Sinking Ships of State

Deep cuts in state and local spending may exert an undertow on the nation's recovery.
May 2010
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.

These are ticklish times. A sustained recovery from the deepest decline since the Great Depression is uncertain. A critical, but usually overlooked, factor in the arc of that recovery is state and local government.

These governments now employ 22 million workers-teachers, cops, firefighters and sanitation personnel-who rent apartments, buy houses, shop locally and pay taxes. The governments procure goods and services, and make assistance payments to the old, sick and disabled, and their caretakers. We are talking about one-eighth of the U.S. economy.

The sector's finances are complex, multi-tiered and interdependent. Most federal aid payments flow to state governments, and states relay much of it, along with their own source revenues, down to local governments. This fiscal interrelationship is now being tested by the depth of the Great Recession.

States and localities are experiencing unrelenting pressure from unceasing waves of budget gaps, which stem not from impetuous increases in spending, but from plummeting revenues-a deterioration unseen since the Great Depression. Gaps first appear while drafting a budget, when spending projected for next year's programs is compared to expected revenues. While the initial shortfall may be closed as the budget is adopted, both sides of the ledger are affected by the economy's ensuing performance. In bad times, expenses go up as the unemployed demand more services; revenues go down as tax bases shrink. During the fiscal year, a government may see new gaps and have to revise its budget, usually by cutting expenditures.

The macroeconomic worry is that widespread cutbacks by states and localities will create a drag on the economy. The most immediate concern is the rapidly approaching disappearance of federal stimulus money. A big chunk-$140 billion of the $787 billion stimulus program enacted in early 2009-is being passed onto the states for Medicaid and general budget support. According to the Washington, D.C.-based Center on Budget and Policy Priorities, the stimulus funds-and other federal aid increases-have clipped $100 billion out of the $200 billion in budget gaps states are experiencing in fiscal 2010. Reserves and some $30 billion in tax hikes will cover much of the rest, so total spending is estimated to decline by only $40 billion.

For fiscal 2011, 48 states (all except Montana and North Dakota) face budget gaps estimated to total $180 billion. Meanwhile, state reserves have been drained, and federal stimulus funds will be consumed by this calendar year's end. States and localities are cutting spending to live within their faltering revenues-their employment rolls have fallen by 180,000 jobs since 2008, and thousands more losses are in the wings. Issuing bonds to cover current spending gaps is pretty much off limits, but it can happen. In New York state, a $9 billion deficit is leading to calls for borrowing to solve cash-flow needs and the creation of a state financial control board along the lines as used for New York City in the 1970s.

We know little nationally about revenues and spending in local government, except that their source revenues are, at best, flat, and that state payments, particularly for public education and social services, are plunging. After the intergovernmental transfers are figured in, local governments represent about 55 percent of the sector's final spending, so much of the cutback pain will end up there.

Depending on political persuasion, one can either bemoan or applaud the states' and localities' fiscal destitution. But it is folly not to recognize the impact on the broader economic recovery. Roughly 50 percent of current state and local spending (net of intergovernmental payments) is on salaries and benefits, 20 percent on transfer payments, and 30 percent on purchases of goods and services. Cutting state and local spending by $180 billion or by 10 percent (about the size of the gaps relative to projected revenues), would be a substantial drag on the national economy. It would transmit a 10 percent unemployment rate to the government sector and the various vendors that supply it.

The implicit hope is that the private sector's rapid recovery will buoy the sinking state and local ships of state. If not, the other seven-eighths of the economy may get sucked down in the undertow.