasing Wisconsin’s share of federal spending at the state and local level.