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Reaction to recession: state and local government in Texas.

Economists often say that the chance of an economic downturn as deep as the Great Depression is very slim because of the various "built-in stabilizers" that characterize our modern economy. These stabilizers include government programs in which the amount of money spent goes up when the economy goes down. One such stabilizer is unemployment insurance, which injects money into the economy in direct proportion to the level of unemployment.

One of the primary policy aims of the federal government is economic stabilization. No similar goal exists for state and local governments. However, researchers have observed that the spending of state and local governments tends to be countercyclical, cushioning troughs and dampening peaks in the business cycle.[1]

As a recession begins, property values decline, incomes fall, and consumers spend less. The diminishing of the tax bases induces a reduction in tax collections. At the same time, demands for government aid for low income groups increase because more people qualify. Inasmuch as state and local governments are not supposed to finance operating expenses with debt, we would expect them to raise tax rates and reduce spending in order to balance their budgets. Accordingly, if they reacted in this manner, we would expect government expenditures and employment to follow the overall business cycle.

Governments, however, do not behave in this way. This is evidenced by the chart, which compares the growth in total employment in Texas to growth in government employment for the last eleven years. (The figures plotted represent a six period moving average of annual growth computed monthly.) The countercyclical nature of government employment is apparent in the period immediately following the oil price collapse of 1985. While the state was plunged into one of its worst recessions in history, the growth of government employment increased noticeably. When total employment began to recover in 1986, the government growth rate fell.

In Texas cities, the same pattern prevails. Dallas, for example, suffered a 1 percent decrease in nonagricultural employment in 1986, but city employment for police, fire, and sanitary services increased by 5 percent that year. The following year, the city grew a scant 1 percent, but city employment for police, fire, and sanitary services increased a remarkable 8.6 percent.

Why Is State and Local Government Spending Countercyclical?

State and local governments are incapable of responding quickly to business conditions. Spending plans are locked in during regular sessions of the legislature. Even if a special belt-tightening session were held, it would take time for the changes to take effect. Spending is often frozen because the government is bound by long-term purchasing contracts or other obligations. In Texas, for example, billions of dollars of state spending on prisons and mental health facilities are locked in by federal court order.

The above factors combine to make it difficult to reduce spending even when there is fiscal pressure from a recession. On the revenue side of the budget there may also be no relief because it is unlikely that state legislators or local authorities will want to enact a tax increase during a recession. This goes double in an election year.

If the recession is long-lived, the state and local authorities will be subjected to budgetary pressure and will have enough time to increase tax rates and reduce spending. Just as the sheer inertia of the government prevented rapid correction in the downward phase of the recession, the same inertia will keep tax rates high and spending low during the expansionary phase of the business cycle. During this period, state and local governments will rebuild reserves because tax revenues are growing and spending remains at a recessionary level.

Even though state and local governments are supposed to operate on a "pay-as-you-go" basis, they can draw upon reserves to survive a recession, using any one of several means to do so. For example, they can draw down account balances, sell assets, tap reserved funds such as highway funds or employee retirement trust funds, delay payments, accelerate tax due dates, or simply live off bond money by performing accounting tricks. Most of these responses are one-shot deals, and, as the recession wears on, fewer and fewer stopgap measures remain. Texans will recognize many of these expedient measures from the last two sessions of the Texas legislature.

What Will the Future Bring?

Because it has no income tax, Texas state government is less vulnerable than other states to revenue shortfalls. In those states with an income tax, the reduction in personal and corporate income that occurs during a recession affects income tax revenues directly and state sales taxes indirectly through a reduction in consumer spending. Without an income tax, Texans suffer only the indirect consequences of reduced consumer spending. This effect is smaller than the direct income effect because consumers try to maintain their previous standard of living during a downturn. While our lack of vulnerability on the income tax front helps, it was not enough to shield us from the results of the collapse of the real estate market. This collapse depressed the property tax base of local governments, causing widespread losses of property tax revenues.

Texas was just recovering from the oil price collapse of 1985 when the national economy began its recession. The national recession nipped the Texas recovery, resulting in a six year period of consistent fiscal pressure on both state and local government budgets. By now, the stopgap measures have pretty much been exhausted, and governments have had enough time to enact belt-tightening measures.

If the national economy continues its modest recovery, then the fiscal pressure on state and local governments in Texas will ease, and they will enter the rebuilding phase of their cycle. However, if the national recovery fizzles, the pressure on our already stressed state and local budgets will become unbearable. State and local governments will be forced to respond by reducing flexible expenditures and increasing taxes. These actions will not constitute a stabilizing effect, but will instead contribute to the downward spiral of the economy.

The budgetary pressure will be strongest on the local governments as the state government shifts the burden to them by reducing state support for local programs. Similarly, the state can expect little help from the federal government as it will continue to shift its burdens to the states.

1. Richard H. Mattoon and William A. Testa, "State and local governments' reaction to recession," Economic Perspectives, March/April 1992, pp. 19-27.
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Title Annotation:government spending analysis
Author:Olson, Jerry
Publication:Texas Business Review
Date:Jun 1, 1992
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