To say it has been a rough few years for state and local governments would be an understatement. Although the economy has been modestly expanding since 2009, the public sector in aggregate has continued to run deficits for almost five years. This has never happened in the time since officials began collecting reliable data following World War II. The deficit today is still roughly 6 percent of revenues--the same as it was in 2009, according to the U.S. Bureau of Economic Analysis. The result has been the ongoing contraction in the provision of basic public services.

Indeed, the slower-than-normal growth experienced in the U.S. economy over the last two years can be chalked up almost exclusively to budget issues at the state and local government level. Since 2010, the private sector has been growing at an annual rate of 3.2 percent compared to 3.4 percent between 1995 and 2007. The public sector, on the other hand, has been contracting by roughly 2 percent a year in real terms--and this is the drag that is pushing down overall U.S. growth to the 2 percent range.

Deep and Wide

Why the ongoing difficulties? There are a number of causes. One is the depth of the downturn that hit the U.S. economy. But more significantly is the weak recovery. The common strategy used by state and local governments when dealing with cyclical budget gaps is often the 'kick the can down the road' option--using stopgap measures and temporary cuts. And this isn't a bad method if revenues come back strongly during the recovery period, as they typically have. Employing temporary and stopgap measures avoids intensifying the strength of a downturn by not adding public spending cuts to an already weak private sector.

This time, however, the recovery in state and local revenues has paralleled the overall weak recovery of the economy--implying this same strategy has done little more than push the deficit down the road. Added to this has been a general reluctance to raise taxes (given the potential impact on the weak recovery), and a decline in federal support as the stimulus programs have faded away. Moreover, several states have seen many of their expenditures put on autopilot through voter referendums and public union contracts, limiting lawmakers' choices greatly.

Where's the Light?

So is there any light on the horizon? Yes and no. On one hand there are a number of solid signs pointing to recovery in real estate markets. Sales are on the rise, inventories are shrinking and prices are finally starting to increase. The latest Case Shiller index figures show prices up on a year-on-year basis in all of the 20 major markets they track, as well as on a national basis. Housing permits are also rising. This will help bump property tax revenues starting this year.

Other revenues are also bouncing back. Tourism has returned. Visitors are filling hotels and bringing transient occupancy tax revenue increases with them. And because real personal incomes have increased in absolute terms over the course of the last year, and there have been rebounds in the equity markets, the 43 states that levy an income tax (all except Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) will see a solid bump in revenue next year.

This will be, however, at least partly offset by weaker results elsewhere on the balance sheet. Even though corporate profits are up from a year ago, they have been flat in recent months. This implies that the healthy gains states with corporate taxes have enjoyed may have come to an end.

The Federal Factor

An even more important concern is what path the federal government will take to close the deficit at the national level of the economy.

Negotiations between the newly reelected Democratic president and the Republican controlled House are sure to be tense, and may even take us past the January 1 deadline. However, Beacon Economics doesn't see the so called "fiscal cliff' (the large federal tax increases and spending cuts set to occur on January 1) as a concern by itself. …