Information about Western Hemisphere Hemisferio Occidental

VII Will the State and Local Budget Crisis Hinder Economic Growth?

Martin Mühleisen, and Christopher Towe
Published Date:
January 2004
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Ivaschenko Iryna

Following a decade of strong revenue growth and significant surpluses, state and local governments (SLGs) are now facing significant budget shortfalls for a third consecutive year. At a time when the federal government has embarked on expansionary fiscal policies to support economic activity, these shortfalls have raised concerns that corrective budgetary measures taken by SLGs could counteract federal government stimulus and dampen economic activity. This chapter reviews the principal causes of the state and local fiscal crisis and attempts to quantify its macroeconomic implications.

State and Local Government Finances

The SLG sector represents an important and growing part of the overall economy. Current expenditures—that is, total spending excluding outlays on capital investments—by SLGs have grown strongly in recent decades, accounting for nearly all of the 7 percent of GDP increase in general government spending since 1960 (Table 7.1).1 Moreover, SLG investment has remained essentially constant in relation to GDP over time, which, given the decline in federal investment, has also made SLGs the principal source of public investment. Growing SLG expenditures have been financed by tax and other revenue increases, amounting to 4½ percent of GDP since 1960, as well as an increase in federal grants of 2 percent of GDP. Indeed, federal grants have become significantly more important for SLGs, accounting for almost one-fourth of total revenues in 2002 (Table 7.2).

Table 7.1.Government Revenues, Spending, and Investment(In percent of GDP)
Current receipts
General government124.927.427.727.5
Federal government17.618.718.217.9
State and local governments8.011.311.412.5
Federal grants-in-aid to state and local governments0.
Current expenditures
General government122.729.030.629.9
Federal government16.320.621.219.9
Federal grants-in-aid to state and local governments0.
State and local governments7.211.011.413.0
Gross investment
General government5.
Federal government2.
State and local governments2.
Source: National Income and Product Accounts.

Excluding intergovernmental transfers.

Source: National Income and Product Accounts.

Excluding intergovernmental transfers.

Table 7.2.State and Local Governments: Composition of Receipts(in percent of total receipts)
Personal income tax receipts6.013.416.215.4
Corporate profits tax accruals3.
Sales taxes28.726.227.625.6
Property taxes38.421.724.320.5
Contributions for social insurance1.
Federal grants-in-aid9.522.816.823.4
Source: National Income and Product Accounts.
Source: National Income and Product Accounts.

The strong increase in SLG spending and federal grant receipts reflects, in part, a response to growing expenditure mandates imposed by the federal government. In the United States, SLGs are the primary provider of government services such as education, public infrastructure, and public health and safety. However, a substantial proportion of SLG spending in these areas is funded by grants, loans, and tax subsidies from the federal government, which are used to buttress federal mandates that specify the level of services to be provided by the states, including for welfare, Medicaid, and education programs.2 For example, states participating in Medicaid must adhere to the requirements of the Medicaid Act, which specifies and defines categories of medical services for which federal reimbursement is allowed, and requires that states cover mandatory categories (O’Connell, Watson, and Butler, 2003). Over half of federal transfers have been directed toward such programs, which has contributed to a growing proportion of state expenditure also being channeled in these areas.

On the tax side, however, there is little coordination of federal and state policies, with the result that states differ greatly in how revenues are raised. The Constitution grants federal and state governments independent taxing powers, and local governments derive their taxing powers from state governments. As a result, each level of government imposes and administers its taxes independently, and there are no tax-sharing arrangements between the federal and state governments (Stotsky and Sunley, 1997).3 However, states typically piggyback on the federal income tax code by using federal definitions of personal and corporate taxable income before applying state-specific adjustments. For corporate taxes, most states also use the depreciation schedule applied by the federal government. Nonetheless, the degree of conformity between federal and state tax systems differs significantly across states.

Recent Developments in State and Local Government Finances

The economic slowdown in recent years has contributed to a significant deterioration in the fiscal position of state and local governments. At the end of the 1990s, SLGs were running current surpluses—that is, excluding spending on capital investments—of up to around ½ percent of GDP, largely reflecting the benefits of solid economic growth (Figure 7.1). As the economy slowed, however, state and local governments fell back into deficit in late 2000, with current deficits reaching a post-World War II peak of ½ percent of GDP in 2002. The budgetary situation among the states remains difficult—with almost 90 percent of states projecting revenue shortfalls that will exceed 5 percent of their general funds, their deficit could reach ½ percent of GDP in FY2004.4

Figure 7.1.State and Local Governments: Current Balances

(In percent of GDP)

Source: National Income and Product Accounts.

The erosion in the fiscal position of the states appears largely to have reflected sharp increases in spending (Figure 7.2a). Most notably, outlays on health-related programs increased by ½ percent of GDP from the late 1990s, largely driven by the Medicaid program (Figure 7.2b, Table 7.3). The demands on the Medicaid system—which provides services to the poor—increased partly as a result of the recession, but many states had become more generous during the 1990s, and broader pressures on U.S. health care costs also played a major role (NASBO and NGA, 2003). The economic downturn and the associated increase in unemployment also boosted SLG spending on income-support and welfare programs after 1999.

Figure 7.2.Revenues and Expenditures of State and Local Governments

Source: Haver Analytics.

Table 7.3.State and Local Governments: Composition of Spending and Investment, 2002(In percent)
General public service9.69.3
Public order and safety14.14.6
Economic affairs8.337.7
Housing and community services0.68.9
Income security8.60.7
Source: National Income and Product Accounts.
Source: National Income and Product Accounts.

At the same time, a sharp drop in income tax collections hurt states on the revenue side. Corporate and personal income tax revenues represent roughly one-fifth of total state receipts, and both these revenue sources declined by roughly ¼ percent of GDP during 2001 and 2002 (see Table 7.2). Other revenue sources, including sales and property taxes, remained relatively robust, reflecting the strength of consumer demand and the housing market.

Several factors have contributed to the sharp decline in income tax revenues:

  • The economic slowdown dampened labor incomes, and the collapse of the stock market severely eroded capital gains, especially in California and on the East Coast, where a considerable amount of personal wealth is concentrated (Figure 7.2c).
  • States had responded to the revenue boom of the late 1990s by cutting tax rates, including on property, which left them more dependent on cyclically sensitive revenue sources such as income tax (Figure 7.2d).5
  • Tax cuts at the federal level have also had a (relatively modest) effect on SLG revenues—the 2001 and 2003 tax cuts are estimated to lower state tax revenues by about $5 billion.6

Balanced Budget Rules and Fiscal Adjustment

All states but one are required—either by state constitution or state law—to maintain a balanced budget.7 However, there are several reasons why these requirements have not typically imposed a hard fiscal constraint in the past. Balanced budget laws typically apply only to current budgets, and states are permitted to borrow to fund capital spending. Moreover, there is often some scope to circumvent balanced budget constraints on a temporary basis. For example, many states are only required to balance their budgets on an ex ante basis, and most states have scope to delay payments and shift spending into future years by building arrears (NASBO, 2002). In addition, until recently, states have been able to draw on significant reserve funds accumulated during the surplus years of the 1990s.

The depletion of reserve funds means, however, that more difficult adjustments lie ahead. By the end of FY2000, state reserve funds had risen to around 10 percent of state expenditures from less than 5 percent at the end of the 1980s. However, in recent years, some 16 states have had to cover their deficits by drawing down these reserves, leaving overall reserve balances virtually exhausted by end FY2003. This sharp turnaround has led some commentators to argue for easing legislative limits on the size of rainy day funds; some studies estimate that states would need reserves of more than 18 percent of expenditures to accommodate a macroeconomic shock of the magnitude of the 1990–91 recession (Lav and Berube, 1999).

States have already made substantial adjustments to control budget deficits in FY2002 and FY2003. On the spending side, measures have included hiring freezes, cuts in spending for prisons, education, child care, and support for local governments (NASBO and NGA, 2003). Medicaid spending has been largely excluded from cuts because of cost-sharing arrangements with the federal government, but states tightened eligibility requirements for optional participants and adopted cost-saving measures.8 There has been considerable political resistance to tax hikes, but states have made increased use of tobacco settlement funds, which amounted to $32 billion between 1998 and 2002 (Lindblom, 2003), to cover revenue shortfalls.

Nevertheless, states have been forced to increase their borrowing, possibly reflecting a reclassification of operating expenses as capital expenditures.9 Out-standing market debt owed by state and local governments increased from 12 percent of GDP in 2000 to 14 percent in mid-2003, but still well below the 18 percent peak during the 1990–1991 recession (Figure 7.3). State credit ratings and risk premiums have not been significantly affected so far, except for several states that are facing more severe financial difficulties (Figure 7.4).10

Figure 7.3.State and Local Governments: Credit Market Debt

(In percent of GDP)

Source: Haver Analytics.

Figure 7.4.State and Local Governments: Budget Balances and Spreads on SLG Debt

Sources: National Income and Product Accounts; Primark Datastream.

Budget difficulties are expected to worsen in FY2004. Surveys by the National Governors Association suggest that more cuts in program expenditures, including education, health services, and aid to local governments, are likely to take place. As a result, state spending is expected to fall by around ¼ percent in real terms in FY2004. In addition, governors in 29 states have recommended tax and fee increases for FY2004 with an expected yield of $17.5 billion (or 0.2 percent of GDP)—the largest since 1979.

How Much of a Drag on Growth?

The prospect of significant budgetary adjustments by SLGs raises questions about the possible effects on the broader macroeconomy and the recovery. The policy response by SLGs is likely to be procyclical and work against the substantial stimulus that has been injected by the fiscal and monetary authorities at the federal level.

Such concerns are partly alleviated by the fact that the size of budget shortfalls is relatively modest. For example, the analysis of changes in structural balances of the general and federal governments indicates that the adjustment by SLGs necessary to satisfy their balanced budget requirements would result in a fiscal contraction of about ¼ percent of GDP in 2003, offsetting only a small part of the fiscal stimulus injected at the federal level (Table 7.4).

Table 7.4.Fiscal Impulse by Level of Government(Calendar year data; in percent of GDP)
Change in Actual Balances (NIPA basis)
General government0.7–1.9–3.0–1.8
Federal government0.5–1.6–2.7–1.9
Change in Structural Balances
General government0.5–1.1–2.7–1.5
Federal government (budget basis)0.5–1.2–2.4–1.7
Sources: Budget of the U.S. Government, various issues; and IMF staff estimates.
Sources: Budget of the U.S. Government, various issues; and IMF staff estimates.

Significant uncertainty surrounds estimates of the impact of fiscal policy on output. Most estimates for the United States place fiscal multipliers in the range of 0.3–1.4 for spending increases and 0.2–1.3 for tax cuts (Hemming, Kell, and Mahfouz, 2002).11 The low end of these ranges are consistent with the view that the demand-side effects of expansionary fiscal policy are offset by Ricardian effects—that is, private saving rises in response to fiscal expansions as households prepare for higher future taxes. Indeed, some studies have suggested that fiscal multipliers can turn negative if fiscal policy increases uncertainty or is expected to crowd out private investment (Caballero and Pyndick, 1996; Krugman and Obstfeld, 1997).

The uncertainty that surrounds these multipliers is illustrated by the results of a simple vector-autoregression (VAR) model. The VAR approach allows for feedback among macroeconomic and fiscal variables, and has been used in a number of studies to assess the effects of monetary and fiscal policies on output (e.g., Blanchard and Perotti, 2002). The model employed in this study uses quarterly data on the output gap and both federal and SLG fiscal variables, so as to take into account feedbacks between policies at both levels of government. The specific fiscal variables were tax revenues net of transfers to persons; public consumption expenditure; and federal grants to SLGs. Fiscal variables were expressed as a ratio to GDP and detrended, using an HP filter to exclude long-term trends in the fiscal variables. Revenues and expenditures were also adjusted to exclude intergovernmental transfers. Four lags were employed in the VAR estimation, as suggested by several information criteria tests.

The results indicate that SLG spending and tax policies could have a significant temporary impact on real GDP. A one standard deviation shock to the share of SLG consumption spending in GDP would reduce the output gap—hence increase GDP—by 0.4 percentage points immediately, with the effect slowly decreasing to almost zero by the fifth quarter.12 At the same time, a similar one standard deviation shock to SLG net taxes would have a negligible effect on GDP in the first quarter, with the impact slowly building and reaching almost 0.4 percentage points in the fifth quarter. The effect of the tax shock dissipates completely after six quarters (Figure 7.5).13

Figure 7.5.Dynamic Responses of the Output Gap to Fiscal Variables

(Dotted lines indicate two standard deviation range)

Source: IMF staff estimates.

The results also indicate that fiscal policies of SLG have stronger impact on real GDP than the federal government. For example, a 1 percentage point increase in net federal taxes as a share of GDP would have no significant impact on the output gap, while a similar increase in federal spending would reduce the output gap by about 0.2 percentage points in the first quarter. However, the latter effect would entirely dissipate after three quarters.


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    Lindblom, E.,2003, “Actual Payments Received by the States from the Tobacco Settlements,” Fact Sheet (Washington: National Center for Tobacco-Free Kids)January15.

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State and local governments are typically aggregated because the breakdown of data between these two levels of government varies across states (see Stotsky and Sunley, 1997, and references therein). Local government expenditures were of roughly the same magnitude as those of state governments during 1960–90.


Federal grants for Medicaid are currently administered on a cost-sharing basis, with the federal share varying across states—from 50 to 80 percent—depending on the state’s per capita income. Welfare programs are financed on a block-grant basis.


Historically, state estate taxes have been set equal to or above the federal estate tax credit—a credit that taxpayers receive against their federal estate tax liability for state estate and inheritance tax payments. However, the federal estate tax is scheduled for repeal beginning in 2005 under the administration’s 2001 tax package. State and local income taxes and property taxes are deductible from federally taxable income.


In most states, the fiscal year runs from July 1 to June 30. The budgetary forecast for FY2004 is based on data provided to the National Conference of State Legislatures; and from NGA and NASBO (2003).


Johnson (2002) estimates ongoing revenue losses from tax cuts at around $40 billion. See also Rivlin (2003).


Specifically, the following measures in the Economic Growth and Tax Relief Reconciliation Act of 2001 affected states’ taxable income base: the increased standard deduction, new rules for individual retirement accounts, and additional deductions for education expenses. In addition, the recently enacted Jobs and Growth Tax Relief Reconciliation Act of 2003 is likely to further reduce state tax revenues. The “bonus depreciation” tax break for corporations, additional deductions for small and midsize businesses, and increases in deduction for married couples are estimated to cost states $3 billion in lost revenues, absent any measures by states to undo the effect (Johnson, 2003; McLaughlin, 2002).


Vermont does not have balanced budget restrictions of any form.


These included tightening eligibility requirements and creating preferred drug lists. Currently 19 states have authorized the use of such lists, compared with three states two years ago, according to the National Conference of State Legislatures. Drug expenses are one of the largest Medicaid spending items (New York Times, 2003).


State and local governments can borrow to ease short-term revenue shortfalls. Stotsky and Sunley (1997)also note that some state governments used short-term borrowing to conceal deficits in their operating budgets.


Premiums have widened for California, New York State, and New York City (Financial Times, 2003).


Most of these results were obtained for the general government.


Generalized impulses—a modification of the Cholesky factorization that does not depend on the VAR ordering—are used in the estimation. See Pesaran and Shin (1998) for details.


The estimation results should be interpreted with caution since most components of SLG budget data available in the National Income and Product Accounts (NIPA) are available only with a two-year lag and the most recent data are estimated. In addition, most quarterly data are being interpolated from the annual data.

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