While many fiscal conservatives are applauding the Senate's passage of a $350 tax reduction, the inclusion of a $20 billion bailout to fiscally troubled states has caused some concern. This bailout unfairly penalizes taxpayers in states that have been fiscally disciplined. Furthermore, it creates bad incentives for elected officials. State legislators may propose even larger spending increases, knowing that if deficits occur, Congress will likely force taxpayers in other states to pick up the tab.
However, the incentives created by the bailout do not necessarily have to be bad ones. Indeed, if the bailout is designed correctly, it might even be a force for good. Congress should use the leverage that comes with this bailout to impose fiscal discipline on the states. One way of doing this would be to require that states enact constitutional expenditure limits before receiving federal bailout funds
These spending limits would go a long way in promoting fiscal rectitude. In fact, there is plenty of evidence that well designed expenditure limits can be effective. During the 1990s, tight expenditure limits in Washington and Colorado demonstrated considerable success at restraining spending growth and providing tax relief.
Furthermore, lenders often impose fiscal restrictions on individuals, companies, or countries in debt. When the United States offers foreign aid, the grants and loans are often tied to monetary and fiscal policy reforms. Of course, long-term enforcement of these policy changes is difficult, which is part of the reason why most foreign aid programs are unsuccessful.
However, the situation that the states are facing is less complicated. The states do not have to worry about currency stability or the rule of law. Instead, their fiscal problems stem from sharp spending increases. This is a straightforward problem that can be solved through well-designed expenditure limits.
Additionally, this approach might actually have a chance of succeeding politically. Forty-nine states have balanced budget amendments, which means that elected officials either have to hike taxes or enact painful budget cuts to bring their books into balance. Needless to say, neither option is particularly appealing to most state legislators. Indeed, to avoid such politically difficult tradeoffs in the present, many legislators would likely be willing to abide by an expenditure limit in the future. This strategy might be especially effective in states that have term limits. Legislators in term-limited states will have to leave office in a few years because term limits will force them out. As a result, if they enact an expenditure limit, they will only have to put up with this limit until the term limits force them out.
In the end, it would be best if the bailout were removed from the final tax bill. This way, governors and legislators would not get a free pass from Congress and would instead have to deal with the political fallout from their late-1990s spending spree. However, if a bailout is included in the final legislation, Congress should only grant bailout funds to those states that enact tight state expenditure limits. Such limits would curb spending growth, provide tax relief, and hopefully prevent similar fiscal crises from happening in the future.