Federal policies may pose the biggest threat to states

March 13, 2013

One of the best muniland research teams, Blackrock, is out with its State of the States and Local Governments report. If you have time to read the 12-page report, you will get a very balanced roadmap of the challenges that municipal governments are facing.

The one area where I felt that the report broke new ground was its emphasis on the uncertainty that state and local fiscal processes face, thanks to the federal government. Here is what the report says (emphasis Blackrock):

Ironically, the greatest threats to state fiscal integrity are not primarily endemic fiscal matters or economic conditions, but rather, the effects of federal policies. First, capping tax exemption is a potential problem for the entire municipal asset class, although offsetting factors would certainly alleviate the impact. For states, as well as local governments, a tax cap could mean higher borrowing costs. Still, as has been the case recently, increased borrowing costs would likely translate into program reductions or cost-shifting to local governments. As stated earlier, we believe passage of the cap will be difficult in the current political environment and is unlikely in 2013.

The threat to cap or eliminate the tax exemption for municipal bonds has been floating around for over two years, and it causes concern for public officials. RBC’s Chris Mauro wrote in a note Wednesday that any change to the muni bond tax exemption would likely go through a traditional legislative process and not be jammed into the continuing resolution. From Mauro’s note:

Yesterday, House Ways and Means Committee Chairman Dave Camp announced that the Committee would hold a hearing next Tuesday, March 19, entitled ‘Tax Reform and Tax Provisions Affecting State and Local Governments.’ According to the Committee’s hearing advisory, the focus of the hearing will be the ‘federal provisions that affect state and local governments, and how those provisions should be viewed in the context of comprehensive tax reform.’ In other words, the bulk of the discussion will be centered on the itemized deduction for state and local taxes and the municipal bond interest exemption.

So there won’t be a speedy resolution to the question of eliminating tax exemption for municipal bonds.

Blackrock outlined the second threat, which I think is more substantial and likely to pressure state and local budget processes:

Furthermore, although Medicaid remains untouched in the current sequestration, the program could face federal cuts in future negotiations. Assuming funding mandates for Medicaid remain, states would bear additional budget pressure from reduced federal dollars, forcing possible tax hikes, increased fees, spending cuts to programs and local governments, delayed pension funding, and use of reserves.

The rigidity and tightness of Medicaid funding has always been the one of the biggest problems for governors. States administer Medicaid, but half the funding and the rules come from Washington. Now Medicaid is set to be expanded by 18 million people under Obamacare, and it’s unclear how its funding will be protected and expanded in Congress. House Republicans would like to repeal Obamacare, and the easiest way to do this is to reduce, or possibly not increase, Medicaid funds to pay for the new enrollees.

Blackrock says that Medicaid funding pressures will squeeze every other part of state budgets. The federal government could be the biggest threat to the states.

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