Focusing On Crumbling State And Local Budgets

By now, everyone is well-aware the US, as the Federal level, is insolvent, and continues to exist merely thanks to 1) the ability to print money and 2) having the world's reserve currency for the time being. Yet more and more are focusing not only on the calamitous, and even more bankrupt, state fiscal picture, but increasingly so on the smallest bankrupt quantizable element: local governments. The following surprisingly objective note from Goldman's Alex Phillips separates fact from propaganda in this increasingly more critical discussion, now that the question of how soon the administration will need to provide state bail out funding reaches critical mass.

From Goldman's Alec Phillips:

  • States reported a year over year gain in revenues in the first quarter, the first since Q3 2008. However, while the revenue trend is stabilizing, excluding tax increases enacted over the last year would turn this gain into a continued (albeit smaller) decline.  Moreover, states face potential disappointment from Washington; the majority of states assume additional fiscal aid that Congress looks increasingly unlikely to provide, potentially adding another $25 billion to the savings will have to come up with in the coming fiscal year that starts next month.
  • While the state revenue trend is at least beginning to stabilize, the local sector may be moving in the other direction. Local revenues lag state revenues, as they rely more on property taxes which react to the economic cycle with a greater delay. In addition, localities face pressure from the states themselves, some of which may shift costs from their budgets to localities to close their own gaps.  
  • The consequence is that local governments, which are not tracked nearly as closely as state government budgets but make up roughly 60% of the state and local sector, will continue to cut spending despite tentative improvement at the state level.  Apart from the effect on overall state and local activity, the shift of fiscal pressure is likely to put the emphasis on cuts to different segments of spending (fewer cuts to income maintenance programs, more cuts to education).  
  • Our preliminary estimate is that nonfarm payrolls fell 100,000 in May, with a 150,000 gain excluding Census workers.  We expect a one-notch increase in the unemployment rate to  9.8% and a 0.1% gain in average hourly earnings.

State and local sector spending has been a weak spot in the recovery, with real spending down 1.7% since the recession trough, the only instance of a real decline at this point in the recovery.  This has been largely driven by significant revenue shortfalls at the state level, which as a result of balanced budget requirements have led to spending cuts of a similar size. From 2009 to 2013, state budget officers estimate revenue shortfalls of roughly $560 billion, with $125 billion of this occurring in the coming fiscal year. While part of this estimated shortfall relates to assumed spending increases (to fund health and other programs that face consistently rising costs), part of this also reflects an assumption of continued revenue declines. Only a fraction of this shortfall will be made up through federal fiscal aid to states.

The most recent reports from states indicate that the revenue picture has improved. However, there are a number of caveats, some with negative implications for the local level of government, which actually makes up the majority of the state and local sector: 

1. State tax collections are up year over year for the first time since 2008… According to the Rockefeller Institute, state tax revenue in Q1 2010 was 2.4% greater than in Q1 2009. This represents the first year over year increase since Q3 2008.

2. …but legislated tax increases appear to account for more than all of the improvement...
State legislatures increased taxes and fees by an estimated $24bn in state fiscal year 2010, which ends June 30, or $6bn per quarter if we assume equal distribution across the year. Removing this effect puts underlying revenues down 2.1% in the first quarter. Legislation boosted sales tax revenue by about 3% and personal income tax revenue by around 4.5%.

3. …and federal aid may come up short of projections, resulting in additional state shortfalls.  The Senate has been debating the addition of another $25 billion in funds to the $150 billion in state fiscal assistance that Congress approved last year.  Originally, this was proposed to cover the second half of the upcoming state fiscal year, i.e. January to June 2011.  The majority of states have assumed in their budgets for the upcoming fiscal year (i.e. the year that begins next month) that Congress will extend this aid.  At the moment, the best case scenario for states is probably less than they were expecting—the latest Senate proposal would provide only $17bn in additional federal transfers in the first two quarters—and there is a clear possibility that state aid will be struck from the bill entirely before the debate is complete, due to growing concerns in Congress over the federal budget deficit. If so, this would result in states facing a greater budget gap yet to close in the coming fiscal year—at around $115 billion (shown in the chart below as the sum of "fiscal aid under debate" and "estimated"—than in the fiscal year that is about to end (which state estimates put at about $110 billion, not counting the portion of the gap that was closed with state fiscal aid). 

4. As state revenues stabilize, local revenues may come under greater pressure... County, city, and other municipal governments, which together account for the majority of spending in the state and local sector, rely heavily on transfers from state governments and property taxes, which together comprised nearly 60% of local revenues in 2007 (the most recent year for which data are available).  So while state revenue changes tend to lag the economic cycle, the local level is likely to lag even more, as shown in the chart below.  The trend in this cycle is likely to be more pronounced than in prior episodes, as the state fiscal shortfall has been worse (increasing the potential severity of cuts to support for local governments) and house prices have clearly declined much more than in prior recessions (gradually lowering property tax assessments in some areas).

5. …and states may balance their budgets on the backs of local government.  Although state governments are likely to see revenues improve ahead of local governments, on average, they are also likely to diverge from local government by pulling back on transfers to municipalities.  In previous recessions states have transferred various health responsibilities to local (usually county) governments, and increased cost sharing ratios for children’s health and several welfare programs.  In the current cycle, some states have begun to debate similar activity.   The level of state support for local government varies significantly among states, however. For instance, counties in California receive more than half of their funding from the state government; nationally, the average is about one-third. Although there is no national tally of how much of the state shortfall has been closed by shifting it to the local sector, this appears to be a common strategy in a number of states. The budget being debated in California, for instance, would increase local funding requirements by an estimated $4 billion (roughly 20% of the state's budget gap).

6. As fiscal pressure moves to localities the composition of spending cuts and tax increases will change.  Like states, most municipalities face some kind of requirement to balance their general funds, so revenue shortfalls will be met with spending cuts or, to a lesser extent, tax increases. As shown in the table below, state governments tend to spend disproportionately on welfare programs, and also usually bear primary responsibility for Medicaid programs. By contrast, localities bear most of the responsibility for education spending. On the tax side, relieving some of the pressure on state governments is likely to reduce the possibility of sales and income tax increases, which are collected mainly at the state level. While it should in theory increase the likelihood of property tax hikes, given that this is how localities collect most of their tax revenue, localities seem less likely to pursue savings through property tax hikes—though a few have already—given the fragile state of the housing market (and the political sensitivity to housing-related issues).

Composition of State vs. Local Budgets