The current recession is having a strong impact on state and local government finances, causing budget shortfalls that will be far greater than we’ve seen in previous economic downturns. Donald Boyd, a senior fellow and former director of the State and Local Government Finance Research Group with the Nelson A. Rockefeller Institute of Government, has studied state and local fiscal issues for more than two decades. In the interview that follows, he shares the findings of his recent research on how this recession is affecting state and local government revenues, budgets, and fiscal conditions.
MuniNet: Starting at a very rudimentary level, what is at the root of the financial pressures on state and local budgets?
Boyd: Most of the effects of this recession on state and local government finances are stemming from markedly decreased revenues, leading to major budget shortfalls. The current recession has resulted in shortfalls that are likely to be far greater than in previous economic downturns. In the first quarter of 2009, state tax revenue fell by 11.7 percent compared to the first quarter a year ago – the worst decline in at least 50 years. Forty-four states experienced a decline in revenues.
MuniNet: Do recessions tend to have a more profound effect on state or local government budgets? Does one tend to precede the other?
Boyd: While both state and local government budgets have felt the impact of the economic downturn, states are hit harder and sooner than local governments. Typically, states have a more volatile revenue structure than local governments because of their dependence on income and sales taxes.
Local governments usually benefit from more steady revenue streams, which are derived largely from property taxes in the typical local government. Despite the decline in housing values, property taxes tend to be very stable, primarily because the taxes don’t adjust automatically, with a few exceptions in certain states. Another important exception is that many large cities and counties do rely on volatile revenue sources, and as a result, they are experiencing budget problems now that are much more like those of state governments.
Reduction in state aid to local governments can also pose a risk to local budgets, but it takes a while – often the span of a few years – for these cuts to trickle down the chain.
MuniNet: Is this recession different from other economic downturns in terms of its effects on state and local governments?
Boyd: Every recession is different. This recession is much deeper than any we have experienced since the Great Depression. For starters, the current economic downturn has caused a dramatic decline – greater than 10 percent – in real retail sales and consumer spending. This figure is particularly significant in comparison to the last recession, back in 2001, when we saw little to no decline in consumer spending.
Second, the housing bust has had a severe impact on state and local government economies in ways that extend beyond the effect on property taxes. With fewer people moving, we are seeing a drop in sales of furniture, building materials, etc. – thereby causing a substantial spillover effect into the broader economy and also with direct fiscal impacts in the form of declining sales tax revenues.
In addition, the collapse of the financial sector and pressure on the financial markets in this recession has been worse than in previous economic downturns. When combined with a decline in private sector employment, the drop in retail sales, and the real estate crisis, this recession is one that leaves nowhere to hide. That’s a marked contrast with the last recession, which really hit those states that rely heavily on income taxes but left sales-tax states much less damaged.
MuniNet: Which states have been hit hardest and why?
Boyd: As mention earlier, 44 states experienced a decline in tax revenue in the first quarter of 2009. And revenue collections worsened after that. The preliminary data we have for April and May – the months in which most states are tallying up revenue for income tax returns due on April 15 – is that state tax revenue from major taxes was down 20 percent year over year. It was a sea of red. The cumulative effect has been extraordinary in some states.
Some states, including Florida, South Carolina, Georgia, Arizona, Virginia, Nevada, Utah, and California, each posted cumulative declines of 10 percent or more declines in real per capita tax revenue over the last two years. Some states, like New York, were hit even harder in recent months. Employment figures dropped in all but one state – North Dakota.
MuniNet: What’s going on in North Dakota – so far, the only state to manage avoiding a decline in employment?
Boyd: North Dakota has functioned as somewhat of an “island” in this recession; its economy relies heavily on minerals, mining, oil – all sectors that have continued to perform relatively well despite the national economic downturn.
MuniNet: You say that some states – California, New York, Wisconsin, as a few examples – are pushing the problem into the future. Is it possible to reverse that trend? What will it take for these hardest-hit states, in particular, to recover?
Boyd: If history serves as a guide, these states will “muddle through,” though their recovery may take a few years or more. Their main strategies will likely involve a combination of tax increases, spending cuts, and temporary “creative” measures.
MuniNet: To what extent can we expect the American Recovery and Reinvestment Act to aid the recovery of state and local budget pressures?
Boyd: The federal stimulus package will help mitigate some cuts in state aid to local governments. Its impact will be significant, although temporary. It is already being felt: through late July, states had received more than $36 billion in aid, primarily in the form of budget relief related to Medicaid and education. Stimulus aid for capital infrastructure spending also will help, but takes more time to get up and running.
MuniNet: In your research, you draw a distinction between economic recovery and fiscal recovery; how do they differ?
Boyd: Fiscal recovery, meaning actual improvement in state and local government finances, tends to lag recovery in the broad economy as measured by gross domestic product (GDP) for a few reasons.
First, some elements of the economy that directly influence tax revenue tend to recover more slowly than GDP. In past recessions, employment and wages, and some forms of nonwage income, have been slower to recover than GDP, which measures production. So economists and the media can be proclaiming that a recovery is underway but it takes longer to affect tax revenue.
Second, institutional characteristics of tax and fiscal structures can introduce lags. For example, during a downturn, many corporations find they cannot use tax credits and prior losses completely during a bad year – in most cases, they cannot use these tax benefits to reduce tax liability below zero. So they accumulate unused credits and losses that they carry forward to future years. Then, when good times return and they are earning profits and generating tax liability, they get to use these “carried forward” losses and credits to reduce their tax payments to state governments.
Another example is property taxes: many states have limits on year-to-year increases in assessed values for individual property, especially for homeowners. During a housing boom, many homeowners benefit because their assessed values for property taxes don’t keep up with the increase in property value. But when the housing market dives, homeowners can be faced with the seemingly strange situation of assessed values that are still rising (to catch up with prior market value increases) even as their home values decline from their peak. This can help stabilize property taxes during the recession. The declines in market value may eventually catch up, though, leading to falling assessed values and property taxes while the economy is recovering.
There are institutional lags on the spending side, too. Pension contributions, in particular, rise after stock markets fall, but with a lag that can be substantial. There are several reasons for this, the most important of which relate to smoothing rules that make the “actuarial value” of pension fund assets less volatile than underlying market values.
MuniNet: How does the role of decision-makers influence fiscal recovery?
Boyd: The final, and perhaps most important reason, in my opinion, for the lag between economic and fiscal recovery are policy choices that governments make to close budget gaps. For political, legal, cultural, and institutional reasons, most governments have extremely short planning horizons. They have sharp drop-offs in revenue, spending demands that actually rise during recessions, requirements to balance their budgets year-by-year, and no reward for thinking about the longer term. This combination at some point leads all but the strongest-willed to conclude that any solution that closes the current budget gap – regardless of its outyear impact – is acceptable.
I don’t mean to minimize the very hard choices that elected officials make. They raise taxes on citizens just when their circumstances are hardest. They cut spending programs for the needy when they are most vulnerable. But they also approve their share of gimmicks – selling roads, buildings, and future revenue streams such as tobacco settlement payments or expected lottery funds; they raid reserve funds and borrow money that belongs to related parties; they delay payments and stretch out obligations; and they adopt temporary tax and spending measures.
These measures can have their place – and unfortunately, to some extent, must have their place – given the environment in which policymakers work. And they serve to stretch out fiscal problems so that instead of adopting draconian actions all at once to close budget gaps once and for all, states and localities solve them over several years. We know from the shape and depth of the current crisis, and the actions that states have taken so far, that this is going on now. States certainly will face further problems as this year progresses, and as they debate budgets anew this coming January and beyond.
Interview Highlights: Why is this recession hitting state and local government finances so hard?
- The current recession has resulted in state and local government budget shortfalls that are likely to be far greater than in previous economic downturns.
- Because states typically have a more volatile revenue stream than local governments, they are hit harder and sooner by downturns in the economy.
- This recession is deeper than any we’ve seen since the Great Depression because of the dramatic decline in retail sales and consumer spending, combined with the housing bust and the collapse of the financial sector.
- Tax revenue declined in 44 states during the first quarter of 2009. North Dakota was the only state that did not experience a decline in employment.
- The impact of the American Recovery and Reinvestment Act will be significant, albeit temporary.
- Fiscal recovery tends to lag economic recovery.
About the Expert
Donald J. Boyd is a senior fellow and the former director of State and Local Government Finance research group at the Nelson A. Rockefeller Institute of Government. Boyd has over two decades of experience analyzing state and local fiscal issues, and has written or co-authored many of the program’s reports on the fiscal climate in the 50 states.
His previous positions include director of the economic and revenue staff for the New York State Division of the Budget and director of the tax staff for the New York State Assembly Ways and Means Committee.
Boyd holds a Ph.D. in managerial economics from Rensselaer Polytechnic Institute in Troy, New York.