State, Local Finances on the Mend

A revival in tax revenues may alleviate some of the drag local governments are placing on the overall economy.

U.S. state and local government finances remain precarious. The degree of trouble varies from place to place, of course, but generally it will take decades for states and cities to put their finances in anything like good order. It is, in fact, a good bet that no middle-aged person today will live to see such an event. One wag has suggested the yet unborn will not live to see such a day. But if such cynicism rings of truth, the immediate outlook nonetheless points to some modest relief, at least enough to ease some of the strains under which state and local governments have labored and improve investment performance in the area as well as the overall economic picture.

The fundamental problems are well known. Profligate spending and unreasonable pension promises have placed states and cities in a financial predicament. Three years into this supposed recovery, many still struggle to balance their budgets, which, as of last measure, show a composite deficit of $130 billion. On top of this, states and cities face huge unfunded pension and healthcare liabilities. Officially, the funding shortfall amounts to some $757 billion, but this estimate assumes much higher investment returns than are generally considered likely. The huge California Public Employees’ Retirement System (Calpers), for example, currently assumes a constant 7.5% annual investment return on its assets. Last year, the system had a 1% return.

Though the growth in tax revenues has been occurring for a while, it is only now providing states and cities a measure of relief. Their problem for the last 18 months has been a decline in federal transfers. The federal government channeled huge flows toward states and cities in its 2009 stimulus package, but since 2011 it has begun to unwind that posture. Federal flows have dropped almost 15% over this time, denying state and local governments some $200 billion in revenue. Against this, tax receipt gains of $62.9 billion have offered only a minor counterbalance. Net cash flows have fallen by almost $140 billion.

But this unfortunate situation seems to have run its course. Federal transfer dollars have just about returned to the levels that prevailed prior to the stimulus surge, suggesting that they will now likely stabilize. Meanwhile, the accelerating pattern of tax receipts promises to continue to add still more to state and city cash flows. If state and city managers are wise, they will resist the temptation to spend all the new net flows and will instead set some aside to fund pension and healthcare liabilities and reserve against future setbacks. Even if they do act with prudence, however, the increasing net revenue flow will free governments from the intense need to cut back that has clearly prevailed for the last 18-plus months.

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