The State of State (and Local) Finances

State and local government finances appear to have stabilized. No one could describe them as sound, neither in aggregate nor certainly in particulars. The sector as a whole continues to run deficits, and there are many pressure points on the expenditures side of those budgets. But state and local governments as a whole have kept spending growth in line with revenues growth and so have contained the flow of red ink. This is good news, even with all the caveats. There are, however, longer-term concerns.

A Look at Where We Have Been

These finances, coding to the U.S. Department of Commerce, certainly have faced a tough pull coming back from the Great Recession. Quite apart from the pension issues that have garnered so much media attention, those economic hard times hit state and local budgets from both sides. Revenues fell between 2007 and 2009, as the economic downturn dragged down personal income tax receipts by 7.2 percent, sales tax receipts by 7.7 percent, and corporate tax receipts by 24.4 percent.

Against this difficult shortfall in receipts, the recession also produced outsized demands for spending on social services. State and local outlays in this area jumped 13.8 percent between the fourth quarter of 2007 and the third quarter of 2009, expanding overall state and local expenditures 10.4 percent during that time. It is hardly surprising, then, that state and local budget deficits rose from an annual rate of $205.2 billion in the fourth quarter of 2007 to $377 billion by the middle of 2009, an 83.9 percent increase that brought deficits up from 9.4 percent of total expenditures to 16 percent.

The sluggish nature of this recovery generally has capped the growth of state and local receipts since. Between mid-2009 and the end of 2012, they grew at a mere 2.8 percent a year. Like incomes throughout the economy, this pace of expansion barely exceeded inflation. The recovery did, however, slow additional demands for social benefits enough to enable state and local governments as a whole to regain control of their outlays. These grew only 2.7 percent a year, enabling governors, mayors, and local managers to hold the annual growth pace of overall spending to a mere 0.8 percent a year and so hold back the tide of red ink. By 2012, state and local deficits as a whole equaled $269.1 billion, about 10.0 percent of overall expenditures.

Since, these governments have eased off a bit on their austerity efforts. Their receipts have continued to grow at the slow 2.8 percent annual pace. But outlays for social benefits have picked up again, expanding at a 5.9 percent annual rate. Because they have outpaced revenues, these governments have had to continue squeezing the rest of their budgets to hold the growth in total outlays to 2.5 percent a year. That figure is faster than earlier in the recovery but still close enough to revenues growth to have held back the annual flow of red ink, which, as of the first half of 2014, stood at $259.7 billion a year, a touch over 10.0 percent of total expenditures.

Looking Forward

For the time being, these trends can continue. A slow-growing economy should promote some growth in state and local revenues but not much faster than the rate of inflation. Given political pressure to sustain some budget control and concern about how investors would react to widening deficits, governments should also continue to manage the pace of outlays growth at about the rate of revenues growth, keeping the extent of red ink to about 10-10.5 percent of total expenditures.

Such trends are, however, unsustainable over the longer term. Except in the unlikely event that the economy quickly gets a whole lot better, the pace of growth in spending on social benefits will continue to outstrip revenues growth, as it has so far in this sluggish recovery. Indeed, the further implementation of the Affordable Care Act threatens to accelerate that pace of growth. The longer this goes on, the harder time state and local governments will have squeezing other parts of their budgets to keep the overall pace of outlays growth in line with revenues. Unless, then, there is some action to address this pressure, state and local finances over the longer term will again come under renewed, severe pressure.

There is another risk for the longer-term outlook, and that is a rise in interest rates. The budget burden of financing has fallen as a part of total outlays from 8.3 percent at the end of 2009 to 7.8 percent recently. Part of the decline reflects the success in holding back the flow of red ink. Part of it reflects the remarkably low level of interest rates during this time. Over the long-term, however, interest rates are very likely to rise. As that happens, state and local governments will have to pay more for financing, burdening their budgets further. Unless they can indefinitely squeeze those other parts of their budgets that they have already shortchanged, a doubtful possibility, their deficits will tend to rise.

These pressures seem unavoidable. An economic acceleration could, of course, relive the strain by accelerating the growth of state and local receipts, but that looks unlikely right now. The budget pressure on this more distant horizon doubtless will create a concomitant political pressure for further reform in state and local financing. Should that reform prove effective, it could improve finances over the longer-term. A failure to reform over this longer time horizon or ineffective reforms would make matters much less secure.

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