Out of the Hole and Over the Cliff? State and Local Budgets in 2012 and Beyond

2012 was the year states and localities finally emerged from massive revenue hole created by the Great Recession… Or was it?

The latest data suggest that state tax collections are back at pre-recession levels. However, this is only in nominal terms. Adjusted for inflation, taxes are still below their 2008 peak and growth has been sporadic and uneven across states. It’s also unclear how much recent gains reflect investors cashing out early to avoid higher capital gains taxes next year if the country goes over the so-called fiscal cliff.

Consistent with stronger revenues, state general fund spending is expected to grow 2.2 percent this year. Although below historic averages, this represents a marked improvement over the Great Recession, when spending declined in real terms for two years in a row. Today, state lawmakers use words like “stable” and “improving” to describe their budgets – versus “grim,” “bleak,” and “dire,” which prevailed at the low point of 2009.

Still, all is not rosy. At the local level, cities, counties, and school districts are contending with lower property taxes and cuts to state aid. Job cuts have largely abated in state and local government, but to the extent they continue it is in local education. And, although only a handful of municipalities (including the two relatively large cities of Stockton and San Bernardino, CA) declared bankruptcy in 2012, muni bond analysts worry about shifting local norms and state limits on local taxation leading to more defaults and bankruptcies going forward.

The Great Recession also exposed long standing weaknesses in state and local public finances, including underfunded employee pensions and the proliferation of non-traditional debt. A State Budget Task Force convened by former Federal Reserve Chairman Paul Volcker and ex-New York Lieutenant Governor Richard Ravitch issued several high quality reports in 2012 on these risks. However, much more work remains to be done to make state and local finances truly accessible and transparent.

Looking ahead, perhaps the biggest vulnerability for states and localities is their exposure to federal fiscal retrenchment. States depend on federal grants for more than a third of their general revenues. Localities derive a comparable share from states, including pass throughs of federal funds.

Although Medicaid and other big ticket items are exempt from automatic federal spending cuts scheduled for 2013, states stand to lose 6.6 percent of their revenues next year if Congress does nothing. These cuts may be small overall, but they will be painful to some jurisdictions. This is especially true because affected programs (like Community Development Block Grants, and Title I education grants) provide relatively discretionary dollars with few federal strings attached.

Of even greater concern to state and local leaders is what going over the cliff would mean for their underlying economies. Making matters worse, as in the 2011 debt limit debate, a deal to avert the cliff could be worse than no deal – because Medicaid and tax provisions benefitting states and localities could be part of any federal deficit reduction “grand bargain.”

But unlike in 2011 and other federal budget negotiations, governors and mayors have had seats at the table in fiscal cliff discussions. This may just be what Washington loves to call “optics.” Still, in 2013 and beyond, governors and mayors would do well to seize the moment to redefine the federal-state-local relationship on their own terms.

A new, more robust federalism would include measuring and publicizing successes managing challenges such as aging populations and rising health care costs. Federal, state, and local governments all share the same fiscal problems. They must all be involved in crafting solutions.