State and Local Fiscal Conditions and Economic Shocks

State and Local Fiscal Conditions and Economic Shocks

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INSIGHTi
State and Local Fiscal Conditions and
Economic Shocks
Updated June 10, 2020
Policymakers’ attention to the current economic recession has included its potential effect on state and
local governments. This Insight summarizes the underlying forces affecting state and local finances
following a negative economic shock, examines tools available to them in response to such forces, and
briefly discusses federal assistance offered in recent recessions.
State and Local Finances and Economic Shocks
State and local governments are an integral part of U.S. economic activity, with $3.7 tril ion in 2017
spending (19% of GDP). Federal, state, and local government revenues tend to increase when the
economy is growing (as taxes are paid on increased economic output) and decrease when the economy is
not growing. Unlike at the federal level, state and local governments must routinely balance their
operating budgets, typical y every one or two years. Al else equal, state and local governments therefore
must offset reductions in revenues caused by negative economic shocks with increases in revenues,
reductions in spending, or a combination of the two.
Balanced budget requirements can limit state and local ability to meet increased spending program
demands during economic downturns. In contrast, the federal government has typical y enacted larger
spending increases in response to economic shocks. Table 1 shows federal, state, and local spending
levels in the years leading up to and during the Great Recession. Measured as a share of economic output,
federal outlays were 21% larger during the period FY2009 through FY2011 than during the FY2006-
FY2008 period. State and local operating expenditures rose by 8% over the same timeframe.
Table 1. Government Spending Before and During the Great Recession, FY2006-FY2011
(as a percentage of GDP)

FY2006-FY2008
FY2009-FY2011
State and Local Operating Expenditures
13.9
15.0
Federal Expenditures
19.6
23.7
Source: U.S. Census Bureau and Office of Management and Budget.
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The timing of economic effects can prove to be an additional chal enge for state and local financing.
About 70% of state and local government spending is devoted to education, general welfare, health, and
infrastructure programs, for which demand tends to increase shortly after a negative economic shock
occurs. A substantial portion of state and local revenues, meanwhile, are collected from taxes on income
and property, which can see more lagged effects from an economic downturn. For state and local
policymakers, this means that any early action taken to address spending needs may need to be
supplemented later on if there is a lagged reduction in revenues, al while working within budgetary
restrictions.
Responding to Economic Shocks
There are a few sources of assistance available to state and local governments to address budget shortfal s
that do not require outside intervention. Rainy day funds are budget accounts that are designed to assist in
closing funding gaps when revenues are insufficient to meet spending demands. Al 50 state governments
have at least one rainy day fund, and recent estimates projected there to be roughly $62 bil ion (or 2.5% to
3.0% of annual state government spending) in those funds at the end of 2019. However, use of rainy day
funds alone would likely be insufficient to bridge state financing gaps from a moderate or severe
recession. Moreover, there is scant evidence of rainy day fund use at the local level.
State and local governments may also consider increasing the relative amount of resources they devote to
their capital budgets, which are not typical y subject to the balancing restrictions of operating accounts.
Capital budgets are general y restricted to funding projects related to infrastructure and land maintenance
and construction, and research has found limited practical ability to move projects from operating to
capital accounts. Capital projects typical y involve substantial levels of government borrowing, for which
costs may increase in recessions due to an increase in the perceived credit risk of state and local
government bonds.
The potential for automatic increased federal support of state and local governments undergoing poor
economic circumstances is limited. Federal government transfers are the single largest source of state and
local government revenue, and the federal contribution for some of those programs is determined by
formula under current law. For many of the largest transfer programs, however, federal contributions
either have increased only in cases of unique economic harm to the state or locality (as has been the case
in the past with Medicaid) or are insensitive to economic conditions (as is true for TANF).
Additional Federal Support
The federal government may intervene to provide fiscal support to state and local governments in times of
economic hardship. Assistance may be offered in the form of increased support for established programs
or through the creation of new programs. The American Recovery and Reinvestment Act of 2009 (P.L.
111-5), passed during the Great Recession, provided $192 bil ion in direct state and local government
transfers, including $54 bil ion for a state fiscal stabilization fund. The Jobs and Growth Tax Relief
Reconciliation Act of 2003 (P.L. 108-27), enacted following the recession in the early 2000s, provided a
total of $20 bil ion to state and local governments, including $10 bil ion in direct assistance payments.
The economic assistance in recently enacted legislation included federal assistance for state and local
governments. The CARES Act (P.L. 116-136) al ocated $150 bil ion in direct payments to state and local
governments through the Coronavirus Relief Fund. The CARES Act also provided the Federal Reserve
with the capacity to support outstanding state and local debt issuances through the Municipal Liquidity
Facility: Treasury has invested an initial $35 bil ion in the facility, with amounts used to support short-
term debt from states and large localities that meet minimum credit standards. Other state and local
assistance, including increased support for Medicaid and domestic food assistance programs, was

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provided for elsewhere in the CARES Act, as wel as in the Families First Coronavirus Response Act
(P.L. 116-127) and the Paycheck Protection Program and Healthcare Enhancement Act (P.L. 116-139).

Author Information

Grant A. Driessen

Analyst in Public Finance

Disclaimer
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to congressional committees and Members of Congress. It operates solely at the behest of and under the direction of
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