States Already Get Bailouts; Some Worry They Could Get Much Bigger

Published November 22, 2010

The federal government is already spending money to bail out state and local governments. The public just doesn’t realize it, because the bailouts are being disguised by transfer payments, subsidized bonds, and shady accounting.

This is the thrust of an argument by Meredith Whitney, CEO of Meredith Whitney Advisory Group LLC, in a recent guest column for The Wall Street Journal.

The column struck a chord with policy experts contacted by The Heartland Institute. These experts agree government spending at all levels has been too high and too opaque to much of the public, but they disagree over the severity and solutions.

Build America Bonds
They are particularly troubled that Congress created a new breed of federally subsidized borrowing, called Build America Bonds, in the wake of the financial collapse in 2008. The U.S. Treasury covers 35 percent of the interest paid by the bonds.

California, Illinois and some other states with low credit ratings have continued to expand their borrowing by using these federally subsidized bonds. Without the subsidies, their borrowing costs would have been much higher.

Here is what several policy experts have to say about the problem:

Nicole Gelinas, Searle Freedom Trust Fellow at the Manhattan Institute, contributing editor of City Journal magazine, Chartered Financial Analyst, and author of After the Fall: Saving Capitalism from Wall Street—and Washington (2009, Encounter Books)

“I do not expect a TARP/stimulus in the same form in which it came in 2008/09—i.e., multi-hundred-billion dollar, headline numbers—any time soon. I think the problem is subtler. To avoid default, profligate states need market discipline—vigilant bondholders—in order to pare back their future liabilities for pension payments and healthcare.

“They are not getting this discipline, because bondholders in the most profligate states—including California and Illinois—believe, probably correctly, that they are ‘too big to fail.’ That is, that the federal government would never allow them to default because of repercussions for global money markets, etc.
“Absent such discipline, bondholders will create a self-fulfilling prophecy. They will lend too much, and in several years’ time states will not be able to service their competing obligations and provide basic public services. That’s when the ‘too big to fail’ issue would come into play.”

Jonathan Williams, economist, director of the Tax and Fiscal Policy Task Force for the American Legislative Exchange Council, and coauthor of Rich States, Poor States: ALEC-Laffer Economic Competitiveness Index:

“I think we have to be careful any time the feds give additional incentives for states or local governments to go into debt. The stimulus bill and Build America Bonds give them incentives to go into debt and to raise taxes for matching funds. I think states and local governments are looking to do questionable increases in spending because they have these debt subsidies.

“Borrowing and spending sprees got them into trouble. This is not going to get them out of trouble.

“Then there’s the issue of states losing autonomy to the federal government by taking this money. They’re going to have to say ‘no thanks’ to federal dollars. Until they do that, we will continue down the road to loss of federalism. Federal dollars never come without strings attached.”

Eli Lehrer, senior fellow and director of the Center for Finance, Insurance, and Real Estate at The Heartland Institute:

“States have every manner of fiscal ill, but I’m a little skeptical of the idea that states are really going to have no choice but to ask for bailouts. A lot of people—particularly on the Right—have tended to overestimate the fiscal problems that states face.

“With the important exception of California—which seems almost ungovernable right now—most states can, with some pain, solve their own fiscal problems. Congress does need to foreclose the possibility that it will be there as the states’ sugar daddy, particularly to California.”

Stephen Entin, president and executive director of the Institute for Research on the Economics of Taxation, former deputy assistant secretary for economic policy at the Department of the Treasury, former staff economist with the Joint Economic Committee of the Congress:

“Subsidizing state and local spending is bad policy. It encourages state and local governments to overspend, because they do not have to pay the full cost of the spending.  It allows states to postpone the spending cuts they must make to bring their budgets back to sustainable levels, in line with the incomes of their citizens.

“Ordinary tax-exempt bonds are treated much like saving in a Roth IRA and like the approach to saving that is part of the Armey Flat Tax. The lender has paid tax on the income that was earned and then saved and used to buy the bond.

“When the bond interest is tax-exempt, the lender is spared an additional tax on the interest, which is what one ‘purchases’ when one buys a bond. This puts the after-tax saving on the same tax basis as after-tax income used for consumption, which is generally not subject to additional federal taxation, except for a few excise taxes. It is one of the ways of constructing a tax system that treats saving and consumption on a level playing field.

“By contrast, Build America Bonds contain a federal subsidy of a fixed amount that is often higher than the tax paid by the saver on the original income. This creates a larger, non-neutral tax subsidy for saving that is directed to state and local governments.

“I worry that these Build America Bonds may come to be regarded as backed by the U.S. government, and therefore by the U.S. taxpayers, in the same way that the bonds of Fannie Mae and Freddie Mac came to be viewed, which led to a bailout by the federal government. We need to make it clear that we are not going to bail out people who lend to states that overspend and later cannot pay their bills.”

Steve Stanek ([email protected]) is a research fellow at The Heartland Institute and managing editor of Budget & Tax News.