Why the States Belong in the Stimulus Package

With state revenues in free fall, governors are banging on the door of Congress, calling on lawmakers to put assistance to the states at the top of the list in the next economic stimulus package. In the ubiquitous media shorthand, the states want a “bailout.”

This shorthand, however, muddies the issue and the stakes here.

Giving help to the states is not the same thing as opening up the Treasury to shore up a failing private bank or manufacturer. States and the federal government are partners. In much of what the states do--educate, medicate, and incarcerate--Washington sets the standards and requirements, whether through No Child Left Behind, Medicaid, or the constitutional prohibition against cruel and unusual punishment.

The big items in state budgets--schools, health care, social services--are, to varying degrees, jointly financed by state and federal dollars. When those budgets must be deeply cut, it is not just a state issue. National purposes are being defeated, too.

The shorthand about “bailouts” also misses the central reason for including the state in a stimulus package: to bolster, or at least protect, the economy.

When recession drives state budgets out of balance, states have only two choices, both of them bad.

The first is to cut spending. But every dollar of state spending eliminated to close a budget deficit is a dollar of demand potentially removed from the larger economy. When teachers are laid off and the blind and disabled have their grants cut, they spend less for goods and services. State spending cuts throw the economic multiplier effect into reverse.

The second choice, raising taxes to close a deficit, also weighs down the economy. Tax increases on low- and middle-income households, which generally spend nearly all of their income, reduce their ability to consume. That is less true of higher-income households, which can choose to reduce their saving to sustain their current levels of consumption. But even taxing the rich to close state deficits is likely to drive down demand and slow the economy further.

To understand how bad those choices can be, consider California’s budget situation. It faces a deficit of $28 billion over the next year and a half. Let’s assume it must close that deficit with a combination of tax increases and spending cuts, which would be the case if Congress does not include the states in the stimulus package. And let’s assume that those measures reduce effective demand by an equal amount.

The result? Demand would shrink by about 1 percent of California’s gross state product, making the recession that much worse.

So the question for the stimulus package isn’t, as the media shorthand puts it, whether to “bail out” the states. It’s whether Washington will stand idly aside and watch the states, forced to balance their budgets, take fiscal actions sure to make the recession deeper and longer.