Even as Detroit's troubles continue to make headlines, state and local governments are poised to contribute to the economic expansion. It would be the first time in years that they made such a contribution. It will, of course, be constrained. State and local finances are hardly in good shape. But their overall revenues are growing at last, and their spending should follow, as should their hiring. Matters won't, however, turn a subpar recovery into a robust one, certainly not by any broad historical standard. But a net contribution from this sector will bolster the economy further against recession. To the extent that it does add to growth, even marginally, this change in state and local behavior will contribute indirectly to the growth of corporate earnings and so continued market increases.

Actually, state and local tax revenues have been increasing for quite a while. According to the Commerce Department, states, cities, towns, and counties as a group have seen increases in their usual revenue sources since 2010. During that year, their personal income tax receipts rose 7.8%, corporate income taxes 6.6%, and sales taxes 6.7%. Not surprisingly, the take from property taxes continued to fall, by some 1.1%. But even with this, overall tax revenue rose 3.7% for the year. In 2011, even property taxes began to tick up. The recovery proceeded slowly, as is well known, but still overall revenues from all these sources grew almost 4.0% a year on average in 2010 and 2011 and continued at close to that pace in 2012. In real terms, the growth came close to 2.0% a year.1

Overall spending has, however, lagged throughout, growing at less than 1.0% a year on average during this time, and registering a real decline. In part, spending has failed to keep up because state and local governments felt obliged to use any revenue growth to close budget gaps rather than to increase outlays of any kind. But there was something else going on during this time as well. The federal stimulus of 2009, a good part of which was directed at state and local governments, began to work in reverse after 2010. Whereas federal grants-in-aid to states and cities increased a phenomenal 16.3% a year between 2008 and 2010, they fell almost 6% a year between 2010 and 2012. This withdrawal of funds held back the annual growth of overall state and local revenues throughout this time to a mere 1.5%, a decline in real terms.2

But now, well into 2013, it looks like matters are poised for a positive change. The downward adjustment in federal transfers seems to have just about run its course. The flow today of about $450 billion in federal monies to state and local governments, though well down from almost $520 billion at the high in 2010, is about back on track with where long-term historical trends would have put it. Though circumstances in Washington will almost certainly block another surge, the weight of cutbacks, under which states, cities, towns, and counties have labored these past few years, should begin to lift. Overall revenues should at last pace tax revenue growth of 3.5–4% a year. Spending should grow about in tandem. Of course, some of these new monies will be directed away from new hiring and spending toward pension trust funds, where many states, towns, and cities face huge funding gaps. The balance of this money flow will, however, go to those areas where the authorities have discretion, and where most of past cutbacks have fallen: education, which constitutes some 27.2% of all state and local spending; police, fire, sanitation, and administration, which constitute some 29.7%; hospitals, 4.7%; and highways, 4.8%.3

Since state and local spending amounts to some 12% of the entire economy, this change should contribute to the overall pace of economic growth. To be sure, the difference in state and local finances is neither so dramatic nor their role in the economy so large that the character of this recovery will change from sluggish to robust. But at the margin, these altered circumstances should help improve labor markets, the overall pace of economic growth and, to the extent that profits benefit from an expansion generally, the growth pace of corporate earnings as well. Of course, the monies diverted for pension funding will not flow into the general spending stream. But since pension funding typically finds its way into financial markets, these contributions will offer them a fillip of a different kind.

1 All data from the Department of Commerce.

2 Ibid.

3 Ibid.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

© Lord Abbett


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