U.S. debt deal has states, cities bracing for cuts

Fri Nov 18, 2011 5:16pm EST

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* Debt negotiations on Capitol Hill keep states guessing

* Automatic cuts would be triggered in 2013

* Medicaid exempt from triggers

By Lisa Lambert and Jim Christie

Nov 18 (Reuters) - State and local governments say there is only one sure effect of the current U.S. deficit negotiations on their budgets: cuts.

And with their tax revenues still not back to pre-recession levels after being hit hard during the financial crisis, state and local governments are keeping a careful eye on the events in Washington.

As tax revenues slid, state and local governments responded by slashing spending, hiking taxes, borrowing and turning to the federal government for help over the last three years.

The bipartisan "super-committee" made up of members of both houses of the U.S. Congress has until next week to introduce a plan to reduce the federal deficit by at least $1.2 trillion over the next 10 years, but its negotiations appeared near collapse on Friday.

"Nobody is quite sure what's going to happen," said Marty Brown, director of the state of Washington's office of financial management.

Without a plan, automatic spending cuts totaling $1.2 trillion, split evenly between military and domestic programs, will begin in 2013 as part of the deal President Barack Obama struck with Congress this summer on the country's $1.3 trillion deficit and $15 trillion debt.

"I keep joking that the watchword is 'uncertainty,'" said Scott Pattison, executive director of the National Association of State Budget Officers. "The folks I talk to seem to be accepting, although they'd prefer a lot more predictability."

Brown said Washington can only make "contingency planning at the margins because you don't know what to plan for."

Lawmakers in Washington are considering how any cuts could affect the state as they prepare for a special session to find ways to keep the current budget in balance, said Brown.

The $600 billion in automatic cuts on defense spending would pose real risks to Washington, where Boeing Co. , a major military contractor, is the marquee employer.

The automatic cuts would not hit Medicaid, the healthcare program for the poor administered by the states with reimbursements from the federal government, or food stamps.

The super-committee, however, has the freedom to lower Medicaid funds. That, too, would hurt Washington because Medicaid provides more than half the money for its healthcare programs, Brown said.

California, the most populous U.S. state, likewise is grappling with uncertainty The many moving parts of the deficit deal keeping the state's finance department guessing, said spokesman H.D. Palmer.

"A lot of these are what Donald Rumsfeld would call 'known unknowns,'" Palmer said, referencing a quote from the former defense secretary under President George W. Bush. "The question will be if the changes are front-loaded or back-loaded."

States rely on federal funds directly and indirectly. As their budgets fell into distress in 2009, the federal government's economic stimulus plan included the largest transfer of money to states in U.S. history. When that money ended this year, states said they fell off a "funding cliff."

Time is on the side of the states in the deficit deal, said David Quam, director of federal relations at the National Governors Association, noting the automatic spending cuts would not "hit until 2013."

Quam said governors have been in "constant contact" with the 12 members of the super-committee.

MUNICIPAL MARKET IS WATCHING

In addition to the need for states to adjust their budgets in response to federal cuts, they also may face a hit to their credit ratings. Lower credit ratings typically result in higher borrowing costs.

BlackRock, the world's largest asset management firm, warns that the deficit deal, and federal trends toward austerity, could threaten the credit quality of some states.

"Even if Medicaid and other state funding are relatively unscathed initially, the prospect of future cuts in federal aid, which constitutes 25 percent or more of state budgets, is obviously negative for all state and local governments," it wrote in a report released this week.

In October, Janney Capital Markets told investors in the $3.7 trillion municipal bond market that the automatic spending cuts "could be a credit positive for state governments compared to other alternatives because Medicaid is exempt."

It added some states are balancing their budgets by cutting money for local governments, which could continue if states have fewer federal funds.

"We believe local governments will ultimately be able to pull through the fiscal stresses even though potential consequences from lower federal spending could be more 'painful' than at the state level," it wrote.

ZEROING OUT FEDERAL AID

In total, cities derive about 5 percent of their revenues from the federal government, according to the National League of Cities.

Cities that do not rely heavily on federal funds are removing that line item from budgets, said Christopher Hoene, research director for the group representing civic officials.

"The simplest thing to do is say, 'We're going to assume there's not the federal aid,'" he said.

After the last few years of fights over the economy, city leaders are "somewhat inured to the gyrations of the Washington process," said Mark Muro, senior fellow and policy director at the Brookings Institution's metropolitan program.

"There will likely not be a lot of good for cities and regions in this process either way it unfolds, but at the same time it won't be a crashing arrival of a disturbing new situation," he said.

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