The States and Sequestration

Now that the requiem has been written for the Super Committee, the question for states is what does “sequestration” mean for state budgets. The bottom line is that the collapse of Washington’s latest effort to set the federal budget on sound fiscal footing is a mixed bag for the states. Medicaid represents the center of gravity of the state-federal fiscal relationship, and the Super Committee’s failure to reach a compromise has spared the program from near-term cuts. However, the nearly $190 billion in “discretionary” pass-through grants received by state and local governments are squarely in the crosshairs of the sequestration process.

Barring an unlikely effort by Congress to defang the automatic cuts contained in the Budget Control Act of 2011, Congress will be required to sequester, or remove from consideration, set amounts of discretionary spending below the $1.05 trillion 2011 fiscal year baseline spending level to achieve $1.2 trillion in savings by the end of 2020. Beginning in 2013, federal discretionary spending will dive nearly $100 billion to a total discretionary level of $967 billion and will then slowly increase each year thereafter. Total federal discretionary spending will not crest above the 2011 fiscal year level until 2019.

As has been reported widely, sequestration cuts will be shared equally between “security” and “non-security” spending. The security spending includes not only defense, but also the State Department budget, foreign aid, intelligence agencies and many other aspects of America’s national security posture. However, as the Department of Defense dwarfs these other budget components, the military will inevitably bear the brunt of the security cuts. Anticipating the impact of these cuts, some observers are already speculating that DOD will need to conduct another round of Base Realignment and Closure, or BRAC, as early as 2015.

A little discussed element of the Budget Control Act could help ease the sting of these defense cuts. Defense Secretary Leon Panetta frequently mentions his department is already grappling with plans to cut $450 billion over 10 years as a result of this summer’s $917 billon debt ceiling compromise. That $450 billion assumes the cuts included in the $917 billion agreement, which are already taking effect, will be shared equally among security and non-security accounts. However, unlike the sequester cuts, the Budget Control Act only requires that the cuts used to generate $917 billion in savings be shared equally for the first two years. If sequestration kicks in as expected in 2013, triggering another $500 billion in security cuts, you can expect Congress will use this flexibility to dial back some of the $450 billion in scheduled cuts under the $917 billion compromise by forcing non-security accounts to cut even more.

The coming push to shift more cuts from the $917 billion compromise to domestic spending is reinforced by the fact that domestic spending will fare much better than defense under sequestration. While at first glance it would appear that domestic discretionary spending is headed to a similar $500 billion dive, dramatically reducing intergovernmental transfers for everything from education to public transit, the blow will be lessened by the fact that domestic discretionary spending includes some areas of mandatory spending that will also be cut.

Although cuts to Medicare are capped at 2 percent per year, the cap still allows for $123 billion in Medicare spending to be trimmed over nine years. In addition while Medicaid, welfare (TANF), and food stamps (SNAP) are exempt, some other categories of mandatory domestic spending, including farm subsidies and the new health exchange insurance subsidies under the Affordable Care Act, are not exempt and can be expected to experience cuts of almost $50 billion. As a result, the total amount of domestic discretionary spending subject to sequestration comes in at roughly $300 billion.

A preliminary estimate of the impact of sequestration on pass through grants, conducted by Federal Funds Information for States, predicts that federal grant funding will drop by more than $24 billion in the 2013 fiscal year. However, final cuts could go even deeper, as even small cuts to federal agencies of 2 to 5 percent often translate into magnified cuts to state grant accounts of 20 percent or higher.

States will be able to pass on many of these cuts to local governments or community service providers. However, some of the education funds set to meet the chopping block, particularly Title I disadvantaged schools funding and IDEA special education money, will need to be back filled with state general fund dollars on a near one-to-one basis or risk court actions that could force states to spend even more money than they would otherwise.

The age of austerity has clearly arrived. It is still too early to know how heavy the axe will fall on each account and which cuts will gash the deepest into wobbly state general funds. However, the axe is coming and it will hurt.