North Carolina State Budget Day October 2007 Vic Miller vmiller@ffis

1. Federalism and the Federal Budget: Today and Tomorrow North Carolina State Budget Day October 2007 Vic Miller vmiller@ffis.org Federal Funds Information for States www.ffis.org

2. The Invisible and Visible Hands • Question: How many free market economists does it take to screw in a light bulb? • Answer: None. They sit in the dark and wait for the invisible hand. • Moral—When it works, the invisible hand of the market place is the best mechanism man has ever devised for allocating resources. • When it does not, we must turn to the very visible hand of government. And public finance drives what government can do.

3. Fiscal Federalism—Taxes • Since World War II, the federal government has been the dominant tax collector. • State and local governments collect about 10% of Gross Domestic Product (GDP) in taxes. • The federal government, until recently, collected 18-21%. • Recent tax cuts have reduced the federal share to 16-18%, probably not sustainable for the long term unless major reductions are made in entitlement spending.

4. Fiscal Federalism—Taxes (cont.) • The federal government collects more than three-fourths of its revenue from direct taxes on persons—income taxes and social insurance taxes. • Most unstable are corporate income tax receipts, ranging from 6-8% in recessions to 14-15% in recent years. • Many state and some local governments also impose income taxes, but they collect the bulk of their revenue from indirect taxes—sales taxes and property. • In 2005, sales (34%), property (30%) and income (22%). • Property taxes heavily for local governments. • Federal grants-in-aid constituted 21% of state and local receipts (2005).

5. Fiscal Federalism—Employment • However, the federal government is actually quite small. • State governments employ 13-14% of the domestic civilian work force --teachers, police, firemen, economists, etc. • The federal government employs about 1.5%. • Remove the civilian employees of the Departments of Defense and Veterans Affairs, and of the Postal Service, and the federal share falls to 0.75%. • Contract employees probably add another 1% to the total. • Federal purchases of good and services constitute slightly more than 25% of the budget; two thirds for defense.

6. The Federal Government—Fiscally Primarily a Transfer Mechanism • So where does this tax revenue go? It goes to transfers. • Transfers to individuals for such purposes as Social Security, military and veterans retirement and pensions, Food Stamps, unemployment insurance, civilian retirement, debt service on our growing debt. • Transfers to the medical industries, for hospital and doctor care, for prescription drugs and vaccines, for community health centers, for graduate medical education, etc. • Transfers to state and local governments, for grants in support of federal and state and local interest. • Transfers to the private sector, for subsidies.

7. Two Types of Federal Spending • Mandatory (60%)—Where the basic substantive legislation provides the legislative authority for spending (Social Security, Medicare, Medicaid, TANF, Food Stamps). • Discretionary (40%)—Where the 12 annual appropriations bills provide the legislative authority for program allocations.

8. Components of Federal Spending, FY 2006($ in billions)

9. Federal Budget Surplus/Deficit

10. Comments on FY 2007 Actuals • Total expenditures are up 2.8% over FY 2006. • Given the drag upward of Medicare and defense (most of the increase), this is not “runaway” spending. • Total receipts are up 7%, driven by an 11.5% increase in personal income taxes and continued high corporate tax receipts. • Neither is sustainable for FY 2008. Withholding from salaries and wages will continue growing at its 7% rate, but unearned income and corporate profits will decline.

11. Comments on FY 2007 Actuals (cont) • The deficit of $163 billion is substantially better than the deficit of $318 billion two years earlier. But it is $400 billion worse than the surplus of FY 2000. • Lower revenue growth and increased entitlement, debt service and defense spending mean that deficitswill grow in FY 2008 and beyond under current law.

12. In sum • In sum, the federal government collects taxes for far more than supporting its own household. • Its finances underlie the finances of essentially all sectors of society—state and local governments, the consumer, private enterprise, etc. • This is especially true when the economy turns soft, and the automatic stabilizers of the federal fiscal machine kick in. • This is happening now. The questions are, how soft and for how long.

13. Budget Concepts • Budget authority (BA). The authority to obligate the federal government to spend money. • Obligation. A formal legal commitment by the federal government to spend money. • Outlay (OL). Same in federal parlance as expenditure or spending; flow of cash or checks issued. • Cost. Generally, the program level, the timing of which may differ from any of the above. • BA and OL are the concepts you usually see—Ols frequently lag BA, sometimes substantially.

14. Federal Budget Timetable • Federal fiscal year begins October 1. President’s budget for that year is transmitted to Congress the previous February. • Congress passes a concurrent budget resolution by April 15th--not a law, but an exercise in congressional rulemaking—what spending and tax legislation is in order in each house, what laws must amended to reconcile their fiscal impacts to the budget assumptions. • The budget resolution sets totals for discretionary spending; establishes rules for possible tax and mandatory spending changes.

15. Federal Budget Timetable (cont) • July 15—President transmits mid-session update; updates budget assumptions, changes in policy, new requirements. • Budget reconciliation act—timing varies—forces changes in tax law or cuts in mandatory spending (entitlements). Requirements for any reconciliation bills are placed in budget resolutions; the source of most changes in tax law and mandatory spending. • September 30—Need to pass new appropriations, extend lapsing entitlements (e.g., SCHIP).

16. Continuing Resolution • If new appropriations action is not finished by October 1, Congress enacts a continuing resolution (CR) to continue funding. • A CR is a joint resolution—president signs, becomes appropriations act. • May be part of a year, or a full year; different rules (e.g., continue last year’s spending level, continue but at the lower of last year or this year’s action to date). • For FY 2008, the first CR is for 47 days—through November 16, 2007—continuing FY 2007 levels.

17. Ongoing Tax Revenue Shifts • At the federal level, the corporate profits tax will decline substantially this fiscal year. • Corporate profits increase will fall from double digit to close to zero this quarter—HEADLINES!!! • It is not this bad. Corporations try to push all the bad news into the same quarter. But FY 2008 federal corporate receipts will fall. • Direct taxes should continue to grow, as wage and salary increases finally kick in, but perhaps somewhat slower. • There will be no substantial federal tax legislation this year. Overall, tax revenue increases will be modest, perhaps only equal to inflation.

18. Ongoing Tax Revenue Shifts (cont.) • At the state level, sales and property transfer tax revenues have already taken a hit. • Direct taxes continue fairly strong. • At the local level, foreclosures and tax delinquencies are reducing receipts for most local governments, who will now look to their states. • Excise tax yields (e.g., transportation) continue weak; trust and special funds that rely on them will experience stress.

19. Sources of Major Federal Program Changes this Year—Not Many • Social Security—No immediate need for change this year, no changes. • Reconciliation—The only budget reconciliation instruction for FY 2008 was for higher education; that bill, which cut subsidies to lenders, has already passed. • Medicare—The Medicare changes in the House-passed SCHIP bill will be deleted for now, but not forgotten. • Reductions for Medicare Advantage • Eliminating reductions for doctors reimbursements. • Medicare growing fast—growth from 2004-2112 greater than total projected federal costs for Medicaid in 2012.

20. Medicare/Medicaid Comparison

21. Medicaid • Medicaid is 42% of federal grants to states. Enrollment is falling nationwide, for a variety of reasons. • Federal Medicaid spending grew 5.5% in FY 2007 after falling in FY 2006 • Impact of the creation of Medicare Part D. • Impact of many other events—DRA shifts, citizenship documentation, changes in state eligibility, benefit and reimbursement structures, intense federal oversight, new federal regulatory shifts, • States receive open-ended reimbursements based on their federal medical assistance percentage (FMAP). These changes are the biggest changes states will face—they will move hundreds of millions of dollars. North Carolina’s FMAP declines in FY 2008, costing the state about $50 million; it will increase about the same amount in FY 2009.

22. Medicaid (cont.) • The administration is attempting to reduce Medicaid programs cost by a variety of regulatory changes—citizenship requirements, graduate medical education, handicapped education reimbursement, rehabilitation services, provider tax limits, etc. • There will be no substantial legislated Medicaid changes this year; Congress has placed moratoria on some. • Long-term, Medicaid is a fiscal problem for both federal and state governments. Short term, it is not a major contributor to spending growth.

23. SCHIP • SCHIP entitlement/ appropriation are provided for the first ten years of the program (1998-2007) in Title XXI of the Social Security Act. • Unlike Medicaid, this entitlement is capped, with allocations based on a formula. • Data feeding the SCHIP formula variable/uncertain. • In 1999, when these data were upgraded, constraints were put on changes. North Carolina loses the most from these constraints (-$16 million in FY 2008 under current law structures). • States reimbursed based on enhanced FMAP. • SCHIP spending is now larger than its annual new BA; states using prior year allotments. Over 5 years, an increase of about $17 billion is necessary just to provide for inflation for the current program.

24. SCHIP (cont.) • Congress passed a five-year SCHIP extension; the president vetoed it. • Major questions—who is to be served, how much to spend? (Note that potential increase is $7 billion annually vs. much larger growth for Medicare.) • Important question for North Carolina—need to move away from the constraints of the current formula. • Projection—SCHIP expansion passes just before Christmas, but it will require further changes—perhaps different FMAPs.

25. Social Services Block Grant • SSBG is established under Title XX of the Social Security Act; a set of state entitlements totaling $1.7 billion annually. • Level was cut from $2.2 billion in late 1990s to offset costs of highway legislation. • The President proposed reducing this amount to $1.2 billion for FY 2007, and has repeated the proposal for FY 2008. • The administering agency refuses to publish state entitlement amounts promptly, as required by Title XX, listing state shares of $1.2 billion. • There is almost no chance that the program will be cut.

26. Other Mandatory Spending • Much federal mandatory spending remains tied to FY1996 eligibility and allocation levels, when the Temporary Assistance for Needy Families (TANF) block grant replaced the Aid to Families with Dependent Children (AFDC) program. Costs are being shifted to the states. • These levels were relatively generous initially, and states managed through early 1990s economic downturn. • These levels will have to be revisited if our current economic softening is protracted.

27. The Clawback • The clawback was designed to make states pay part of the cost of the Medicare Modernization Act, that created Medicare Part D, expanded Medicare Advantage, etc. • Parameters for calculating the clawback are far from definitive. Though it is clear that CMS overestimated for the 2007 calculation, no change was made; States are overpaying for 2007. • North Carolina will have paid about $225 million for 2007; may on net have saved money. • Clawback multipliers will decline 0.23% for 2008; federal government repaying overpayment? • The clawback may be revisited next year per a Medicare “cost containment” requirement.

28. Focus on Discretionary Appropriations • Most discretionary grants received level funding in FY 2007; the major exception was funding through many programs for hurricane relief. • The President’s proposed cuts in FY 2008 domestic discretionary spending will not be enacted; the President has threatened to veto levels assumed in the budget resolution. It will not be an easy fall in Washington (Projection—final action just before Christmas). • Under the current FY 2008 continuing resolution (thru Nov 16), programs receive level funding. • Elementary and secondary education will not experience the president’s proposed cuts. Overall, the increase should be 5-10%, with increases for compensatory education and special education offset by reductions elsewhere.

29. Focus on Discretionary Appropriations (cont.) • Low Income Home Energy Assistance (LIHEAP) should get an increase, as will Community Health Centers and Ryan White AIDS grants. • HUD programs should receive some of the larger increases, both for Section 8 housing and for community development programs. • A few Justice and Homeland Security programs will also receive increases. • Overall, however, these will be modest increases in FY 2008 following a year of level funding in FY 2007.

30. Transportation • Highway spending has continued a slow growth through the decade, with FY 2007 spending $8.8 billion higher (35%) than the $24.9 higher than for FY 2000. • At least half the increase is either for earmarks or for emergency highway reconstruction. • At the same time, Americans are driving less. Receipts into the highway trust fund grew only 2% in FY 2007.

31. Transportation (cont.) • It is now projected that the highway account of the trust fund will be $4 billion in deficit in FY 2009; the mass transit account somewhat later; legal implications are unclear. • It is clear that without more revenues states will wait longer for reimbursement of valid expenditures. • Mass transit spending has grown somewhat more. • Airport construction grants, also funded through a trust fund, have more than doubled since FY 2000. FY 2007 receipts increased 10%.

32. In sum—the Federal Government • Federal revenues continued a second year of strong growth in FY 2007, up 7% after a 12% gain in FY 2006. This is primarily growth in capital gains and the corporate income tax. These levels are not sustainable for the long haul unless additional unearned income is redefined as capital gains. • Withholding is up about 6-7%; that is an improvement. That will be sustained. • FY 2007 federal spending was up only $77 billion over last year (2.8%). Social Security, Medicare and Defense were up over $100 billion; the balance of the budget shrunk over $30 billion. • Congress will attempt to add discretionary spending for FY 2008; the administration will oppose it. Total FY 2008 domestic discretionary spending will not be much above FY 2006.

33. In Sum—the States • Unlike the federal government, most state and local governments cannot borrow for current expenditures, only for capital expenditures. • State revenues increased with the economy; the growth is now softening with the economy. • Sales taxes have leveled off, property tax yields are beginning to level off or shrink with the end of the housing bubble. Will the federal government have the resources to assist?

34. Next Year • As a country, we need to come to grips with our budget situation. We cannot continue forever our expenditures with the revenue structure we have established. • Any major changes will probably wait until 2009. They will not happen in a presidential election year. • Medicare amendments, if not achieved this year, will be revisited next year. • With a potential softening of the economy, we may see efforts to expand Medicaid and/or SCHIP to reduce state costs, or to provide fiscal relief. • The administration will continue its pressure on domestic discretionary spending while attempting to maximize appropriations for national defense in its last year. This will permit expansion of defense procurement expenditures regardless of who is elected to Congress and the presidency.

35. Take Aways • Bad News: The budget process is highly contentious this year; expect more vetoes, expect delays. • Good News: The outcome will almost certainly result in increased funding for some grants. LIHEAP will almost certainly receive an increase. • Bad News: The cost of the war will continue to put pressure on the federal budget, as will the rising costs of Medicare. The problems of the Highway Trust Fund may result in a retreat from federal-aid highway collaboration. • Good news: SCHIP will be reauthorized and expanded--eventually.

36. Take Aways (cont.) • No news: There will be no sustained action from either the Administration or the Congress to address the issues that are driving our fiscal deficits. • Next Year’s News: Medicare cost containment legislation will be presented with the President’s budget, and considered in Congress. • Bad News: The rules keep changing; program planning becomes difficult. • Bad news: The economy is soft; federal and state receipts are leveling off, service demands are increasing. Will the visible hand be visible?