Shelter from the Fiscal Storm

This may be a time for states and localities to keep spending up and, if need be, to borrow money to finance new projects.
October 2001
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

Surpluses are disappearing. Tax receipts are fading. Budgets are under pressure. But unlike the ill-fated dot-coms and debt-laden telecom sector, state and local governments are not laying off workers and will not be closing up shop. Public-sector spending continues to crank along. State and local governments are momentum spenders with big payrolls and transfers. They move to fiscal year rhythms and take time to adjust.

It has been out of fashion to view states and localities in the aggregate and examine their impact on the overall economy. But their size and continuity play a significant role in stabilizing demand in the economy: The state and local sector, along with consumer spending, posted the only positive growth performance in the national GDP in the second quarter of this year. In fact, without the state/local sector's 7 percent growth in spending, the U.S. economy would have not grown at all. Overall, total spending by the 50 states and the thousands of local governments make up about 12 percent of GDP. About one out of every 10 jobs is in state and local government, which all together employ about six times as many persons as the federal government. The $220 billion in annual gross investment spending by this sector is equal to about 20 percent of all non-residential fixed investment.

The sector's numbers have been significant for the national economy for years, even though they've been mostly ignored. That was not always the case. In the late 1960s and early '70s, federal officials worried that the state and local propensity to raise taxes and cut spending during recessions went against federal efforts to revive the economy. In part, that was why the federal government set up counter- cyclical spending programs. But these stimulus programs, which were rolled out in the early 1970s, were often too slow-moving to have the intended impact: By the time the money from Washington got spent, the recession was over. Instead of reviving the economy, the new dollars added to demand and fueled inflation.

For the past three decades or so, the state and local sector's finances have continued to more or less track the rest of the economy. In recent years, however, the sensitivity of state and local revenues to economic conditions has increased. That's because the states have narrowed their tax bases and become reliant on elastic revenues such as the personal-income tax.

Localities, on the other hand, react more slowly to national trends, primarily because of the sticky nature of the property tax: Assessed values tend to change slowly and with a considerable lag.

But they are not immune to the vagaries of the economy. In the early 1980s and again in the '90s, states balanced their budgets by significantly reducing aid to localities and, faced with declining property values, the latter raised tax rates and chopped programs. The relatively brief recession of the early 1990s proved particularly harsh for local governments because of the extended slump in property values, which haunted many well into mid-decade.

If the rainy days continue and recession takes hold, how will the sector fare this time? There'll be no help in the form of federal aid. New intergovernmental assistance, much less any predicated on fighting recession, is no longer on anybody's agenda.

The more pertinent concern is how long the stash of rainy day funds-- some of which have already been taken down this past fiscal year--and assorted other fund balances can shelter spending. In view of the greater elasticity in the revenue systems, it is unlikely that the funds on hand will put much of a dent in budget shortfalls if there is a serious slump lasting more than a couple of quarters. In the double- dip recessions of 1980 and 1981, states in the aggregate did run slight deficits, and they almost did again in the brief swoon of 1990- 91.

But there is a remaining question that is seldom addressed. That is, should states and localities do their own counter-cyclical spending in the face of declining revenues? Is this a time to keep spending up and, if need be, borrow to finance it? That case can be made--not out of patriotic valor or self-indulgent profligacy but in terms of simple self-interest. States and localities, in short, are in a superior position to take advantage of soft markets and flagging demand.

The best target for homegrown counter-cyclical spending is public works. The construction industry, which is peculiarly subject to cycles, has been buoyed by housing demand that won't last forever. Nobody can borrow more cheaply than state and local governments and interest rates are attractive. Unlike consumers and industry, most governments enjoy low debt burdens and credit ratings that are the highest ever. Contracts let and bonds sold in the belly of a recession can mean doing well is not inconsistent with doing good.