State Spending.


Beyond debt subsidies, general federal government transfers to states now stand at the highest levels on record. Traditionally, state revenues were primarily comprised of sales, personal and corporate income taxes. Over the years, however, federal government transfers have subsidized business-as-usual state spending not covered by state tax collections. Today, more than 28% of state funding comes from federal government transfers, the highest contribution on record.

These transfers have made states dependent on federal assistance. New York, for example, spent in excess of 250% of its tax receipts over the last decade. The largest 15 states by GDP spent on average over 220% of their tax receipts. Clearly, states have been spending at unsustainable levels without facing immediate consequences due to federal transfer payments and other temporary factors.

At the same time, local governments now rely on state government transfers for 33% of their funding. Thus, when a state finds itself in a financial bind, it has the option of saving itself before saving one of its local municipalities. Pennsylvania recently assisted the state capital, Harrisburg, in the form of a one-time "advance" payment—but there are hundreds of towns like Harrisburg that will also need assistance. These one-time fixes fail to address the real structural problems facing so many states and municipalities.

State budgets are likely to experience their second consecutive year with deficits of close to $200 billion. The root of the problem is simple: State governments have spent recklessly and unsustainably. Rainy-day funds are depleted, pension-fund contributions are already at record lows, and almost all of the major federal government subsidy programs will run out in June 2011.

Until now, the states have been able to evade the need to rein in spending largely because the federal government enabled them to do so through record high federal allocations, and by creative accounting that put off funding well over a trillion dollars of state-employee pension and other retirement obligations.

The level of complacency around this issue is alarming. Most assume, as last week's Buttonwood panel did, that the federal government will simply come to the rescue of the states without appreciating the immensity of the cumulative state-budget gaps. I expect multiple municipal defaults to trigger indiscriminate selling, which will prompt a federal response. Solutions attempted in piecemeal fashion, as we've seen thus far, would amount to constantly putting out recurring fires.

Rather than waiting for more federal intervention, states need to make their own hard decisions and not kick the can down the road. How will taxpayers from fiscally conservative states like Texas or Nebraska feel about bailing out threadbare Illinois or California? Let's hope we never have to find out.

-- Meredith Whitney, in the WSJ