by Josephine M. LaPlante, Associate Professor of Public Policy and Management, Edmund S. Muskie School of Public Service, University of Southern Maine*

On July 31st members of the House and the Senate voted overwhelmingly to approve two pieces of legislation, one that in spirit if not substance produces a balanced federal budget in fiscal year 2002 and a second that provides nearly $100 million in tax reductions, principally through a cut in the rate at which the capital gains of high-income households are taxed. With Democrats and Republicans both scrambling to lay claim to a feat the president described as "the achievement of a generation and a triumph for every American," it may seem unnecessary to ask whether Maine should be celebrating. Yet, one need only consider the content of the two bills before a big question mark emerges: How could massive spending cuts applied to only the small portion of federal spending that remains unprotected by political pacts combined with huge cuts in taxes primarily benefitting the wealthy make everyone better off, as the politicians claim? The answer is they do not, particularly when one considers the distribution and the effects of the huge budget cuts enacted since the beginning of the decade, cuts that established the foundation for this comparatively facile agreement.

Over the past several years, as the press to reduce federal spending has intensified, scant attention has been paid to the negative effects of spending reductions and virtually none to alternative ways of thinking about investing in the nation's future. Members of Congress or candidates for office who have questioned the wisdom of such vigorous pursuit of budget balance or suggested alternative views of government spending and investment quickly have found themselves labeled by peers and the press as "liberal" and "incapable of saying no to special interests." The widespread impression that if we could only balance the federal budget and keep it balanced everyone would be a winner is the product of one of the most concerted and effective advertising campaigns since the advent of designer jeans, which also was proclaimed as an inevitable response to overpowering demand.

As the recent budget and tax bills underscore, the political agenda has never really been about balancing the budget. Rather, it has been about shrinking government sufficiently to enable the magnitude of tax cuts President Reagan envisioned and Newt Gingrich continues to promote, without driving the deficit through the roof. The notion that tax cuts are the true engine of action is supported by data. First, the new tax breaks will take effect sooner than spending cuts can be implemented, so the gap between spending and revenues will widen in the next year or two. Second, the balanced budget bill reduces spending by proclamation, not through specific programmatic cuts. Aside from reductions in Medicare spending (primarily leveraged by increasing the age at which one becomes eligible for assistance from 65 to 67) and Medicaid (where reductions target hospitals that serve the indigent), the balanced budget accord has little substance. Instead, the bill requires Congress to find an additional $140 billion in cuts -- later, after the tax cuts are all set. Finally, even in the absence of tax cuts, the budget would probably have approached balance all by itself, due to the strength of the economy. The deficit for the current fiscal year is approximately $34 billion, which is not only well below initial projections but also substantially beneath the $290 billion level that faced Congress and a newly elected president at the end of the recession in 1992.

Reinventing the Federal Role

Arguments put forth by the proponents of budget balance have been aided by the public's lack of understanding of distinctive roles the federal government plays that set it aside from businesses and in many respects from other levels of government. First, since the 1930s, federal deficit spending has been used to stabilize income in times of economic decline, preventing the kind of downward spiral that characterized the Great Depression. Congress does not need to approve countercyclical fiscal policy, as stepped-up demand for programs like Medicaid and food stamps automatically initiates the flow of public dollars to replace dwindling private spending. Using the federal budget to stabilize the economy and to protect people from the sudden and severe hardship makes federal spending unpredictable and generates deficits during recession. The change to block-grant funding will reduce spending uncertainty in the federal budget and enhance Congress's capacity to keep the budget in balance. However, this structural change will diminish the current match between a state's magnitude of need, its ability to pay, and the amount of federal aid it receives. In addition, the automatic response and rapid income stabilization are sacrificed when Congress must approve each increase in aid and find the dollars to finance it.

Recent experience in Maine underscores the importance of the federal fiscal stabilization role, for, as Figure 1 shows, increased federal aid substituted for a plummeting state capacity to finance vital safety-net programs. Between 1990 and 1993 federal spending for social programs in Maine was augmented by $580 million. If real, inflation-adjusted dollars of federal spending had remained constant between 1990 and 1993, 26,000 fewer people would have been assisted through Maine's Medicaid program, 3,000 fewer households through AFDC, and 54,000 fewer households with food stamps in 1993. If a balanced-budget requirement had forced a reduction in federal spending during the recession, these numbers would, of course, have been multiplied.

Balancing the federal budget during an economic downturn will require spending reductions, tax increases, or both. These types of actions escalate contraction of the national economy, which further increases human need in the states and reduces tax resources to meet those ends. States like Maine, whose tax systems are structured progressively in an effort to achieve an equitable distribution of burden, and, consequently, whose revenues are more responsive to economic change, will see tax revenues dwindle faster than average. Policy makers will face the prospect of enacting significant and damaging pro-cyclical policy actions or telling scores of people the promised "safety net" has a big hole.

Another key distinction between the federal government and businesses is that federal tax and spending policies traditionally have been compensatory and redistributive. The progressive federal income tax system is used to require households of higher income to pay for government programs that benefit the needy. Federal policies have helped to redress mismatches among the level of needs in a state, the cost of producing services, and the ability of that state's residents to pay for the required services. As Figure 2 shows, Maine has been a primary beneficiary of federal spending. While the federal government spent about $2.40 in the average state for each dollar of income tax paid in 1993, Maine received $3.17 back for each dollar of federal income tax paid. This ratio is explained by the combination of below-average per capita personal income, a higher-than-average need for services among the population coupled with higher-than-average production costs (especially the high cost of medical care in the northeast), and heavy use of a state income tax, which is fully deductible from federal tax liability.

Impacts of Federal Retrenchment in Maine

The newest reductions in federal spending will not affect the states uniformly. Rather, states that are the most dependent on federal spending will bear the brunt of cuts. In 1995 federal spending and obligations in Maine totaled $6.65 billion, or $5,362 per capita. This total exceeded the U.S. average by about $180 a person. Of the $6.65 billion, $1.2 billion, or 18 percent, was defense related. Total per capita federal aid to Maine state and local governments ($1,023) exceeded the U.S. average by $212 and was 26 percent above the average allocation. Medicaid reimbursements that totaled $493 per capita ranked fourth in the U.S. and explain much of Maine's advantage with respect to state aid.

As the magnitude of these figures suggest, federal expenditures provide a critical injection of external money into Maine's economy. A large portion of federal spending enters the economic cycle as personal income in the forms of wages or income-support payments. Salaries of federal employees in Maine topped $700 million in 1995 and federal reimbursements to state government for employees involved in federal programs totaled $137 million plus fringe benefit costs of $45 million. A variety of income-support programs administered directly by the federal government paid out a total of almost $3.7 billion to individuals and households. In addition, through the Medicare and Medicaid programs, a huge amount of federal money is expended in Maine each year on behalf of the needy and the elderly. These funds, which in 1995 totaled close to $1.3 billion, flows into Maine's health-care sector, where it not only helps the programs' beneficiaries meet the expenses of health care but also finances jobs and capital investment.

The site of federal spending is very important economically. The health-care industry has been one of the fastest-growing sectors in the state, and it pays some of the best wages. Defense procurement spending, which totaled $713 million in 1995, has been -- and continues to be -- an extremely important "driver" of Maine's economy. Employment in contracting businesses is concentrated in high-wage skilled and technical positions, and federal jobs pay comparatively high wages. As a consequence, the contribution of federal spending to statewide personal income has been greater than the percentage of statewide jobs supported might predict.

The significance of federal spending becomes even more apparent when one considers that much of the total direct spending is subject to the "multiplier" effect on income and employment. The multiplier effect is a process wherein one household (or business) receives income, then spends some of the money to purchase goods and services and saves some of it, which provides income to businesses and households that, in turn, sustains and creates jobs. If each dollar of federal expenditure produced only an additional fifty cents of income through the multiplier effect, the economic impact of federal spending and obligations in Maine would have been $10 billion in 1995, an amount that is equivalent to 40 percent of the state's total personal income.

Unfortunately, economic multipliers also work in reverse. When federal dollars are withdrawn from the economy, households have less income to spend, businesses sell less, and people lose their jobs. When retrenchment reduces spending for social welfare programs or defense, program recipients as well as government- and private-sector contractor employees who get laid off suffer direct negative consequences. The economy and the community suffer from the loss of both direct and indirect employment. Eventually, the livelihoods of many people are affected as the results of "ripple" spending reductions set in.

Maine is still reeling from the negative ripple of federal defense spending cuts enacted since 1989. Between 1989 and 1994, Maine lost 48 percent of its total defense employment -- almost six times the U.S. average loss of 8.3 percent -- for the second biggest drop among the fifty states. Close to 60 percent of the 1989 complement of military positions, and more than 40 percent of civilian positions, have been lost already.

Although the tremendous importance of military contracts in Maine has been well publicized, it is less well known just how far out of line procurement is in comparison to other states, or that the dependence escalated during the early 1990s. In 1989 Maine's per capita defense contracts of $689 were 47 percent above the U.S. average and ranked tenth in the nation. Considering contracts as a percentage of personal income, Maine was 62 percent above the average and ranked ninth. Despite a real-dollar reduction in contract value, Maine's reliance on federal procurement actually increased relative to other states between 1989 and 1994 because the typical state saw an even larger real-dollar loss. By 1994 the per capita expenditure for defense contracts in Maine ($756) had increased to 76 percent above the national average and ranked sixth. Defense contracts accounted for 4 percent of Maine's personal income (disregarding any consideration of multiplier impacts), almost double the U.S. average.

A regional pattern of dependence intensifies Maine's defense dependence as well as the impact of cuts in defense spending. And, as Figure 3 illustrates, nearly every state in the Northeast suffered unusually large reductions in combined military and civilian defense employment between 1989 and 1994. With the demise of Pease Air Force Base, neighboring New Hampshire lost 86 percent of its military employment between 1989 and 1994, ranking first among the states in percentage the percent of military jobs lost -- just ahead of Maine. Like Maine, Massachusetts and Connecticut still garner larger-than-average portions of their personal income from contracts with the Department of Defense. Although a number of New England defense contractors have begun to diversify into other lines of business during the 1990s, many that have made progress still depend on the Department of Defense for one-third or more of their annual sales. Typically, these businesses receive a small number of very large contracts, so the loss of one contract can have serious consequences for a company's employment level and sales total. Maine's largest private employer, Bath Iron Works, is one of only three companies in New England that is more than 75-percent dependent on military contracts. (The other two are General Dynamics and Lockheed Sanders).

The cumulative impact of defense-spending reductions in Maine is in evidence today. Fourteen thousand of the state's best-paying jobs are gone, which reduced personal income in Maine by an estimated $460 million in 1996. These figures shed important light on why Maine's recession was among the worst in the United States and its recovery among the slowest. Despite the loss of jobs, personal income from Maine's remaining defense-related employment will be approximately $1.4 billion in 1997.

The unparalleled importance of Bath Iron Works and Portsmouth Naval Shipyard within the Maine economy -- from the perspectives of both income and employment -- leaves the state less capable of making up for lost dollars and susceptible to substantial repercussions from continuing defense cuts. Many of the best-paid positions require extensive, well-honed skills but not a college education. Thus, for these workers to transfer to other well-paid jobs will be a significant challenge. The Governor's Task Force on Defense and the Maine Economy concluded: "Maine's economy will be hard-pressed to replace a significant number of shipbuilding jobs lost to defense cuts with jobs of similar skill types or wage levels."

The Future

Even with level national spending, Maine could see sizable reductions as the Department of Defense seeks to balance its budget in the face of declining real allocations. Because defense cuts often mean base closings or fewer multimillion-dollar contracts, a small state with modest personal income can see extraordinary impacts that would be far less severe in a state with a larger and more diverse employment base and where defense spending is a smaller portion of personal income. Although reducing defense dependency is an important goal for Maine, the severity of the impacts already experienced leaves little residual capacity or flexibility to absorb future federal retrenchment. Any "peace dividend" that accrues to the nation from these reductions is not likely to benefit Maine, particularly given the federal government's near abandonment of its traditional compensatory and income-redistribution roles.

Fortunately, the strength of the national economy already has mitigated the need for very deep cuts in spending envisioned in the 1997 budget resolution (May 1996), but $140 million is still to be cut. As Congress begins the task of designating specific programs for reductions in spending, Maine is likely to find itself losing more than most states because of its unusually high allocations from the Departments of Health and Human Services and Defense. In each of the past two budget agreements, the projected state-by-state per capita reductions in federal spending placed Maine in 7th place for the magnitude of losses.

While the current economy provides some reprieve for the short term, it is important to understand that the most significant impacts of new federal policies for funding public welfare programs will lie dormant until the inevitable next economic slump. To achieve federal budget stability and predictability, Congress and the president are passing along a larger portion of the costs of public welfare programs -- and the accompanying budget-balancing headaches -- to the states and local governments, some of which are far less able than others to assume those burdens. It is probable that self-defeating choices (raising taxes and cutting important spending) by the poorer states will be one consequence of a reduced federal presence in mitigating interstate fiscal disparities, which will widen the gap between the "haves" and "have nots." The exacerbation of disparities in the ability of states to pay for services is likely to intensify interstate educational spending variances, to the detriment of the affected states and to the nation as a whole.

Given the effects of federal spending cuts already imposed, the prognosis for future impacts, and the small percentage of Maine citizens who can benefit from tax cuts skewed towards households earning over $100,000 (of whom Maine has very few), we are not in a position to be celebrating the recent enactment of balanced budget and tax cut legislation.