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Look Out Below: States Are Facing Their Own Fiscal Cliffs

The federal budget continues to attract the attention of policy wonks and investors. And well it should. The upcoming 'fiscal cliff' — the combination of tax increases and spending cuts poised to phase in starting January 1, 2013 — may cause the economy to lurch back into recession. But the 50 states, which are supposed to be laboratories of democracy, may also be functioning as 50 laboratories for fiscal crises down the road. That's the conclusion of a new report from the State Budget Crisis Task Force

The task force, a non-partisan, non-profit outfit jointly chaired by former Federal Reserve Chairman Paul Volcker and Richard Ravitch, the former Lieutenant Governor of New York, looked into the long-term prospects of six large states: California, Illinois, New York, New Jersey, and Texas. Donald Boyd, executive director of the task force, is our guest on the Daily Ticker. He warns that it's worth paying to attention to the fiscal challenges faced by these large states. Even though they have different economic, political and demographic profiles, they all face similar challenges in aligning revenues with financial commitments over the next two decades.

The task force has identified six threats to state government fiscal health. Chief among them is Medicaid, the federally-backed insurance program for the poor and disabled. "It's a large and growing program, and it is reflecting the large issues related to health care costs in the broader economy." Boyd notes that Medicaid costs have generally been rising at a rate that is 3-5 percentage points faster than the overall economy. The health care reform legislation, which was largely upheld as constitutional by the Supreme Court earlier this month, is something of a double-edged sword. It offers significantly more resources for states to fund Medicaid care, but also expands eligibility.

A second threat Boyd identifies is the federal government. But the threat lies more in what Washington can take away rather than in costs it will impose as mandates. The stimulus bill of 2009 provided states with tens of billions of dollars to plug holes in their budgets after state revenues plunged sharply. That support is waning. But now the momentum to reduce the federal deficit is likely to hit states. "As the federal government tends to reduce the deficit it's going to turn to actions that will create difficulties to states," Boyd says. Over the coming years, states can expect to see reduction in grants, cuts in overall funding for procurement and programs, and changes to the tax system that could have significant implications for states.

Pensions constitute a third set of long-term challenges. States have long made a practice of promising pensions to public employees without setting aside adequate funds. And years of poor market returns and low interest rates make it difficult to make up the gaping deficits. Governors have been trying to make a dent in the problem by encouraging — or sometimes, bludgeoning — employees to accept changes. But as Boyd notes, it's difficult to make changes to pensions unilaterally. "They're promises — compensation for work that people already did, and they have strong legal protections," he said.

State finances have been a persistent black cloud over the economy. Every month, as the private sector adds jobs, the public sector — particularly state and local government — continues to cut them. That trend has continued even as state revenues have been rising. The Nelson A. Rockefeller Institute of Government has reported that overall state revenue collection has been rising for eight straight quarters, and that in most states collections have surpassed their pre-recession peaks. That's good news, to a degree. "There's no doubt that rising revenue is welcome from states," said Boyd. But we should temper our enthusiasm. As he notes: "After adjusting for inflation, state revenues are still not at the peak."

Daniel Gross is economics editor at Yahoo! Finance

Follow him on Twitter @grossdm; email him at grossdaniel11@yahoo.com