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State and local government fiscal position in 1986.

State and Local Government Fiscal Position in 1986

THE surplus of State and local governments, as measured on a national income and product accounts (NIPA) basis, was $63 billion in 1986, $1 1/2 billion more than in 1985 (table 1). This stability in the overall fiscal position of State and local governments was the net result of a $3 billion increase in the surplus of social insurance funds and a $1 1/2 billion decline in the other funds surplus. In 1985, the social insurance funds surplus had increased $4 billion, and the other funds surplus had declined $10 1/2 billion. The sharp decline in the other funds surplus since 1984--from $19 1/2 billion to $7 1/2 billion--reflects a strong increase in capital spending financed by borrowing rather than an indication of current fiscal difficulty.1

Receipts increased $43 1/2 billion in 1986, $6 1/2 billion more than in 1985. The acceleration was accounted for by general own-source revenues (GOSR) and by Federal grants-in-aid, both of which were boosted by one-time oil-related payments. Contributions to social insurance funds slowed. Expenditures increased $42 billion, slightly less than in 1985. The deceleration was accounted for by purchases of goods and services.

1. In the NIPA's, State and local receipts exclude proceeds from borowwing, while spending financed by those borrowings is included in State and local expenditures. Consequently, when capital spending, which is largely financed by borrowing, increases, the other funds measure tends to move towards a deficit.


State and local government receipts increased 7 1/2 percent in 1986, one-half percentage point more than in 1985 (table 2). As mentioned earlier, GOSR accelerated slightly, as did Federal grants-in-aid. The step-up in the rate of increase in GOSR was accounted for by corporate profits tax accruals, which rebounded from a sharp decline in 1985. The other two categories in GOSR--personal tax and nontax receipts, and indirect business tax and nontax accruals--increased at about the same pace as in 1985.

Legislative actions in 1986 lowered personal income taxes $2 1/2 billion and increased sales taxes $1 billion, thus slowing the increase in GOSR by one-half of a percentage point. In the absence of these actions, personal taxes increased about 1 1/2 percentage points faster than in 1985, and sales taxes increased about 1/2 percentage point slower. (In the absence of both 1985 and 1986 legislative actions, sales taxes increased 6 percent in both years.)

Total receipts would have registered the same increase in 1986 as in 1985 if it had not been for two types of oil-related payments made to State governments. Both indirect business taxes--specifically, those labeled "other' in table 2--and grants-in-aid were larger because of these payments.

The first type of payment was the result of two court settlements involving earlier violations of Federal oil pricing regulations. The courts did not find a viable mechanism for determining which, or how much, individual consumers or business had been overcharged for oil or oil products and, therefore, decided that the funds would be allocated to State governments (on the basis of population, with the States mandated to spend the funds on specified energy-related programs). The first settlement involved a $2 billion fine paid by a major petroleum corporation, and the second involved payments by various owners of stripper wells, of which $1 billion was allocated to State governments. Excluding these payments, other indirect business taxes increased only 2 percent. That sharp deceleration from 1985 also was energy-related, reflecting large declines in severance taxes, revenues from leases of State-owned land, and royalties paid on discovered oil. These receipts, which had decelerated late in 1985 as the price of oil dropped, declined in 1986 as the price continued to fall.

The second type of oil-related payments accounted for about one-quarter of the growth in Federal grants-in-aid. In 1986, the Federal Government paid a total of $1 1/2 billion to five States for settlement of a dispute over revenue from leases on the Outer Continental Shelf and from royalties paid on discovered oil. Excluding these payments, grants increased only 5 percent.


State and local government expenditures increased 8 percent in 1986, compared with 9 percent in 1985 (table 3). As mentioned earlier, the deceleration was accounted for by purchases of goods and services. All other expenditures increased 9 1/2 percent in 1986, compared with 8 1/2 percent in 1985; the acceleration was accounted for by transfer payments to persons.

The slowing pace of purchases in 1986 would have been more pronounced if purchases of structures had not accelerated sharply. Purchases of structures have accelerated since 1984, funded by the large volumes of new borrowing for public capital purposes since late 1983. Largely because of lower inflation, other spending increased at a slower pace than in 1985.

Although purchases of goods and services in current dollars decelerated in 1986, they accelerated as measured in constant dollars (table 4). In general, the difference reflects a deceleration in the prices paid by State and local governments; the fixed-weighted price index for total purchases increased 4 percent, compared with 5 1/2 percent in 1985. The deceleration in prices occurred in all major categories of purchases except durable goods; prices for durables increased 2 percent in both 1985 and 1986. Prices for nondurable goods declined 9 percent in 1986 after being flat in 1985; falling prices for petroleum products were a major factor in the 1986 decline. Prices for structures increased 2 percent in 1986, compared with 6 percent in 1985. (Estimates for 1986 for the price indexes are shown in NIPA table 7.16.)

The acceleration in constant-dollar purchases was more than accounted for by purchases of structures, which increased 13 percent in 1986, compared with 7 percent in 1985. Almost all major categories of structures-- but especially educational buildings, office buildings, correctional institutions, and water and sewer facilities-- recorded strong gains in 1986. Although constant-dollar purchases of structures were at the highest level since 1975, they had been much higher--on average, 20 percent higher--during 1963-75.

The acceleration in transfer payments was in benefits from social insurance funds and in public assistance. In social insurance benefits, the acceleration appears--based on anecdotal information--to be the result of a larger number of "early-out' retirees in some of the Midwestern and Southwestern States experiencing fiscal difficulty. In public assistance, the acceleration was largely due to medical vendor payments, which comprise more than one-half of the category. Most of the 7-percent increase in these payments reflected continued increases in prices of medical services, rather than a substantially larger volume of services.2

2. Effective with the 1985 NIPA comprehensive revision, medical vendor payments are treated as transfer payments; previously they were treated as purchases.

Net interest paid rose about $1 billion. Interest paid decelerated, reflecting declining interest rates on new borrowing and a smaller addition to new borrowing. Interest receipts accelerated somewhat, reflecting investment of a larger propertion of proceeds from new borrowings.

Fiscal position

The State and local government other funds surplus declined only $1 1/2 billion in 1986, to $7 1/2 billion, despite the $8 1/2 billion increase in purchases of structures. This relatively small decline in the other funds surplus reflected two especially favorable developments: The $4 billion of oil-related payments and a marked deceleration, due to sharply lower inflation, in other purchases. Growth in compensation of employees slowed, primarily because of slower growth in average compensation, but also because employment growth was slightly lower in 1986.

On a quarterly basis, as shown in chart 6, the other funds surplus in 1986 was up sharply in the first quarter but then moved unevenly lower, dropping to $1 billion in the fourth quarter. Excluding the one-time oil-related payments, the decline from the end of 1985 is more pronounced.

One factor that moved the fourthquarter fiscal position toward a deficit was an extraordinary employer contribution to a locally administered retirement system. Los Angeles County borrowed to make a large one-time contribution ($1.8 billion at an annual rate) to the retirement system. The transaction substantially reduced the system's actuarially determined underfunding. For the locality, the debt service will be less costly than a schedule of contributions accomplishing the same reduction in the under-funding. (Such transactions are not likely to be repeated because the Tax Reform Act of 1986 severely limited arbitrage profits--of the sort generated by this transaction--from tax-exempt debt issuance. This transaction was allowed under a transition rule included in the Act.)

In contrast, the $1 billion other funds surplus in the fourth quarter would have been about $2 1/2 billion lower had it not been for large payments of declared State personal income taxes at the end of 1986. It appears that these revenues primarily reflect taxes due on capital gains realized at the end of 1986, when relatively favorable Federal tax treatment of capital gains was still available. Many taxpayers elected to pay State taxes on these gains--as well as other State income taxes--in 1986, in order to maximize the State income tax deduction on the Federal tax return for liability year 1986, when the Federal marginal tax rates were higher.

The move toward deficit at the end of 1986 did not take place under the same kind of conditions as did the move toward deficit at the beginning of 1983. At the beginning of 1983, State and local governments had used up reserves accumulated during the late 1970's. Further, they had increased taxes and had reduced staff and construction spending, the latter despite widespread concerns about the need for major new investment in infrastructure. Thus, the move toward deficit indicated deteriorating fiscal conditions. In contrast, at the end of 1986, when the continuing increase in purchases of structures was clearly the primary element, the move toward deficit did not indicate deterioration. In fact, employment was increasing, although modestly, and legislated tax reductions outweighed increases-- again, modestly.

However, as is often the case, such overall changes in the State and local government sector mask important contrasts in different geographic areas and at different levels of government. The geographic contrasts were evident in 1985 and even more so in 1986. Although sufficient data are not available to prepare estimates for individual States in a NIPA framework, the information available shows major differences between the fiscal positions of States in the East and much of the Far West, on the one hand, and those in the Midwest and Southwest, on the other. States dependent on oil-related revenues experienced fiscal difficulty in 1985; when oil prices declined more sharply in 1986, oil-related revenues declined further, and difficulties faced by Texas and Louisiana, among others, worsened. Similarly, high yields, weak prices, and declining export markets for agricultural commodities in 1985 caused problems for Iowa and North Dakota, among others. In 1986, these conditions persisted and the fiscal situation of farm States worsened. Both sets of problems will continue to affect major parts of the country for at least the near-term future.


Uncertainties make it difficult to assess the 1987 outlook for most major categories of revenues for State and local governments. In addition to the usual uncertainties about the pace of economic activity, the uncertainties about Federal grants-in-aid and the State-by-State response to the effects of the Tax Reform Act of 1986 on GOSR (primarily State) are especially important.

If economic growth for 1987 remains around 2 1/2 percent, and in the absence of effects from legislative actions, GOSR would increase around 7 percent. Legislative actions already taken will approximately offset each other; income tax reductions in Massachusetts, New York, and Ohio, among others, will be offset by sales and excise tax increases in Texas and Virginia, among others. However, it is likely that a number of other States will increase taxes--especially sales taxes--in 1987 legislative sessions. These legislative actions could bring the GOSR increase for 1987 up to the 8-9 percent range.

In the absence of further major program changes, Federal grants-in-aid will decline in 1987 by $5 billion; the end of general revenue-sharing in 1986 will account for most of that decline. It is likely that local governments will accommodate a substantial part of the loss through increases in property taxes and in fees for services. However, grants-in-aid for highways are a major source of uncertainty. The Surface Transportation Act of 1986 failed to pass at the end of the 99th Congress because of disagreements about demonstration projects, the Federal speed limit, and limits on billboards, rather than about basic authorization levels. If the disagreements are resolved by March, the probable effect of the delay in grant funding on highway construction spending will be minor. If the delay is longer, highway construction activity is likely to begin shrinking, perhaps by the second quarter of 1987.

The Tax Reform Act of 1986 broadened the Federal tax base for both corporate and personal income taxes and removed other provisions--notably the investment tax credit--that had held down tax liabilities. However, the act also reduced both corporate and personal tax rates. Because almost all States that levy taxes on incomes use references from the Federal tax code in defining their basis for tax, the 1986 act will affect both types of income taxes for States and localities. The extent to which the States are "coupled' to the Federal code varies widely, so the extent to which Federal changes will affect State revenue also varies widely.

The effect of the Federal tax changes on State corporate profits tax accruals for 1987 will probably be quite modest. Many States, in varying degrees, had "decoupled' their definitions of taxable income from Federal definitions with respect to Federal tax changes in the 1981-84 period. The Federal changes in 1986 bring Federal practice nearer to what these States have been doing since 1981. (Even for States that follow Federal practice in defining corporate taxable income, elimination of the investment tax credit, which is a major element in the increased liability for Federal corporate taxes, will not affect State taxes because the elimination of the credit does not affect the definition of taxable income.)

For personal income taxes, there are two uncertainties in 1987. First, will States choose to conform to the Federal tax changes expanding the taxable income base? Second, if they choose to conform, when will they modify withholding tables? The States taxing personal income can be put in four groups. (1) Four States set tax liability as a function of Federal liability, and withholding rates are set accordingly. Three of these States have already acted to offset the effect of the Federal change, and the remaining State will probably do so. (2) About a dozen States will, in the absence of action, automatically conform to the broader Federal base. Most of these will probably elect to retain the additional revenues, but the two largest States in the group almost certainly will lower tax rates, offsetting the broader tax base with respect to its effect on revenue. Those that do not lower their tax rates will, for the most part, not change withholding rates in 1987, so most of the additional revenues will appear in net final settlements in 1988. (3) Five States are sufficiently "decoupled' from the Federal definition of taxable income so that there will be little or no direct effect from the Federal action. (Indirect effects--for example, very low new deposits into individual retirement accounts because they are no longer deductible in deriving Federal taxable income even if States continue deductibility--are beyond the scope of this article.) (4) The remaining States--about 20--will need to take legislative action if they wish to conform. Many are likely to retain any additional revenues. Withholding rates are unlikely to be changed in 1987, so the additional revenues will appear in net final settlements in 1988. Overall, it appears that personal income tax liability for States and localities is likely to be increased in 1987 by the Federal changes, but most of the effect will not be evident in payments until early 1988.

Uncertainty about the growth of expenditures in 1987 is in part associated with the highway grants-in-aid discussed earlier. On the assumption that Federal grants in 1987 do not decline by more than about $5 billion-- including a timely resolution of the highway legislation--purchases of structures should be about 10 percent higher in current dollars than in 1986. The large new borrowings for public capital should provide for continued high levels of public construction spending in the near term. However, if the decline in total grants is significantly more than $5 billion, or if concerns about the economy cause States and localities to become more cautious, structures spending could well decline sharply, especially in the latter part of 1987.

For other types of purchases, compensation will probably continue to increase at about 7 1/2 percent, and other purchases of goods and services will probably accelerate modestly in 1987 on the assumption that the absence of inflation in both durable and nondurable goods in 1986 will not recur. Total purchases, as well as total expenditures, should increase about 8 to 9 percent.

Overall, these changes would result in a NIPA surplus of around $55 billion, down from $60 1/2 billion in 1986. The social insurance funds surplus should increase to about $60 billion, resulting in an other funds deficit of $4-5 billion. The expected move into deficit for the other funds measure in 1987 is primarily a reflection of continued increases in debt-financing for purchases of structures, although it also reflects fiscal difficulty in some States and localities.

Table: 1.--State and Local Government Receipts, Expenditures, and Surplus or Deficit, NIPA Basis

Table: 2.--State and Local Government Receipts, NIPA Basis

Table: 3.--State and Local Government Expenditures, NIPA Basis

Table: 4.--State and Local Government Purchases in Constant Dollars

Photo: CHART 6 State and Local Government Surplus or Deficit, NIPA Basis
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Author:Levin, David J.
Publication:Survey of Current Business
Date:Feb 1, 1987
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