You can almost feel the foreboding in statehouses, school board offices and city halls across America this week as the fiscal year 2006 budget cycle begins with the submission of the president's budget. State and local governments did not fare well in the 2005 budget, but that may seem like child's play compared to what is expected for 2006.

The president's budget submission will be only the beginning. Congress is expected to reject many of the proposed cuts in areas such as weapons procurement, and it will also want to increase spending for things like veterans medical programs. To do so, it will have to make cuts in other areas of the budget that are even deeper than those proposed by the president.

Federal budget policy seems to run in cycles. The "austerity" efforts now underway are strongly reminiscent of the budget battles during the late 1970s and throughout the 1980s. Then as now, deep cuts were being directed at only one relatively small portion of the budget, while revenues, entitlement and defense spending were largely left off the table as means of reconciling outlays with federal income.

THE HISTORY OF RECENT FEDERAL AUSTERITY EFFORTS

During the later 1970s, rising commodity prices pushed up the overall cost of living, forcing spending for federal entitlement programs such as Social Security and Medicare rapidly upwards. The president and the Congress attempted to at least partially offset these increases by holding back spending on non-entitlement programs. Concern that defense had already been cut back too far following the Vietnam War led to the decision to direct the cuts entirely at domestic non-entitlement programs—a category of programs that constitutes less than 20 percent of all federal spending.

With the election of Ronald Reagan, the pressure on these programs intensified as the administration sought simultaneously to implement large tax cuts and to double the defense budget.

For a time, the Reagan administration attempted to also apply fiscal discipline to the entitlement side of the budget, but soon recognized that it could not withstand the political maelstrom that such cuts would entail.

Interestingly, there were two significant exceptions to the federal government's general inability to hold back entitlement spending during this period. Both involved federal programs that shared federal revenues with state and local governments. By far the larger of the two was General Revenue Sharing, which was initiated in fiscal 1972 at the level of $6.6 billion, equal to almost $30 billion in today's dollars. Funding for General Revenue Sharing fell steadily over the period and by fiscal 1988, General Revenue Sharing had been terminated.

While state and local governments were the sole recipients of the only major entitlement program to be terminated during this period, they did only somewhat better on the discretionary (non-entitlement spending provided in the annual appropriation bills) side of the budget. Since discretionary spending accounts for only about one-third of all federal outlays, and since only domestic discretionary programs were on the cutting board (they represent only about half of all discretionary spending), even deep cuts in these programs could not offset the growth in the rest of the budget.

It is difficult to measure federal spending for a particular purpose over time if two factors are not taken into consideration: inflation and population change. Over the course of the last four decades, the dollar has dropped to less than one-sixth its 1965 value and the population has increased by about 50 percent.

As Chart 1 illustrates, total federal spending, even when adjusted for inflation and population growth, has grown at a relatively steady rate over the past four decades and continued to grow through the late 1970s and 1980s—the period of alleged belt tightening. Between 1965 and 2005, real (inflation adjusted) per capita outlays grew from $3,748 to $8,116, or by about 116 percent. [1] Even during the late 1970s and 1980s, real per capita growth continued at a substantial pace.

But domestic discretionary programs were hammered over the course of this period. As Chart 2 illustrates, real per capita domestic discretionary spending grew rapidly during the late 1960s and through most of the 1970s, peaking in 1978 at $1,576. But over the course of the next 11 years, tight budgets severely eroded the buying power of federal domestic programs. By fiscal 1989, they had shrunk to $1,141 per person—about 28 percent below fiscal 1978 levels. [2]

This alone was bad news for state and local governments, since a great many domestic discretionary programs provide grants to state and local governments. These include federal aid to elementary and secondary education, federal aid to highways, airport grants, low-income fuel assistance, grants to health departments for disease surveillance, urban mass transit funds clean water grants, disaster assistance and assistance to local law enforcement.

But the cuts in domestic discretionary programs fell disproportionately on state and local governments. This can be demonstrated by looking at total grants to states excluding Medicaid, which roughly kept pace with increases in Medicaid costs over the period. Non-Medicaid grants to states and local governments grew from $337 in 1965 to $928 in 1978. During the following 11 years, when domestic discretionary spending fell by 28 percent, non-Medicaid grants (which include more than discretionary spending) fell to $555, by $373 or 40 percent. [3]

Unfortunately, this analysis does not have sufficient detail with respect to the distribution of the cuts that took place in state and local grants between discretionary and entitlement spending to permit a precise statement as to how much of the reduction in discretionary spending came out of state and local grants. It can, however, be said that the major reduction in entitlement spending in the category of state and local grants was the elimination of the General Revenue Sharing program. Other entitlement spending in this category may very well have increased faster than inflation and population growth, as did entitlement spending generally. In real per capita terms, General Revenue Sharing expenditures declined by $98 over the 11-year period.

If Revenue Sharing represented all or nearly all of the entitlement cut that occurred in state and local grants, then the decline attributable to discretionary program cuts was about $270 in real per capita terms, or more than 60 percent of the total cuts that took place in domestic discretionary programs.

THEN AND NOW

So what can we draw from the budget history of the past 40 years to help us anticipate what may unfold for state local governments over the coming year and in the budget cycles beyond? The answer to that question depends on how similar one finds the circumstances we face today to those during the period of 1978 to 1989.

Then as now, budget deficits were seen as a large and growing problem. In fiscal 1979 the deficit equaled 1.6 percent of GDP but grew to 6 percent of GDP by 1983. It stayed in the 5 percent range until the later part of the decade. This year it appears that the deficit will exceed 3.5 percent, but slower than expected growth, further tax cuts or unexpected military or homeland security requirements could easily push the deficit much higher.

During the late 1970s and through the 1980s, the Federal Reserve Board placed extreme pressure on the president and Congress to reduce the deficit. The same appears to be taking place today.

During the 1980s, the pressure for tax cuts greatly outweighed the prospects for tax increases. The current administration is even more adamant in its opposition to putting revenue increases on the table than was the Reagan administration (which actually agreed to tax increases in 1982).

Today, as during the earlier period, the question is how fast the defense budget will grow rather than whether or not it can be cut.

The one area where the parallels are less clear is entitlement and mandatory spending. But as the Reagan administration eventually steered clear of entitlement cuts, it is now becoming clear that whatever Social Security plan this administration eventually puts forward, it will increase rather than reduce federal outlays in the near term. It is also clear that no major Medicare reform is in the offing over the next few years.

But as in the 1980s, there is one major entitlement that may be substantially rewritten, and as in the 1980s, the entitlement which is the focus of the would-be budget cutters is a program that sends money directly to the states: Medicaid.

Medicaid costs have been rising at an average rate of more than 10 percent a year. The federal government contributed $180 billion last year and the states kicked in another $130 billion. If the average rate of growth continues over the course of the next decade, total costs could approach a trillion dollars a year. Any effort to cap federal participation would have huge implications for state finances.

SCOPE OF STATE AND LOCAL GOVERNMENT

While repetition of the treatment afforded state and local governments in the late 1970s and 1980s is a matter of concern to those who serve in state and local governments, it should also be of concern to the broader public.

A cursory comparison of federal spending with that of state and local governments would provide the impression that the federal programs dwarf those of state and local governments. In fiscal 2003, the last year for which there are complete statistics, federal outlays totaled $2.16 trillion, while states spent only $1.16 trillion from their own revenues.

But if you consider that about $387 billion in federal outlays went to assist state and local governments in fiscal 2003, the relative size of federal activities to those of state and local governments is much closer.

If you compare federal activities with those of state and local governments and look at only at domestic programs—that is, excluding defense, foreign aid and the operation of our diplomatic missions—state and local government is about 15 percent larger.

If you also exclude Social Security, a program that is officially designated as being "off-budget," state and local activities account for about double the spending of the federal government.

When we think of government services that touch our everyday lives, such as maintaining roads and bridges, law enforcement, operating our schools and universities, picking up the trash, protecting the public health and providing for parks and recreation, the vast majority of those services are the responsibility of state and local government. Nonetheless, about a quarter of the funds that sustain those services come from the federal government. That is why the prospect of major federal cutbacks is so important.

When the president and Congress pick local governments to bare the brunt of fiscal discipline, they impact on a wide array of daily services that nearly all of us rely on. They force up the amount that people must pay for services such as tuition at state colleges and universities. They also put greater upward pressure on state and local taxes. Federal tax cuts that lead to reduced support for state and local governments, and ultimately to higher sales taxes and property taxes, leave most taxpayers worse off. Only the very wealthy who receive huge breaks in the form of reduced income tax rates and elimination of estate taxes will be net winners. That probably includes the bulk of those who traveled to Washington to attend inaugural festivities a few weeks ago, but the vast majority of taxpayers (in both red states and blue states) will be worse off.

Scott Lilly is a former Clerk and Staff Director of the House Appropriations Committee and is presently a senior fellow at the Center for American Progress.

[1] The Budget of the United States 2005, Historical Tables, Table 1.2. Office of Management and Budget Adjusted by the Consumer Price Index; U.S. Department of Labor and the Estimates of Population, U.S. Department of Commerce.

[2] The Budget of the United States 2005, Historical Tables, Table 8.7. Office of Management and Budget Adjusted by the Consumer Price Index; U.S. Department of Labor and the Estimates of Population, U.S. Department of Commerce.

[3] The Budget of the United States 2005, Historical Tables, Table 12.3. Office of Management and Budget Adjusted by the Consumer Price Index; U.S. Department of Labor and the Estimates of Population, U.S. Department of Commerce.