Muni Green Shoots

During the 1st quarter of 2014, state and local government fiscal conditions have improved in line with what would be expected during a “new-normal,” low-growth period. The aggregate demand-dampening effects of the recession and its flow-through to state and local government budgets has manifested itself in a continued subdued growth in tax receipts and greater demand for nondiscretionary entitlement spending. The challenge in 2014 and beyond will be recovery from the effects of the recession and a continued commitment to cost containment.

From 2008-present, higher outlays for Medicaid and unemployment compensation, coupled with a 17% decline in tax revenues from the contraction in the national economy, forced across-the-board reductions in budget areas such as appropriations for K-12 education, higher education, transportation, and corrections. Without help from the federal government under the American Reinvestment and Recovery Act (ARRA), state budget cuts and tax increases would have been much more substantial[1]. Among the fifty states, the accumulated budgetary shortfall from 2009-2011 was $431 billion. States received approximately $140 billion in stimulus funds from 2009-2011, most of it distributed in 2010 when the total state budgetary shortfall was $191 billion, allowing states to temporarily maintain most of their funding levels[2]. When stimulus funding expired, in the face of weak sales and income tax collections, governors were forced to raise income and sales taxes and cut expenditures.

In 2013 and continuing into the first quarter of 2014, we saw a reversal of these trends. Given the severity of the conditions, the ability of states to bounce back in such short order is a testament to their flexibility. In recent quarters, enacted budget cuts and budget gaps have substantially declined while revenues have continued to outperform projections[3].The National Association of State Budget Officers’ “Fiscal Survey of States,” fall 2013, shows that enacted fiscal 2014 budgets reflect an aggregate increase in expenditures of 3.8% over 2013, a strong indicator of states’ new focus on stimulus and investments instead of austerity. Anecdotal evidence such as New York Governor Andrew Cuomo’s $300 million budget surplus in his proposed 2014 budget, which includes outlays for new programs such as universal pre-K without use of tax increases, suggests somewhat of a return to normalcy and a positive contribution from the state government sector to the overall economy[4].

The improving fiscal outlook for states has positive implications for other areas of the municipal market as well. We expect local government finances to improve in conjunction with the outlook for states, since the costs of several major expenditures such as K-12 education funding are borne by both state and local governments. The challenge in 2014 will be gaining access to funding from lesser-used revenue sources such as user fees and sales and income taxes, in the face of a continuing decline (albeit, at a decelerating rate) of property taxes. Since costs on the local level are much “stickier” than on the state level, because they cover provision of services and associated personnel costs rather than fiscal transfers to other entities, the cuts will be more difficult to enact and will involve workforce cuts and contract renegotiations.

Lastly, the subject of entitlement spending by state and local governments is a concern. Medicaid enrollment has tripled in the past three decades, from 20 million in 1980 to 53 million in 2011, accounting for, on average, 24% of state expenditures, making it the single largest expenditure item in state budgets. The expansion in eligibility for Medicaid under Obamacare and the declining Federal government funding structure associated with these increases points to an increasingly larger burden of these costs having to be funded by states. This will likely crowd out other major budgetary priorities such as education and create additional funding pressures.

We will watch closely to see how states respond to these challenges. Tax revenues are likely to continue their upward climb at a subdued pace, as would be expected in a 2.5% real-growth environment. The recession created a void that put pressures on the rest of the market by taking away funding for important priorities while increasing demand for entitlements. We expect state and local governments to take the needed steps to address these patterns, as they have done in the past, through some combination of revenue diversification and cuts to expenditures. We will keep readers apprised of future developments.

•1,2,3 “Fiscal Survey of States Fall 2013” National Association of State Budget Officers
•4 New York Seeks Upgrade after On-Time Budget; featured in Bloomberg Brief 3.31.14; Klopott, Freeman; Chappatta, Brian

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