State and Local Governments Outpace the Feds

State and local government finances appear to have stabilized. No one could describe them as sound, in aggregate and certainly not in certain particulars, but they have stabilized in general. The sector as a whole continues to run deficits, of course, and there are many pressure points on the expenditures side of state and local government budgets. But these governments have kept spending growth in line with revenues growth and, so, have contained the flow of red ink. There also is the likelihood of such continued relative stability going forward, even in the country’s slow-growth economic environment. This is good news, even with all the caveats. There are, however, longer-term concerns.

A Look at Where We Have Been
State and local government finances have faced a tough pull back from the great recession of 2008–09. Quite apart from the pension issues that have garnered so much media attention, those economic hard times hit state and local budgets from both sides. Revenues fell as the economic downturn dragged down just about every tax line item. Between the fourth quarter of 2007 and the second quarter of 2009, personal income tax receipts fell 7.2%, sales tax receipts fell 7.7%, and corporate tax receipts fell 24.4%. Ironically, given the real estate roots of the recession, the only revenue item to rise was property taxes, which expanded 6.1%, largely because these flows reflected prior strength.1     

Against this difficult shortfall in receipts, the recession produced outsized demands for spending on social services. State and local outlays in this area jumped 13.8% between the fourth quarter of 2007 and the third quarter of 2009, when this particular pressure began to ease. As a consequence, overall state and local expenditures expanded 10.4% during that time. It is hardly surprising, then, that state and local budget deficits rose, from an annual rate of $205.2 billion in the fourth quarter of 2007 to $377 billion by the middle of 2009, an 83.9% increase that raised the deficit, from 9.4% of total expenditures to 16%.

Following the devastating effects of the recession, the sluggish nature of this recovery has capped the growth of state and local receipts since. Between mid-2009 and the end of 2012, those receipts grew only 10.1%, or a mere 2.8% a year. Like incomes throughout the economy, this pace of expansion barely exceeded inflation. The recovery did, however, enable state and local governments as a whole to regain control of their outlays. Though substandard by historical standards, the pace of economic growth slowed demands for social benefits, keeping growth in this expenditure line item to 2.7% a year. This moderation, plus budget cuts elsewhere, enabled governors, mayors, and local managers to hold the pace of overall spending to a mere 0.8% a year, thereby stemming the tide of red ink, so that by the close of 2012, state and local deficits as a whole equaled $269.1 billion a year, about 10.0% of overall expenditures.

Since then, these governments have eased off a bit on their austerity efforts. Their receipts have continued to grow at the slow 2.8% annual pace they set earlier in the expansion. Because outlays for social benefits have continued to rise faster than revenues—at a 5.9% annual rate in fact—these governments have had to continue squeezing the rest of their budgets to contain the growth in total outlays to 2.5% a year. That figure is faster than earlier in the recovery, but still slow and close enough to revenues growth to have held back the annual flow of red ink, which, as of the first half of 2014, stood at $259.7 billion a year, a touch over 10.0% of total expenditures.

Looking Forward  
For the time being—a horizon of two to three years—likelihoods favor a continuation of this contained trend. A slow-growing economy should promote some growth in state and local revenues, but, as during the past few years of recovery, not much faster than the rate of inflation. With little sign of an acceleration in the economy, there is little chance of revenue growth exceeding 3.0% by much. At the same time, the limited chance of recession removes much risk of an outright decline in revenues, certainly not on the scale that occurred during 2008–09. Given political pressure to sustain some budget control and concern about how investors would react to widening deficits, governments should also continue to manage the pace of growth in outlays at about the rate of revenues growth, keeping a lid on the growth of red ink to about 10–10.5% of total expenditures.  

Though this pattern can last for a while, it is, however, unsustainable over the longer term. Except in the unlikely event that the economy gets a whole lot better quickly, the pace of growth in spending on social benefits will continue to outstrip revenues growth, as it has so far in this sluggish recovery. The recent growth rate of 5.9% is entirely plausible. An improvement in the jobs market, even a modest improvement, would tend to slow the pace, but against that, the further implementation of the Affordable Care Act threatens to add to the figure. The longer this goes on, the harder time state and local governments will have squeezing other parts of their budgets to keep the overall pace of outlays growth in line with revenues. Unless, then, there is some action to address this pressure, state and local finances over the longer term will again come under renewed, severe pressure.  

There is another risk for the longer-term outlook, and that is a rise in interest rates. The budget burden of financing has fallen as a part of total outlays, from 8.3% at the end of 2009 to 7.8% recently. Part of the decline reflects the success state and local governments have had keeping a lid on the flow of red ink. Part of it also reflects the remarkably low level of interest rates during this time. Over the long term, however, interest rates are very likely to come under upward pressure. Because municipal yields and rates at present (though low by historical standards) are high relative to Treasury and corporate yields and rates, they likely will resist any initial up move in yields and rates generally. Eventually, however, they will succumb to any general move upward. When that happens, state and local governments will have to pay more for financing, burdening their budgets further. So, unless they can indefinitely squeeze those other parts of their budgets they have shortchanged since this recovery began—a doubtful possibility—their deficits will tend to rise.          

These pressures seem unavoidable. An economic acceleration could, of course, relieve the strain by accelerating the growth of state and local receipts; but, as indicated, that looks unlikely right now. The budget pressure on this more distant horizon will, doubtlessly, create a concomitant political pressure for further reform in state and local financing. Should that reform prove effective, it could improve finances over the longer term and the security of municipal bond investments with it. A failure to reform over this longer time horizon or ineffective reforms would make matters less secure. Even in this case, however, the fears of investment loss, which surely would accompany such pressure, will almost surely overstate the risk. Since most of these governments know how much future financing depends on a reliable discharge of their debt obligations, they will squeeze a good deal else in their budgets, including social benefits, to avoid reneging on their bond obligations in any way.  

1 All data herein from the Department of Commerce.

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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