For states and local governments, the revenues they receive from income taxes and sales taxes are beginning to perk up a little too. Although it's been two years since the Great Recession officially ended, it has taken this long for tax receipts to begin growing like they typically have in previous economic recoveries. But what's different this time is that the rapid "V-shaped" rebound in government revenues has been more muted than what seasoned revenue officers have usually seen in the past. Revenues are running ahead of very conservative budget projections in many states and localities, but not enough to create budgetary windfalls that can restore public services to 2008 levels. The latest jobs report showed state and local payrolls still shrinking a little.
Property tax revenues in most localities will likely lag behind the general economy for several more years as the overhang of distressed real estate keeps home prices from growing rapidly. In the seven states with the worst foreclosure problems, it will still take another two years for markets to absorb the short sales and bank liquidations enough to rebalance housing supply with demand. Property assessments also lag behind the market by a year, so 2009-2010 short sales will hobble those tax revenues in many localities. Thus, we should expect to see income and sales tax revenues above the consumer price index and property taxes growing below that rate in the next fifteen months.
In the labor markets, the growth in civilian employment is good news. Each new job creates additional household income that is immediately taxable and will eventually work its way into consumer spending that lifts sales tax receipts. But the economy must also cope with the reabsorption of military troops assigned overseas and the exhaustion of unemployment benefits, which will keep unemployment rates persistently high. And it's unrealistic to expect any notable growth of jobs in the state and municipal sector.
In the financial markets, we are beginning to see stock prices recover but not to 2008 levels. This means that individual investors have plenty of accumulated tax losses to offset capital gains for another year or two. Income tax receipts from the investor community will improve, but not rapidly until 2015 or later, even if stock prices grow 10 percent or more in coming years as we would all hope to see as the economy expands. The only foreseeable short-term impetus to capital gains revenue at the state level would be a stampede by investors to cash out their paper gains this December if Congress decides to raise the federal capital gains and dividends tax rates to levels above 20 percent. Of course, that would be immediately followed by lower revenues in 2013.
GDP growth rates in 2013 will also be retarded by the scheduled increase in federal income tax rates as the Bush-era rates and the Obama payroll tax reductions expire this December. With the federal budget sorely out of balance and a (half-hearted) nationwide consensus that something must be done to address the federal deficit, it is highly likely that federal fiscal policy next year will be contractionary, not expansionary. Historically, the first year of a presidential term is when the castor-oil is delivered, in order to set up a rosier economy in later years. Most economists expect a 0.5 to 1 percent drag on GDP to result next year, regardless of who is elected in November. That won't throw us into a tailspin, but it will stifle the rapid economic growth normally seen when the economy starts to recover. Overseas demand from debt-plagued Europe and slower-growing China will reduce economic growth globally, which limits American exports. Thus, a muted recovery phase is the most likely scenario.
All this is consistent with the economic views of those who coined the term "new normal," which has come to mean that our economy simply won't snap back to 2008 levels immediately. Pent-up demand will have to wait another year or two in most localities. For state and local governments, the new normal thesis is that we won't get back to pre-recession levels for many years -- and possibly not until the next business cycle. That's because the financial problems facing states and localities include the withdrawal of federal aid and deferred costs for retirement plans that they cannot keep punting off into the future.
Of course, there is still the risk that something bad actually happens overseas, whether it's a Middle East conflagration, Mediterranean financial crises or a hiccup in China. Wise budget officers must plan for such contingencies, as I will explain later.
Deferred retirement benefits costs. A huge fiscal headache for state and local government leaders is the pension and retiree medical (OPEB) debt that has accumulated in the past decade and is now coming due in many states. Over $700 billion of pension underfunding and twice that much in OPEB liabilities are hanging out there waiting to be addressed. That's a $2 trillion liability that will hit their books as the accounting standards put these debts on the balance sheet for the first time. Although the pension funds have delayed sending the bills for their deficits by using actuarial smoothing practices that defer the increase in employer's required contributions, those chickens are now coming home to roost. In some states and localities, including New York, the costs of retirement plans have already crossed the tipping point despite the recovering economy. Elsewhere, public employers are looking at 5 to 10 percent increases in payroll costs to pay for the amortization of unfunded pension liabilities and other actuarial adjustments. Meanwhile, the vast majority of states and localities have failed to fund their OPEB plans actuarially, and most budget officers know that they need to start addressing this problem during this round of economic growth. If they keep paying as they go for retirement medical benefits, their costs will double or even triple in the next business cycle, so the time has come to begin putting away some acorns for the next winter.
Even if public employee unions agree to share more of the costs of their retirement benefits, the coming fiscal drag on state and local government budgets will likely be in magnitude of 10 percent of payroll in the next two years. Budget officers know this and must begin to explain the dilemma to policymakers and labor negotiators who must then explain why salary increases are likely to lag behind the inflation rate for several more years. The annual cost of prudently amortizing state and local government pension and OPEB debt nationwide is somewhere in the ballpark of $150 billion for the principal alone plus actuarial interest, which adds up to more than 20 percent of the sector's total payroll. Now I don't expect every public employer to begin overnight funding at the levels I would recommend, but even the can-kicking funding formulas allowed under current accounting standards will require at least half that level of incremental funding.
Budgeting and bargaining for fiscal 2013 and 2014. Meanwhile there isn't much room for salary increases, restoring frozen positions and re-hiring workers who were laid off in 2009. "Temporary attrition" will become permanent position-elimination in many cases. The state and local government workforce will be leaner in coming years -- and unlikely to return to 2008 levels for at least another three years if not longer. Financial officials, government managers and policy leaders will be well advised to set realistic expectations as the advocates of greater spending begin to see increased revenues that they presume to be available for restoration of their pet causes. Right now they are competing with deferred obligations that must first be funded properly. Those folks need advice to come back later to compete with the rainy-day fund when the economy has fully recovered. My suggestion to budgeters is that it makes perfect sense to earmark a 3 to 4 percent revenue contingency for exogenous risks -- to automatically revert to a rainy day fund if everything comes up roses next year.
