The States Are Strapped

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For homeowners, garbage day is never pleasant. Getting the trash together takes some doing (and during the summer, nose plugs don’t hurt). There follows an argument among children over whose turn it is to take the bins out to the curb, which usually ends with a parent performing the chore to get it over with.

But it could be worse. In most areas, trucks arranged by local governments come through weekly to collect the detritus and take it to a dump. Imagine what the process would be like if pickup was provided only monthly, or not at all.

Yet this is the prospect faced by many U.S. communities for a range of public services. Poor fiscal health at the state and local levels clouds their economic futures, and ours; the situation promises to get worse as demographics march on. And if recession returns, some states may find themselves in very serious difficulty.

While major headlines often focus on the national economy and national debt, our state and local governments are prominent contributors to both. Combined, local governments employ more people and collect and spend more money than the federal government.

Sustaining public payrolls and expenditures requires money. Relative to the federal government, states and municipalities have limited sources of revenue:

  • Taxes.The majority of funding for state and local governments is through sales taxes, property taxes and income taxes. The rates and composition of these taxes vary by state. Seven states have no income tax, and four charge no sales tax. Income and sales taxes are especially susceptible to volatility during economic downturns: As consumers earn and spend less, local governments immediately feel the pain of lower tax receipts. Property tax receipts can also be cyclical, as we learned during the housing crisis ten years ago.
  • Fees and fines. Some fees are routine, such as vehicle and business registrations. Fines, like traffic violations, are an unpleasant but reliable component of municipal income.
  • Federal grants-in-aid. To support specific needs such as public health and education, the federal government provides funding to individual states. Infrastructure projects are often jointly funded by both federal and local taxing bodies. The amount of federal funding in state budgets varies from 17% in North Dakota to 41% in Mississippi.

All levels of government can issue debt. More than $3 trillion in state and municipal debt is currently outstanding. While local governments have reliable income streams to service debt, they must keep their budgets close to balanced. States do not issue currency and therefore cannot run printing presses to manage their debt burdens.

From that base of income, states and municipalities provide a broad set of services. In healthcare, local governments manage Medicaid programs. Local governments provide education beginning with kindergarten and extending through public universities. They are therefore critical to the formation of human capital in the United States.

Under the best of circumstances, our local governments are stretched. They are now under even greater duress as the cost of healthcare rises and decades of pension obligations are coming due. Research by Morningstar found that 21 states had pension funding ratios worryingly below 70%.

State and local governments have mounting financial obligations and no reductions in demand for their services. How can they maintain solvency?

  • Employer growth: New employers mean new jobs, additional tax revenue, more demand for housing and multiplier effects for local economies. States and cities have many motivations to offer incentives to attract employers. However, this can be a slippery slope. In the case of Wisconsin, the state’s incentives to attract the first U.S. factory for Foxconn Technology Group are approaching $4 billion—a generous package for a single facility promising 13,000 jobs. As states compete against each other to attract investment, they risk a winner’s curse of committing to public incentives greater than the value of the private investment.
  • Tax increases and service reductions: A tax increase will immediately and directly raise revenue. Higher tax rates can deter new business investment and may give residents a reason to relocate—or, at minimum, a reason to be displeased with their elected leaders.
  • Federal funding: While the federal government is an important source of state funding, the national deficit is growing, and the capacity for further support is limited.

Default is a growing concern. Until recently, government debt was considered very safe, with historians looking back to the Great Depression to find examples of insolvency in the public sector. However, the past decade has given us the default of Puerto Rico and bankruptcy declarations in Detroit, Michigan and Stockton, California. Municipal defaults remain rare but possible.

Overburdened state and local governments are a risk to both their residents and their investors. In the past year, Moody’s has issued debt downgrades from California to Connecticut, with Illinois teetering on the brink of a junk bond rating.

To avoid that fate, cost reductions are being stressed. There are some promising angles: neighboring cities or overlapping levels of government may merge in order to reduce administrative staff, such as the successful merger of Kansas City, Kansas, with Wyandotte County. On the other hand, many solutions designed to resolve issues of pension funding face immense political opposition. Cutting back on education seems short-sighted, as human capital is a key to economic success. The recent wave of teacher’s strikes is a clear sign of what’s ahead on this front.

Given the importance of state and local conditions to the national economic picture, failure to solve fiscal problems at this level would be damaging to the whole country. If the situation isn’t addressed soon, it will leave a mess for our children that will be almost impossible to clean up. Even if they all pitch in.