Bailing out the States

Last month, the National Governors Association requested a $136 billion bailout from Congress. Many have been skeptical of these bailout proposals. However, a bailout would actually present Congress with a unique opportunity to impose some fiscal discipline on the states.

Generally speaking, bailouts create bad incentives for elected officials. Legislators may propose even larger spending increases in the future, knowing that if deficits occur, Congress will likely force taxpayers in other states to pick up the tab. Furthermore, they are unfair because they penalize taxpayers in states that have been fiscally disciplined.

However, the incentives created by the bailout do not necessarily have to be bad ones. Indeed, if the bailout is designed correctly, it might even exert a beneficial influence. One way of doing this would be to require that states enact tight constitutional limits on either expenditures or revenues before receiving federal bailout funds.

Spending limits would go a long way in promoting fiscal discipline. In fact, there is plenty of evidence from the states that well‐​designed expenditure limits can be effective. The most well‐​known example is Colorado’s Taxpayer’s Bill of Rights (TABOR). Enacted in 1992, TABOR placed a tight limit on state revenue growth and mandated immediate refunds of all revenues above the limit. Between 1997 and 2002, Colorado taxpayers received $3.2 billion in tax rebates from the state government. Furthermore, Colorado led the country in both tax relief and economic growth during this time.

Other less heralded spending limits have also enjoyed success, including Washington state’s I‑601 that took effect in fiscal 1996. I‑601 established a low limit for expenditure growth and the resulting surpluses allowed the legislature to cut, then eliminate, the car tax in 1998 and 1999, respectively. Even though I‑601 has been weakened over the years, it has still been effective at limiting the growth of government in Washington. In the 14 years prior to enactment of I‑601, biennial expenditure growth in Washington averaged 16.1 percent. In the 14 years after I‑601 was enacted, biennial expenditure growth has only averaged 9.1 percent.

Furthermore, the federal government is certainly well within its rights to require fiscal policy changes before offering bailout funds to the states. Indeed, lenders often impose fiscal restrictions on individuals, companies or countries in debt. When the United States offers foreign aid, the grants and loans are often tied to monetary and fiscal policy reforms. Of course, long‐​term enforcement of these policy changes is difficult, which is part of the reason most foreign aid programs are unsuccessful.

However, the situation the states face is less complicated. The states do not have to worry about currency stability or the rule of law. Instead, their fiscal problems stem primarily from sharp spending increases. This is a straightforward problem that can be solved through well‐​designed expenditure limits.

And this approach might actually have a chance of succeeding politically. Forty‐​nine states have balanced budget amendments, which means elected officials either have to raise taxes or enact painful budget cuts to bring their books into balance. Needless to say, neither option is particularly appealing to most state legislators.

Indeed, to avoid such politically difficult tradeoffs, some legislators would likely be willing to abide by an expenditure limit. This strategy might be especially effective in states that have term limits. Legislators in term‐​limited states would only be bound by the limit for their relatively short tenure in elected office, and would likely be more willing to make difficult decisions if they aren’t worrying about re‐​election.

The first, best policy, of course, is for Congress to refrain from bailing out the states. Governors and legislators would not then get a free pass from Congress. Instead, they would have to deal with the political fallout from their spending spree. However, if a bailout is included in the final legislation, Congress should only grant bailout funds to those states that enact tight state fiscal limits. There is plenty of evidence that well‐​designed limits can promote savings, curb spending growth, and provide tax relief.

Most importantly, tying a bailout to spending limits might be the best way to ensure there won’t be a need for bailouts in the future.