The state and local government sector: long-term trends and recent fiscal pressures.

Many state and local governments have been under pressure in recent years to deal with significant erosion in their fiscal positions, and in the aggregate, the state and local government sector has reported a deficit in its combined operating and capital account since the end of 1986 (chart 1, upper panel).(1) Much of the imbalance can be traced to the expansion of spending programs in the late 1980s in combination with the reduced revenue growth that accompanied the recent recession and the subsequent slow pace of economic recovery. The recent fiscal difficulties have been reinforced by longer-term trends in state and local spending and taxation, by a growing number of mandates to provide services, and by decreasing federal support.

The rise in state and local outlays in recent years has been concentrated in education, corrections, and Medicaid. Demographic and social changes have resulted in increased demands in all three areas. Moreover, spending on elementary and secondary education has been boosted by national and state efforts to improve the quality of schooling; outlays on prisons have been increased to comply with court orders to alleviate overcrowding; and Medicaid expenditures have risen sharply, in part because of federal mandates to expand coverage. As these demands have mounted, receipts have been restrained by the weak economic expansion, putting a squeeze on state and local government budgets.

The state and local government sector has recorded sizable deficits at other times since World War II. Throughout the 1950s and 1960s, the sector's operating and capital account remained in deficit. To a large extent, the deficits reflected heavy capital spending, which ran 25 percent or more as a share of state and local expenditures, excluding social insurance funds. (See box for a discussion of these funds.) The rapid pace of public construction began to abate in the late 1960s, and over the next fifteen years the budget position of state and local governments was, on net, in rough balance, with deficits developing during periods of recession and surpluses during periods of expansion. The pattern was broken with the emergence of large budget gaps in late 1986, nearly four years before the most recent cyclical peak. Consequently, it appears that the current problem extends considerably beyond a cyclical imbalance and that state and local governments will need to make fundamental adjustments to restore fiscal health.(2)

An understanding of the current structural difficulties confronting state and local governments requires that recent developments be viewed from a longer-term perspective. Over the postwar period, the role of state and local governments has expanded noticeably; total expenditures (excluding social insurance funds) rose more than 4 1/4 percentage points as a share of gross domestic product (GDP) between 1959 and the mid-1970s. Early on, the expansion was funded, in part, by grants from the federal government. When the growth of federal grants was trimmed in the 1980s, however, state and local spending on many of these programs was not cut back. To some extent, the decrease in federal resources has been offset by an increase in state and local tax burdens. However, the magnitude of the current aggregate deficit of the state and local government sector suggests that many difficult decisions remain ahead. This article examines some of the trends in spending, taxation, and grants that underlie the fiscal difficulties, which have now persisted for five and one-half years.

Statistical Preliminaries

Analysis of the state and local government sector is limited by the quantity and quality of economic data. One of the complications arises from the enormous number of government units - more than 80,000. Definitions, fiscal reporting periods, and the range of spending priorities vary widely within as well as across states. The national income and product accounts, which provide information about these governments on a conceptually consistent basis, form the framework for much of the macroeconomic analysis of the sector.

Separate data for state governments and local governments are available only for the period 1959-88. Even if the database were more current, it is not clear that these two levels of government should be separated when examining general trends in spending and taxation, because the division of responsibilities between states and localities varies considerably from state to state. Some states perform functions that are carried out by local governments in other states. For example, Hawaii administers the state's public elementary and secondary schools and funds 92 percent of expenditures, whereas New Hampshire funds only 7 percent of public school expenditures. The mix of state and local taxes shows a similarly wide divergence. The percentage of total state and local own-source general revenue that is raised by states varies from a high of 69 percent in Hawaii to a low of 39 percent in New Hampshire and Colorado.

The State and Local Government

Sector

The state and local government sector accounts for a relatively large share of economic activity in the United States. Employment by state and local governments grew steadily over the quarter century beginning in 1945, from 7 1/2 percent of nonagricultural employment in that year to 14 percent in 1970; it has remained at roughly that share ever since. Likewise, purchases of goods and services by these governments as a share of GDP grew from 8 1/2 percent in 1959 to more than 11 percent in the first half of 1992.

By composition of spending, purchases account for most state and local government expenditures, excluding those of social insurance funds. The bulk of the remaining outlays are for transfer payments to individuals, which rose from about 10 percent of state and local government expenditures in the 1960s to more than 20 percent in the first half of 1992, primarily a reflection of the growing importance of Medicaid. By function, the largest share of expenditures is for education, which has hovered around 40 percent over the past thirty years (table 1). The second largest function is income support, at around 22 percent of expenditures. The magnitude of income support programs has grown dramatically over the past three decades. By contrast, the share of expenditures for transportation, largely highways and mass transit, exceeded that of income support programs by a considerable margin in 1960 but has diminished significantly since then.

1. Selected components of state and local government
   expenditures, by function, selected years, 1960-91
   Percentage of total government expenditures (excluding social
   insurance funds)
                             1960   1970   1980   1990   1991
Education                    37.1   40.9   39.9   40.1   39.0
Income support and welfare   11.9   15.4   17.1   18.4   21.5
Transportation               18.4   13.6   11.0   10.0    9.2
Administration                5.7    5.2    5.9    6.7    6.6
Health and hospitals          6.2    5.6    5.1    4.3    3.6
Police                        4.1    4.0    4.2    4.6    4.5
Corrections                   1.4    1.4    2.0    3.8    3.7

Purchases of Goods and Services

Purchases of goods and services by state and local governments rose as a share of GDP between World War II and the mid-1970s. Since then, the share has fluctuated between 10 percent and 12 percent (chart 2, left panel). The separate patterns for state governments and local governments (not shown) were quite similar.

The overall pattern of state and local spending has been driven, to a large extent, by demographic and social factors. The 1950s was a decade of rising birth rates, increasing per capita real income, and expanding suburbanization. In response to these developments, real outlays for construction rose rapidly. Enrollment in public schools soared, necessitating construction of new educational facilities. In addition, the federal interstate highway system, begun in 1956, produced a surge in road construction. (In contrast to spending for school buildings, highway construction was financed in large part by federal grants to states.) By the late 1960s, the school-age population had peaked and highway construction had begun to wind down. As a result, state and local spending on construction fell, both in real terms and as a share of GDP, until the 1980s, when the school-age population began to increase once again and governments were called upon to expand and upgrade many infrastructure projects. The per capita stock of state and local public structures then resumed an upward trend after having drifted downward slightly for several years (chart 2, right panel).

Transfer Payments to Individuals

During the first half of 1992, transfer payments to individuals by the state and local government sector reached $225 billion; excluding payments to retirees, transfer payments to individuals totaled nearly $170 billion, or 3 percent of GDP. Transfer payments as a percentage of GDP have risen throughout the past three decades (chart 3, upper panel), with sharp increases in the late 1960s and again in the 1990s. Because a large proportion of state and local government transfer payments to individuals goes to Medicaid and Aid to Families with Dependent Children (AFDC) - 73 percent and 14 percent respectively in the second quarter of 1992 - the explanations for the recent sharp rise can be found by examining developments in those programs.

Medicaid is administered by the states but is financed by both the states and the federal government; the federal share differs from state to state and ranges from 50 percent to 78 percent, depending on the state's per capita income. After remaining below 4 percent of state and local expenditures (excluding social insurance fund payments) during the first half of the 1980s, Medicaid spending from state sources rose to above 6.0 percent in fiscal year 1992 (chart 3, lower panel).(3)

The increase in state Medicaid spending in recent years partly reflects advances in medical technology, die rapid increase in the cost of medical care, and the recent weakness in aggregate economic activity. Another important factor boosting the cost of Medicaid to the states has been the imposition of federal mandates requiring states to expand their coverage. Federal mandates concerning Medicaid added an estimated $2.6 billion - or roughly 5 percent - more to the states' portion of Medicaid costs in fiscal year 1992. To illustrate, in 1988, states were given until July 1990 to cover pregnant women and infants up to age one in families with income below the poverty line. The requirement-was later changed to include pregnant women and infants in families with income less than 133 percent of the poverty level as well as children up to age six in families with income below the poverty line. The Omnibus Budget Reconciliation Act of 1990 further expanded coverage, phasing in coverage so that by the year 2002, all children eighteen years and younger in families with income below the poverty line will be covered.

Likewise, in recent years, federal mandates have further expanded AFDC, a program for needy children that is administered and financed like Medicaid. The Family Support Act of 1988 mandated two important changes to the program, effective October 1, 1990, that appear to have raised costs for at least some states. First, states are now required to include children in two-parent families in which the principal wage earner is unemployed before the change, coverage was optional, though all large states were already including these children in the program). Second, all states must operate job opportunity and basic skills (JOBS) programs to provide education, job training, and, if necessary, day care, along with other developmental and support services.

Taxes

Taxes and fees constitute nearly 80 percent of the receipts (excluding contributions to social insurance funds) of state and local governments. The ratio of tax revenues to GDP is a simple gauge of tax burdens. Total receipts from state and local personal and corporate income taxes and indirect business taxes (sales, excise, and property taxes) including fees and charges - that is, state and local government own-source revenues - have risen from about 7 percent to more than 10 percent of GDP over the past thirty years (chart 4, upper panel). Hence, it appears that the tax burden at the state and local level has increased over the postwar period.

Among the components of total receipts, state and local personal tax and nontax receipts rose from about 1 percent of GDP following World War Il to 2.5 percent in the late 1980s (chart 4, lower panel); indeed, these receipts increased from around 16 percent of state and local revenue (excluding contributions to social insurance funds) in the late 1970s to more than 20 percent a decade later. Among indirect business taxes, sales and excise tax receipts as a percentage of GDP moved up until the early 1970s and then stabilized at just over 3 percent of GDP. Profits tax receipts of state and local governments (not shown) remained at a very low level as a percentage of GDP throughout the period. State and local property tax collections as a share of GDP rose until 1971 and then began a decline that was accelerated later that decade by a wave of tax revolts in many states. The trend was reversed in the late 1980s, and since then there has been a small, but steady, pickup in property taxes as a share of GDP.

For the most part, state and local governments rely on different sources of revenue. Most property tax revenue is collected by local governments, and most income and sales taxes are paid to state governments. For example, in 1988, the most recent year for which separate data are available, state governments collected 86 percent of personal income and sales taxes, while local governments collected 97 percent of property taxes.

Grants

Federal aid to state and local governments totaled nearly $170 billion in the first half of 1992, accounting for more than 20 percent of their revenues, excluding social insurance funds. About 12 percent of the federal aid was earmarked for highways, mass transit, and waste treatment and was spent by state and local governments primarily on construction. Around half was for Medicaid and other public assistance programs, especially AFDC. The remainder covered a wide range of special programs, from disaster assistance to aid for vocational and adult education.

The postwar growth of federal aid to state and local governments was suspended in 1980, largely reflecting the scaling back and eventual elimination of revenue sharing.(4) Federal aid as a share of state and local revenue (excluding social insurance funds) fell from 27 percent in 1980 to 19 percent in 1989 (chart 5, upper panel); over the same period, federal grants to state and local governments as a percentage of GDP slipped from 3 1/4 percent to 2 3/4 percent. Indeed, federal support actually declined in nominal terms, from nearly $89 billion in 1980 to $84 billion just two years later. The reduction in federal aid was felt by both state and local governments. In 1975, 30 percent of state revenue came from federal grants, but by the end of the 1980s the figure had slipped to 24 percent. The decline was more dramatic for local governments: The federal contribution to local revenue fell from 13 percent in 1978 to 4 percent in 1988 (chart 5, lower panel).

The sharp cutback in federal aid to state governments did not lead to an immediate reduction in state aid to local governments during the 1980s. Indeed, state aid held up well, and throughout the 1980s state grants continued to represent around 36 percent of local revenue, about the same as during the 1970s. State grants as a percentage of all grants to localities increased from 73 percent in 1978 to 91 percent by 1988. That year, states provided local governments with $145 billion in aid, two-thirds of which was intended to support primary and secondary education. Other programs receiving significant contributions were higher education, highways, hospitals, and welfare and social services. However, state support has been slipping in the past few years, as many states, as part of their budget-balancing efforts, have reduced aid to local governments and to school districts. For example, more than half the respondents to an early 1992 survey of the 100 most populous counties reported reduced aid from states.(5)

More recently, federal aid to state and local governments has rebounded sharply, rising at a 15 percent annual rate, in nominal terms, during the past two and one-half years, compared with an average annual increase of just 4 percent during the preceding ten years. Nearly all the recent acceleration has been in increases in grants for Medicaid, which account for more than 40 percent of federal aid to these governments.(6) During the two and one-half year period, Medicaid grants have grown at about a 30 percent annual rate. As a result, federal aid for Medicaid as a share of total state and local receipts has risen dramatically, while the share of grants for all other programs has changed little (chart 6).

The Administration's fiscal year 1993 budget proposed an increase in federal aid to state and local governments of around 10 percent per year, on average, over the period 1992-97 (table 2). Increases in grants for Medicaid are expected to average 16 percent a year, while annual growth in aid for all other categories is projected to average around 2.5 percent.(7) Under this scenario, Medicaid grants would rise from 35 percent of federal aid in fiscal year 1991 to 55 percent in fiscal year 1997.

[TABULAR DATA OMITTED]

Long-Term Trends

and Short-Run Pressures

By most measures, the responsibilities of state and local governments have increased over the postwar period. Purchases, transfer payments, and taxes are a larger share of GDP than they were thirty years ago. Yet, federal aid to these governments has fallen from 3.5 percent to 2.7 percent of GDP over the past decade and a half, after rising earlier in the postwar period. The reduction in aid was apparently not a major problem for state and local governments during the mid-1980s, when strong overall economic growth and rapidly escalating property values boosted tax receipts. But when the pace of revenues slowed, there was, at least initially, little corresponding slowdown in the growth of state and local spending.

Much of the recent pressure on state and local spending reflects the confluence of relatively new developments and the underlying upward trends in spending and taxes. Currently, nearly two-thirds of state general fund budgets is dedicated to education, Medicaid, and corrections - and demographic trends point to further increases in these areas in coming years. Furthermore, court orders related to prison overcrowding have added to the financial pressures in many states, and the repair and expansion of the public infrastructure have become important goals in many states and localities.(8)

Mandates also have added to outlays for many state and local programs. The 1980s were notable for the increasing number of new, unfunded or partly funded mandates imposed on states by the federal government and the courts. In addition to Medicaid and AFDC, mandates have concerned nursing homes, wildlife, drinking water, child welfare, environmental cleanup, and highway safety. The lack of funding for these new programs presents significant financial obstacles. One such example is a 1990 law requiring coastal states to test beach water regularly. The Congress authorized $3 million a year to cover the costs, but testing the Florida waters alone was expected to cost $2 million annually, and twenty other states have shoreline.(9)

Similar to the response of the federal government, state governments have been responding to fiscal difficulties by imposing increased burdens on local governments. In addition to hiking taxes and cutting spending across-the-board, state governments have employed a variety of strategies, including reducing state aid, providing no reimbursements for new mandates, and requiring local governments to pay for services provided by the state. Examples are numerous. The State of California now retains, as compensation for its administrative expenses, a portion of the receipts it collects for a local option cigarette tax. In Minnesota, cities are paying higher fees for water certification. According to a 1988 U.S. General Accounting Office report, Illinois passed fifty-seven unfunded mandates between 1981 and 1989 that cost local governments $148 million each year.(10) And in Milwaukee County, Wisconsin, the portion of property tax collections used for state-required programs has risen from 32 percent several years ago to 46 percent.

To deal with shortfalls in their general fund accounts, most local governments must choose between reducing services and raising taxes. Some of each will likely occur in the years ahead. With no significant decline in constituent demands for services, especially education, local governments will have to look at raising taxes, particularly property taxes. About a third of total local government receipts, and more than half of these governments' own-source receipts (that is, excluding grants as well as contributions to social insurance funds), come from property taxes; therefore, the property tax is a logical place for these governments to look for additional revenue when budgets are tight. Indeed, property tax collections have assumed a somewhat more prominent role in state and local government finance: Between 1988 and the second quarter of 1992, property tax collections rose from 27 percent to 30 percent of revenue raised through state and local taxes, fees, and other charges.

The rise in the share of property tax collections was due partly to rate hikes: Nearly three in every ten municipalities raised property tax rates in fiscal year 1992, according to a survey by the National League of Cities.(11) Even for many communities that did not raise rates, property tax collections were bolstered by increases in assessed values that reflected price advances during the late 1980s. However, given recent real estate price developments, rising property assessments are no longer likely to provide widespread relief to local governments.

In addition to the potential for hikes in property taxes, some states are beginning to expand local option taxes. For example, the county of Philadelphia, faced with severe fiscal erosion in 1991, was allowed to piggyback an additional percentage point onto the existing state sales tax, and other counties were allowed to add on an additional 1/2 percent. Also in 1991, a court decision in California did away with the requirement for a two-thirds majority popular vote of approval to increase county sales taxes, paving the way for future increases.

The Role of Debt Financing

In addition to reductions in spending and increases in a variety of taxes and fees, debt financing has played a more prominent role in recent years. Offerings of public-purpose bonds for new capital, the proceeds of which are intended to finance capital projects, rose to a record high in 1991 (chart 7, upper panel), and issuance appears to have remained strong during the first half of 1992.(12) Historically, state and local governments financed around 40 percent of capital construction with tax-exempt debt raised in the credit markets; another 40 percent was financed with current receipts, and the remaining 20 percent came from grants. In the mid-1980s, the portion financed by bonds rose to around one-half, as less construction was financed with current receipts.(13)

State and local governments have traditionally sold short-term securities to help during a cash crunch. These securities are usually called tax- or revenue-anticipation notes, as they are issued in anticipation of future funds. In 1991, gross offerings of these notes rose above $40 billion, about 15 percent above the amount issued in the preceding year (chart 7, lower panel). The increase in recent years is probably the result of the current pressing fiscal situation, just as the rise in the early 1980s apparently was in response to recessionary pressures.

Although the practice is limited in scope, some state and local governments have also issued long-term debt to cover operating deficits. For example, the Louisiana Recovery District was created in 1988 and in that year issued $1 billion in bonds to relieve accumulating state deficits. In recent years, both New York and Massachusetts considered such measures. In February 1991, the Local Government Assistance Corporation of New York sold the first in a series of bonds with maturities of thirty years or less to replace short-term borrowings; by mid-1992, little more than half the total $4.7 billion in bonds had been sold. In addition, since 1989, New York has sold deficit notes to finance interyear shortfalls; sales of these notes rose to more than $1 billion in 1991 and then fell to about half that level in spring 1992.

The Outlook

The restoration of fiscal balance to the state and local government sector is not likely to be easy. Postwar trends indicate that the responsibility of state and local governments has expanded in a number of areas, and demographic and social factors that affect important programs likely will continue to put pressure on budgets for years to come. Nearly two-thirds of state general fund budgets are dedicated to education, Medicaid, and corrections - and population trends point to further increases in these areas in the coming years. Also adding to state spending requirements are quality goals (particularly for public school education), court orders (primarily concerning public school education, corrections, and Medicaid), and federal mandates (particularly for Medicaid coverage). In addition, the repair and expansion of the public infrastructure has become an important objective in many states and localities. Continued economic expansion should help to lift revenues, but probably not enough to close existing budget gaps. Consequently, many difficult decisions lie ahead for state and local governments.

State and Local Insurance Funds: A Source of Saving and Revenue

Concern about the fiscal position of the government sector has increased in the last two decades as the federal deficit has risen as a share of GDP. Indeed, the combined deficit of all governments has grown, even though total government purchases of goods and services as a percentage of GDP have remained relatively constant. At the state and local government level, total sector revenues may appear to exceed total outlays, but the apparent surplus reflects the inclusion of social insurance funds. When these funds - primarily state and local government employee retirement funds, but also, in some states, workers compensation and disability insurance funds - are excluded from the figures, a different picture emerges (chart 8). This article looks at state and local government receipts and expenditures excluding these funds so as to focus on the fiscal picture for the governments themselves.

Social insurance funds grow through contributions from employers and employees and through interest and dividend earnings. Offsetting these revenues are transfer payments to beneficiaries and administrative expenses. The surpluses, along with the assets, of state and local social insurance funds are invested in the credit and equity markets and are a source of savings that is available to the rest of the economy; in the first half of 1992, the surpluses amounted to around $58 billion.

Although social insurance funds are a source of national saving, they are not generally available for operation of state and local governments, but are dedicated to retirement annuity and other payments. Much of the long-run growth in state and local social insurance funds can be attributed to the increase in public sector employment. Had this employment growth occurred in the private sector instead of the public sector - for example, through greater dependence on private schools or privately operated services - then, other things equal, public pension fund balances would have been lower, and private pension fund balances higher. Private pension funds are considered part of personal saving; because state and local government employee pension funds have similar characteristics and are not available for day-to-day government operations, they, too, may be thought of as personal saving. As such, these contributions are not appropriately considered part of the tax burden or as an indicator of the fiscal status of the state and local sector.

An important distinction should be noted between the state's contribution and the corpus, or assets, of the trust itself The assets of these funds are considered to be outside the general fund and capital accounts of state and local governments and are rarely touched, even in the event of severe fiscal deterioration. Their fiduciary responsibility requires the administrators of social insurance funds to guard the corpus and to earn the highest return possible. Although states rarely borrow money directly from the corpus of the funds, it is not uncommon for public employers to reduce their contributions to social insurance funds in response to budgetary distress. To facilitate such adjustments, some accounting device typically is used to decrease contributions, such as assuming that the corpus will be earning a higher rate of return in the future, and that therefore the state can contribute less.

(1.) Much of this analysis is based on data (through 1992:Q2) from the national income and product accounts (NIPA). The most recently revised data date back only to 1959, however, and statements about trends over the early part of the post-World War II period are based on unrevised data. Revisions to early figures are unlikely to alter the story presented here. (2.) Roughly half the recent fiscal squeeze in estimated to have come from structural imbalances, and half from the cyclical downturn. (3.) Total federal and state outlays for Medicaid increased an average of nearly 30 percent a year over the two and one-half years ending in the second quarter of 1992, compared with annual gains in nominal GDP of about 4 percent over the same period. Indeed, total Medicaid spending rose from 0.9 percent to 2.1 percent of GDP between the late 1970s and 1991, with much of the increase in share occurring in the past two years. (4.) Federal grants for revenue sharing, which began in 1972, reached $7.1 billion in 1973, accounting for 17 percent of total grants to state and local governments that year. The dollar amount peaked at $8.3 billion in 1977, accounting for 12 percent of total grants. While total grants rose through 1980, funds for revenue sharing remained between $6 billion and $7 billion until 1981, when the amount was cut back to $4.6 billion (5 percent of total grants). The revenue sharing program was discontinued in 1987. (5.) National Association of Counties, Counties in Crisis: A Fiscal Survey of 80 of the Nation's Largest Counties (Washington, D.C.: NAC, February 1992). (6.) Of course, an increase in Medicaid grants, in and of itself, does not relieve budgetary pressures on state and local governments, as federal grants must be matched, primarily by the states. (7.) About 60 percent of federal grants to state and local governments are for entitlement programs and are subject to the pay-as-you-go rules for mandatory spending stated in the Omnibus Budget Reconciliation Act of 1990. Medicaid accounts for nearly 60 percent of this entitlement spending, and the remainder goes largely for family support (AFDC), child nutrition, and housing assistance programs. Other federal grants are considered part of the discretionary portion of the federal budget, which in total must grow in line with inflation. In this category are grants for physical capital, such as highways, airports, mass transit, sewage treatment plants, and community development, and for education, training, employment, and social services. (8.) See Laura S. Rubin, "The Current Fiscal Situation in State and Local Governments," Federal Reserve Bulletin, vol. 76 (December 1990), pp. 1009-18. (9.) David Rapp, "Just What Your State Wanted: Great New Gifts from Congress," Governing, vol. 4, no. 4 (January 1991), p. 53. (10.) "Around the Nation," MuniWeek, April 13, 1992. (11.) The property tax hike as the second most common source of additional revenue; 72 percent of cities had increased the level of other fees and charges or imposed new ones during the preceding twelve months. The most common means of dealing with fiscal imbalances was reducing the rate of growth of operating outlays, reported by 73 percent of surveyed cities. In addition, 61 percent had reduced the actual level of capital spending. (12.) Data for the first half of 1992 are not shown in chart 7, as they are not available on a seasonally adjusted basis and would be inconsistent with the annual figures shown. The surge in offerings of public-purpose bonds in 1985 was due to a rush to beat proposed legislative deadlines related to tax reform. (13.) John E. Petersen, Catherine Holstein, and Barbara Weiss, The Future of Infrastructure Needs and Financing (Washington, D.C.: Government Finance Research Center of the Government Finance Officers Association, December 1988), p. II-2.