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Why state budgets could reshape national politics

The electoral map, the demographics behind President Barack Obama’s re-election and the high-end tax increases that were just wrung from the Republicans give Democrats reason to believe that long-term political trends are on their side in budget negotiations. This view, however, ignores what is happening at the state level.

The fiscal outlook for many states is unsustainable. This eventually may influence the politics of the national budget, both directly (through battles over federal measures to help troubled states) and indirectly (through voters’ attitudes toward government).

It may take a decade or more for this dynamic to take hold, but as leaders of both parties bargain over the debt ceiling and assess their strategies for deficit talks during Obama’s second term, they should also think about the path of state finances. The prospects should unnerve Democrats, in particular: The 26 states that Obama carried in November tended overwhelmingly to have lower credit ratings than the 24 where he lost.

The most obvious examples are California and Illinois, two big states that are deep-blue politically and deep in the red fiscally. The pattern holds much more broadly, however, across the states that broke for Obama rather than the Republican nominee, former Massachusetts Gov. Mitt Romney. To see this, imagine an electoral college in which each state’s worth, rather than being dependent on its population, was instead determined by the soundness of its Standard & Poor’s credit rating.

Credit ratings

For easy comparison, the 50 states in this make-believe electoral college (which would exclude the District of Columbia) could be assigned a cumulative 538 points, equal to the total number of votes in its real-world counterpart. The 13 states with the highest rating, AAA, would get 15 points each, for example; those with the next best rating (AA+) would get 12 points each, and so on.

Using this system, the states that Romney won would be sufficient to give him a strong victory in this imaginary electoral college: 278 to 260. A simpler system, which assigned each state from zero to five points depending on which of six S&P buckets it fell in, would also give a solid victory to Romney, 94 to 88. It would appear, then, that Obama, who won handily in both popular and electoral votes, did so largely by carrying states that are more poorly governed fiscally.

To see the pattern another way, consider the type of state where each candidate racked up points in the real Electoral College. Romney got 73 percent of his electoral votes from 16 states that have either AAA or AA+ ratings from S&P; Obama received only 39 percent of his electoral votes from states with these two highest ratings, and those included swing states such as Florida, Ohio and Virginia. Instead, the bulk of the president’s electoral support — 61 percent — came from 14 financially weak states that he won handily. These states had credit ratings of AA or below and he won 13 of the 14 by at least five percentage points.

To be sure, a few states that consistently trend Republican, such as Arizona and Kentucky, have lower credit ratings, too. Governance has also been divided in some states: as at the national level, voters will be treated to a debate in these capitals about whether high-spending Democrats or low-taxing Republicans are more to blame.

Still, it is likely that the bluest states will disproportionately be the first to face serious fiscal stress over the next few decades. It will also be hard for high-tax states (the most Democratic ones) to solve the problem with revenue, because higher taxes could drive away companies and workers. And blaming the opposite party will be much tougher in states than at the federal level, where divided government and the swapping of party control in Congress and the White House mean both parties’ fingerprints are on the national budget.

Permanent majority

Democrats will probably bear the brunt politically, therefore, as the public becomes increasingly concerned about widespread fiscal problems in many states. The credit-strained blue states thus represent a long-term threat to the permanent national majority that many Democrats believe they see emerging from the past two presidential elections. Both parties are likely to clash over state-budget issues at the national level, no matter what happens to federal taxes or health care spending.

One potential battle, as with the federal budget, is over how to measure the size of the mess. Many of these states have gotten into trouble using flawed accounting for public-sector pensions, a problem that Joshua Rauh, of Stanford University’s business school, has highlighted. This gimmick has allowed state politicians to make long-term promises to public-sector unions without having to admit that they are taking on huge liabilities through these spending commitments. Any federal effort to push states to account for these liabilities correctly would entail a political battle.

Debates over limiting federal income-tax deductions also could involve state-budget politics, because taxpayers now get a federal break for state and local taxes. A provision in the new tax rules that Congress just passed reduces deductions for high-income households. This affects top earners in high-tax states, which tend to be Democratic, more than their counterparts in low-tax states. Efforts to eliminate or further restrict the tax break for states would also hurt the bluest ones disproportionately.

Finally, because the most troubled states have unsustainable budgets, they will eventually face sharp spending cuts and tax increases if they don’t address their difficulties soon. This long-term problem will await them even if their budgets begin to look a little better in the short-term than they did at the depth of the recession. In 2009, the states’ budget crunch was so severe that the federal government chose to help them as part of the stimulus package. If continuing state-budget neglect leads to heavy austerity later on, the resulting economic pain may create strong political pressure for some type of federal bailout.

As Congress and the president clash over the nation’s fiscal sustainability, they should be thinking clearly about how wayward states will affect the long-term federal budget. Voters could use a much better debate over state finances.

Barry is an economics professor and executive director of the Initiative on Global Markets at the University of Chicago Booth School of Business.

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