completely make up for the lost state tax revenues ($67 billion). Nonetheless, even as the revenue declines among the states contributed to budget crises for some of them, we differentiated this from outright debt crises among states, even in cases where fiscal strain fac- tored into credit rating downgrades. This was due to the states’ taking cor- rective budget actions—in many instances, in mid-fiscal year.

Phase two: alternative scenarios. Phase two of the BCA envisions deficit reduction ranging from $1.2 trillion to $1.5 trillion through 2021 achieved via one of two contemplated scenarios. For the states, much depends on the efficacy of the joint special committee, whose goal, pursuant to the BCA, is $1.5 tril- lion in deficit reduction. Under the BCA, the joint special committee will recommend a deficit reduction plan by Nov. 23, 2011 with a Congressional vote by Dec. 23, 2011. If this process does not materialize in the enactment of deficit reduction legislation, across-the- board cuts, or funding “sequestration,” would be triggered automatically. Because the trigger cuts exempt certain programs important to states, this sce- nario could be more favorable to state and local government finances than potential cuts that could emerge under the joint special committee process.

Phase two: no deficit reduction legisla- tion (automatic trigger cuts). If the joint special committee process does not result in enacted deficit reduction legislation, the automatic trigger cuts would total $1.2 trillion over 10 years. Compared to the $756 billion in reduced discretionary spending of phase one, these spending reductions are, according to the BCA, more evenly dispersed across the horizon. However, the BCA exempts specific programs, including Medicaid and CHIP, thereby shielding prominent parts of state budgets.

Nonetheless, given the interdepend- ence between the states and the federal government, with federal sources of rev- enue comprising about 32% of total state revenues (2009 data, U.S. Census Bureau), we expect reduced funds for states to be an unavoidable outcome at

least to some degree should the auto- matic cuts be triggered. In a scenario where the across-the-board cuts were triggered, state grants and pass-through funds could experience large reductions. However, states would know by Jan. 15, 2012 whether the sequestration cuts are triggered, nearly one year before they would be implemented in January 2013. This timeline provides some opportunity for states to accommodate the cuts from a budget management perspective. By and large, this reduced federal funding would not affect states’ discretionary revenue. Therefore, if across-the-board cuts were triggered, we believe that the reduced aid to states might not have a commensurately negative effect on states’ fiscal positions. In short, we expect that reduced federal funding could be met by states with program- matic cuts in many areas that have been heretofore funded with federal dollars. As we noted earlier, to the extent states decide to continue funding such pro- grams on their own, fiscal tradeoffs will be involved. We understand that some mandates, such as for certain education- related programs, would likely remain in place and represent an increased fiscal responsibility for states. Whether and how states manage any potential federal cuts could play a role in our review of budget management as a part of the larger rating process.

Phase two: deficit reduction legisla- tion. If the joint special committee process achieves enactment of deficit reduction legislation, in our view state finances could be more vulnerable to potential changes in the federal-state funding relationship. Entitlement pro- grams represent some of the biggest drivers of the federal government’s long- term projected fiscal deficit. With wide latitude regarding how to shape deficit reduction, the joint special committee can recommend changes in entitlement pro- grams, with Medicaid representing the most significant from the states’ perspec- tive. The federal and state governments jointly finance Medicaid but each state manages it individually. According to the Centers for Medicare and Medicaid Services, total governmental spending on

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