Academic journal article Economic Perspectives

The State of the State and Local Government Sector: Fiscal Issues in the Seventh District

Academic journal article Economic Perspectives

The State of the State and Local Government Sector: Fiscal Issues in the Seventh District

Article excerpt

Introduction and summary

The National Governors' Association has projected that state budgets will face an $80 billion deficit in fiscal year (FY) 2004. This would represent almost 18 percent of total state spending. This comes on the heels of a nearly $30 billion spending gap in FY2003. This degree of budget insolvency in the state sector is unique for two reasons. First, it follows a relatively mild national recession that, by historical standards, would not have been expected to send the states into such budget turmoil. Second, it has affected virtually every state, regardless of the type of revenue system they use to support state government functions. The persistent nature of these budget shortfalls has exhausted the usual budget adjustments that states make to pull themselves through tough times. Fund transfers, drawing down reserves, and one-shot revenue infusions were all used to balance state budgets in FY2002 in the hopes that stronger economic growth would restore fiscal health going forward.

In addition, states have been operating in a distinctly "anti-tax" environment, in which proposals to increase taxes to balance budgets have been met with public and political opposition. Given this bleak situation, it is an appropriate time to examine the prospects for a return to fiscal good health in the state and local government sector, as well as the background to the current instability. Some analysts have suggested that beginning in the late 1990s, states began running structural rather than cyclical deficits. (1) In a structural deficit, available revenues are simply inadequate to maintain existing government services. Many of these same analysts also suggest that states' and localities' existing revenue systems no longer support government commitments. Gradual exemptions and distortions in major tax bases have increased the volatility of tax sources, while reducing the tax base. If this is the case, managing state government through a boom and bust cycle will require new models for state budgeting. Policymakers need to restructure budget models to reflect the service commitments of state government and the productivity of the revenue structure.

In this article, I review the state and local budget situation. In particular, I look at conditions in the states that comprise the Seventh Federal Reserve District (Illinois, Indiana, Iowa, Michigan, and Wisconsin). These states have pursued different fiscal policies over the last decade and have relied on different tax structures to pay for government, yet all are facing significant budget shortfalls.

This article suggests that budget problems during the most recent period are indeed different from past experience. Structural factors seem to be playing a larger role in fiscal stress. As illustrated by the behavior of the five Seventh District states, the roots of fiscal stress vary based on policy actions taken over the course of the last decade. Putting state budgets on a sound footing will require different strategies, depending on each state's choice of tax structure and expenditure commitments.

Long-run trends in state and local budgets

In this section, I examine broad trends in state and local revenues and expenditures over a number of economic cycles from 1960 to 2002. (2) This period includes recessions in 1975, 1980-81 and 1981-82, 1990-91, and 2001. The most current data for the combined state and local sector is provided by the U.S. Bureau of Economic Analysis in its National Income and Product Accounts (NIPA). However, the NIPA data aggregates the sector into broad categories and cannot be used to understand spending and revenue trends in specific state and local activities and programs, such as education and welfare. In order to perform this analysis, I use the U.S. Bureau of the Census' Government Finance Series; however, this series is produced with a two- to three-year lag, making it difficult to analyze the most recent trends. …

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