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Budget cuts in Washington may put added pressure on state governments already strained by employee pensions and rising health-care costs, according to a report by a group led by former Federal Reserve Chairman Paul Volcker.

Congress’s need to reduce the budget deficit jeopardizes state aid as well as tax breaks, including those for buyers of municipal bonds, which assist state and local governments, according to the report released today by a panel of former government officials. It’s led by Volcker, 84, and Richard Ravitch, 79, New York’s Lieutenant Governor in 2009 and 2010 and state adviser during New York City’s fiscal crisis in the 1970s.

“Though politics is inherently uncertain, it is reasonable to assume that the future will bring restraints on federal government spending, pressure to cut grants-in-aid to states, cuts in federal procurement, and uncertainty about federal tax changes,” the group said in the report. “Such developments would hit the states in this study particularly hard.”

President Barack Obama and lawmakers are seeking to narrow the gap between the federal government’s revenue and spending over the next decade to curb the U.S. debt. Their decisions may affect the more than $600 billion a year in federal money that goes to state and local governments for health care, public works, schools and other programs, according to the report.

Fresh Challenge

The cutbacks would pose a fresh challenge to states as their finances are stabilizing from the toll taken by the 18-month recession that ended three years ago. State tax revenue has been rebounding for the past two years, easing the pressure on public officials who must balance their budgets.

The states face several fiscal challenges that will linger even after the effects of the recession are over, according to the group, which is seeking to draw attention to the issues. They include: underfunded pension and medical benefits for employees; growing costs of the Medicaid health-care program; a volatile tax base that leaves states vulnerable to crises during recessions; and oversight of cash-strapped local governments.

Stockton, California, last month became the biggest U.S. city to file for bankruptcy protection, unable to cope with mounting retiree health-care costs and accounting errors that overstated municipal revenues. San Bernardino, another California city, may turn to the courts for protection from its creditors.

Apocalypse Not Now

These long-term pressures on states probably will worsen if left unaddressed, according to the report. It called for state officials to set aside enough money to pay for employees’ retirement benefits, provide clearer financial information to the public, and shun accounting methods that make it easy to paper over -- rather than eliminate -- budget shortfalls that result when governments commit to spend money they don’t have.

“We’re digging a very, very serious hole for ourselves and the real victims of that are going to be social services, the infrastructure -- that’s what’s being cut already,” Ravitch told reporters in Washington. “Our basic effort here was not to say the Apocalypse is around the corner, but to say that it’s going to be a hell of a lot more costly to deal with this problem five years from now than it is to try to deal with it today.”

Grant Funding

In addition to Ravitch and Volcker, known for his aggressive steps to curb inflation in the early 1980s and a pending regulation aimed at curtailing banks’ risk taking, the group includes former Treasury Secretaries Nicholas Brady and George Shultz. Another member is Alice Rivlin, a former vice chairman of the Federal Reserve and budget director under President Bill Clinton.

The group’s work was funded by grants, from groups including the Open Society Foundations and the Peter G. Peterson Foundation.

As state tax collections recover, the U.S. budget deficit is casting uncertainty over the nation’s capitals.

While some state programs, including Medicaid, are exempt from automatic cuts that will begin in January if Congress doesn’t act, states may be affected by agreements struck by lawmakers. California and New York would each lose more than $6 billion if federal aid to states is cut by 10 percent, according to the group.

The long-term financial pressures on states is well known in capitals and in the $3.7 trillion bond market, where investors and credit-rating companies have discussed the risks posed by widening shortfalls in public employee pension funds.

Until Brink

Municipal bonds have gained this year as state budget pressures eased and most new bond sales were used to pay off higher-cost debt, contributing to a scarcity of tax-exempt securities. The debt has earned about 5 percent this year, compared with 2.6 percent for Treasuries, according to Bank of America Merrill Lynch data.

Volcker, the former central banker, told reporters that it’s typical for Wall Street to continue lending money until an immediate crisis, and said the low yields in the municipal bond market reflect investors’ perceptions that state and local debts will be repaid. He declined to offer his own views on whether the market was adequately pricing the securities.

“This is a characteristic of financial markets, they lend right up to the brink,” he said.

(Adds Volcker’s comment on bonds in final two paragraphs.)