Win some, lose a few.

With the start of October the United States government begins the 1994 fiscal year and actually has a budget--one of the few years in the last 20 that this has happened. The key legislative measure in the federal budget process, the reconciliation bill, was passed on Aug. 6. Only twice before has budget reconciliation been completed before the beginning of the new fiscal year. Though much federal spending is determined in 13 separate appropriations bills, the reconciliation bill contains all of the tax changes as well as changes to entitlement programs and overall spending ceilings.

This year's reconciliation act, HR 2264, is by any measure a substantial package of tax increases, spending cuts and miscellaneous changes. Like its predecessors, this one will not eliminate the deficit. (Unlike some of its predecessors, it does not pretend to.) Like earlier deficit reduction agreements, HR 2264 is a mammoth bill, roughly the size of a big-city telephone book. And like all such bills, this one contains many measures that will affect state government.

Assessing the net result for states is difficult at this point. It is not clear whether the "wins" for states outweigh the "losses." That is in part because it is not clear in every case how big some of the wins and losses actually are. But, generally speaking, states made out fairly well this time. Unlike some earlier federal actions, this reconciliation act does not shift a disproportionate share of the burden of deficit reduction onto state and local governments. And it does contain some clear victories for states--both in what was included in the final bill, and in what was not.

The federal budget directly affects states in three ways: through funding for joint state-federal programs, through federal entitlement programs that states administer, and through the influence of federal tax changes on state tax systems.

The Expenditure Side

Federal grants to state and local governments have been a prime target for budget cutters in earlier years, because most of the cuts were aimed at domestic discretionary spending. This year with more savings coming from defense, mandatory spending and the revenue side, grants were far less vulnerable.

Christopher Nolan, director of Federal Funds Information for States (FFIS), observes that "given the magnitude of cuts being talked about, states made out pretty well" in the budget agreement. Nolan notes that the budget places a freeze on discretionary spending, but that there is no longer a "wall" between defense and domestic spending. Since the Clinton administration intends to cut defense spending by 3 percent per year, and raise domestic spending by a like amount, there is some room for growth in federal aid to state and local governments.

Though not quite as severe as some congressional actions in earlier years, the budget agreement for FY 1994 does contain some cost shifts to states, mostly through changes in entitlement programs.

One key change that was strongly resisted by states is the elimination of so-called "enhanced matching rates" for the administration of AFDC and food stamps. This action will mean less money for states to verify the immigration status of aliens, to automate their systems and to control fraud and abuse.

Wisconsin Representative David Prosser worries that the reduction in administrative money for control of fraud and abuse will ultimately prove to be a false economy--both for the federal government and the states. Though he would have supported greater expenditure reductions in the budget overall, Prosser says, "I am quite confident that this action will cost the government more in the long run" than the savings from the reduced expenditure. "In my state the money recovered is greater than what we spend on fraud control." More important, Representative Prosser notes that fraud control generates savings far beyond the money directly recovered: "It's the deterrent value that is so important."

In another loss, states will now be charged a fee for the administration of Supplemental Security Income (SSI) benefits. Most states augment federal SSI benefits, but contract with the federal government for administration, so that beneficiaries receive one check. According to FFIS, the new fee could cost 27 states and the District of Columbia a total of $771 million over five years. However, some states may adjust their programs or opt to do their own administration rather than pay the fee. Testifying before the U.S. House Ways and Means Committee earlier this year, Wisconsin Representative David Travis said that states that elect to have the federal government administer their supplement should not be penalized. He said that a user fee will prompt Wisconsin to reexamine whether it can "participate at our current level."

In an important victory for states, HR 2264 provides more than $900 million to states through 1998 for family preservation programs and family support services. "For the first time the federal government has specifically recognized the effectiveness of programs that intervene early and keep families together," says Ohio Representative Jane Campbell. "With this assistance, we can build on our own state efforts to keep families together and help parents and children before the problems grow into a crisis that will be costly to the family, the state and the federal government."

The reconciliation agreement also contains a significant expansion of the earned income tax credit (EITC), allocating an additional $21 billion to it over the next five years. While the EITC does not affect states directly, it does so indirectly by improving the income status of the working poor. This expansion may keep some families off the welfare rolls, and could ultimately save states money by reducing pressure on public assistance.

The reconciliation act makes a number of changes to Medicaid, for net federal savings of more than $7 billion. It also includes about $1 billion in new spending.

States will lose their ability to designate "disproportionate share" hospitals (hospitals that disproportionately serve indigent or Medicaid-eligible patients). This designation is now defined in statute. The result will be lower payments for such hospitals, saving the federal government more than $2 billion over five years. For some states, it may require administrative or even legislative changes.

The correction of a drafting error in the 1990 act should save both the federal government and the states billions in Medicaid costs, by removing the unintended mandate for personal care services. The bill also eliminates a federal restriction on the use of drug formularies by states and establishes guidelines for their use.

HR 2264 also requires a small increase in Medicare Part B premiums. This will cost states something, because Medicaid pays for Medicare beneficiaries who qualify for Medicaid.

More than half the new Medicaid spending goes toward a new entitlement for childhood immunization, under which the federal Department of Health and Human Services will buy vaccines for the states. This bulk purchase arrangement is expected to save substantially on the cost of the program, for both states and the federal government. States will also be permitted to purchase additional vaccines at the discounted price to cover nonentitled children; under-insured children can receive free immunizations at federal clinics. Vaccine price increases are limited to inflation, and insurers are prohibited from dropping immunization coverage.

Perhaps the most significant win for states in the reconciliation agreement with regard to entitlements is what did not happen. Despite much talk, Congress did not adopt a "cap" on means-tested entitlements, which could have resulted in a major cost-shift to states.

The agreement also includes an overhaul of the guaranteed student loan program, the thrust of which is to reduce the role of banks in the system. (Earlier versions of the legislation would have removed them altogether.) The new program, to be called the Federal Direct Student Loan Program, will be phased in gradually, and will require states to contribute to the cost of student loan defaults (if a state's default rate exceeds 20 percent). Overall, the student loan reforms are expected to save close to $5 billion over five years. The state cost-sharing feature is expected to save the federal government $300 million over five years.

Tax Changes

Any substantial change in the federal income tax can have a profound effect at the state level because of the linkage between many state income taxes and the federal code. A good illustration was the potential "windfall" from the 1986 federal tax reform, which prompted a legislative response in nearly every state. The windfall was possible because the 1986 act was a large package of base broadeners. The income tax changes in this year's budget, however, should have minimal effect on state tax collections.

As Harley Duncan, executive director of the Federation of Tax Administrators, notes, "The number of states affected significantly is small, since most of the revenue is raised by hiking the rates." Though the agreement is filled with myriad miscellaneous provisions, the bulk of the revenue increase is concentrated in a handful of rate hikes.

Those states most affected are the few in which the state income tax is calculated as a percentage of the federal tax, specifically, Rhode Island and Vermont (and North Dakota for short-form filers). These are the only state personal income tax systems in which a change in federal rates has a direct revenue impact. In the absence of legislative action, increased revenues can be expected in these states.

At the other extreme are those states that use some kind of "gross income" definition, so that the base is largely independent of the federal tax. In such states (Alabama, Arkansas, Mississippi, New Jersey and Pennsylvania) the federal changes should have no direct effect.

In the rest of the 41 states that levy a personal income tax, the federal changes should tend to increase taxable income slightly, by varying degrees. Some changes, the restriction on moving expenses for instance, will affect most states. On the other hand, the changes to Social Security will have a more limited effect, since about half the states have a specific exclusion for Social Security

In a handful of states there is a countervailing factor. Where federal tax paid is deductible against the state tax, there will be a tendency for the federal increase to lower state collections slightly. Alabama, Iowa, Louisiana, Missouri, Montana, Oregon and Utah fall into this category.

On the corporate income tax side the story is much the same: Most of the increased revenue comes from the boost in the top corporate rate to 35 percent.

"Base changes such as the denial of deductibility for club dues, will flow through to state corporate bases but should have a relatively modest impact," says Duncan.

The act also makes permanent a restriction on deductibility that was adopted in the 1990 budget agreement, over the strong objections of state governments. This provision, known as the Pease amendment, includes state and local income taxes in a phase-out of deductions for higher income taxpayers. The effect was to limit the deductibility of state and local income taxes for the first time since the institution of the federal income tax in 1913.

Another significant change is the repeal of the cap on the Medicare wage base. Currently, the hospital insurance tax applies only to the first $135,000 of income; under the new law, all wages will be subject to the tax. This will affect states as employers, although the portion of state employees in the applicable salary range is obviously small.

One of the more controversial provisions accounts for less than a tenth of the revenue raised by HR 2264: namely, the 4.3 cent per gallon hike in the gas tax. Other things being equal, an increase in the federal tax will displace some state revenue, through the effect on prices. (Briefly, the higher tax leads to a higher price at the pump, which suppresses gasoline sales, if only slightly. Since the state tax is also levied on a per gallon basis, state collections fall.) The increase is so small, however, that the effect will be slight.

Unfortunately, from the state point of view, the conference dropped a Senate provision that would have deposited the revenue raised by this 4.3 cents in the highway trust fund. Instead, revenue raised from the increased gas tax will help fund the government generally. The principle that federal motor fuel tax revenues are to be dedicated for the joint state-federal effort in transportation was first breached by the 1990 budget law, which put 2.5 cents in the "general fund." If that was the camel's nose, under this year's budget the whole head is now clearly in the tent, with 6.8 cents of the 18.3 cent per gallon federal gas tax going for nontransportation purposes.

Still, it is worth remembering that the administration's original energy tax proposal, which would have been levied on the British thermal unit (Btu) content of most fuels, would have been very expensive for state and local governments, because they would not have been exempt, as they are under the motor fuel tax. (The Joint Tax Committee estimated that some 13 percent of the revenue raised by the Btu tax would have come directly from state and local governments.)

Some of the tax changes will directly benefit state and local governments. The budget revives a number of tax credits that had expired, including some of importance to states. The low-income rental housing tax credit and the mortgage revenue bond exemption are extended permanently under the bill, as is the credit for small-issue industrial development bonds. The targeted jobs tax credit is extended through the end of 1994. Another change affecting tax-exempt bonds moves borrowing for high speed rail outside state private-activity volume caps.

Assessing the Impact

All in all, states made out relatively well. The tax changes should have a comparatively small effect on state revenue collections, and the cost shifts are tempered with some new program funding.

In assessing its impact, however, it is important to remember the many ways a federal budget affects states. In the first part of the 1980s the defense budget was growing sharply, so cuts in discretionary spending fell heavily on state and local governments. Now that pattern is being reversed: A falling defense budget takes much of the pressure off grants-in-aid. But the "peace dividend" has costs for states as well. Base closures will have a profound impact on local economies, as will cutbacks in defense-related industries. So, although states may receive a little more help from Washington for unemployment insurance, job training, social services and so on, they may wind up needing every penny and more. Deficit reduction has a price.

Deficit reduction has benefits for states, too. Its most immediate economic benefit is lower interest rates, which greatly lower the cost of capital for state and local governments. Schools, roads, bridges, sewage treatment plants and jails will all be cheaper to build.

It is also important to remember that, although discussion of the budget naturally tends to dwell on changes in the flow of federal funds to states, or how tax changes may affect state collections, their relative magnitude is marginal. A small change in the pace of national economic growth can quickly swamp the effects of any of these changes.

Thus, whether this budget agreement will be a boon or a bane for states really depends upon how it affects the economy. If, as some critics predict, it pushes the country back into recession, then none of the new program money will help much. On the other hand, if the budget produces even a small resurgence of the economy, the resulting dividend for state budgets--as increased economic activity boosts revenue collections and demands for social services fall--could more than pay for all the cost shifts the reconciliation act imposes on them.

Deficit Reduction: Where It Comes From

With a roughly even mix of spending cuts and tax increases, HR 2264, the Omnibus Budget Reconciliation Act of 1993, reduces federal deficits by a cumulative $496 billion over five years. As Figure 1 shows, this will cut the deficit about in half, but still leaves a substantial gap between the government's income and outgo.

Figure 2 shows the sources of deficit reduction. Spending is reduced by $255 billion, including $102 billion from discretionary programs, $88 billion in mandatory and entitlement spending, and $65 billion in reduced debt service costs. Discretionary spending is frozen at 1993 levels; specific cuts will be made in separate appropriations bills. The entitlement cuts come mostly from Medicare ($55.8 billion) and federal retirement ($11.9 billion).

The bill's tax provisions will increase federal revenues by almost $268 billion over five years. Other provisions, however, will cost the federal treasury some $28 billion, so that the net effect is an increase of just over $240 billion.

Most of the revenue raised by the new law comes from three changes increasing individual and corporate income tax rates. The top individual income tax rate is raised to 36 percent, raising almost $115 billion, while the top corporate rate goes to 35 percent, raising more than $16 billion. Thus these two changes account for more than half of the revenue increased under the bill. In addition, another $29 billion is raised by the repeal of the health insurance wage base cap.