The current fiscal situation in state and local governments - includes related information on the stock of public capital and productivity

Federal Reserve Bulletin, Dec, 1990 by Laura S. Rubin

This article was prepared by Laura S. Rubin of the Board's Division of Research and Statistics. Catherine B. Wood provided research assistance.

The fiscal position of state and local governments has deteriorated markedly during the past several years, with many governments confronting potential shortfalls in their operating accounts. Budgetary problems have been most severe in New England, New York, and New Jersey, partly as a consequence of slumping real estate markets and weakness in the defense, finance, and high-technology industries; but fiscal problems have been widespread.

The last half of the 1980s has seen the financial resources of the states pressured by several concerns: the quality of education and rising school enrollment, the deterioration of the public infrastructure, and mandates to improve the health care of the needy and to upgrade correctional facilities. Over the same period, revenue sources have dwindled; early in the 1980s, the federal government cut back its aid to the sector, and some states subsequently reduced their grants to localities. State and local governments made up some of the difference through tax policy, but tax collections have been lower than expected, particularly in 1988 and 1990.

This article describes the accounts of the state and local sector, discusses the recent spending requirements and revenue shortfalls that have precipitated the current budget woes, and gives a brief perspective on the outlook.

THE FISCAL ACCOUNTS OF STATE AND LOCAL GOVERNMENTS

Three fiscal accounts are important to a full understanding of the state and local budget situation--the relevant portions of the national income and product accounts (NIPA), the general fund accounts of the governments, and the accounts of the governments' social insurance funds covering their employees. A description of these accounts should help clarify the factors influencing the budgetary picture and avert potential misconceptions about, for example, balanced general fund accounts and social insurance funds.

Operating and Capital Accounts in NIPA

The combined operating and capital accounts of state and local governments as reported in NIPA (prepared by the Bureau of Economic Analysis in the U.S. Department of Commerce) give a broad view of the fiscal condition of the sector. These accounts cover all expenditures and revenues of the current fiscal year (proceeds of bond issues are excluded, although interest on state and local debt is part of outlays); NIPA operating and capital accounts exclude the social insurance funds, which consist of the funds for state and local retirement systems plus, in some cases, those for worker's compensation and disability. The aggregate operating account for the sector is not calculated separately from the aggregate capital account.

As reported in NIPA, the deficit of state and local governments grew from $3 billion at the end of 1986 to $30 billion in the first half of 1990. When scaled by state and local government expenditures, the current deficit is in the range last seen during the 1974 recession. Deficits of a similar magnitude, relative to expenditures, were chronic in the 1950s and 1960s, when construction spending for roads, schools, and other infrastructure--which is partly financed through the capital markets--made up about one-fourth of state and local outlays. In contrast, the rise in the deficit during the second half of the 1980s has not reflected a disproportionate surge in public capital spending. Even when building activity advanced in the mid-1980s, outlays for construction remained around 10 percent of expenditures.

The sector's deficits in the last few years have been the first since 1967 to worsen in the absence of a general economic downturn. As spending on infrastructure became less important in the late 1960s and early 1970s, the sector began to experience budgetary surpluses, except when recessions eroded tax bases and expanded the demand for resources. However, the recent deficits evolved during a period of economic expansion, which suggests that the imbalance between revenue collections and spending priorities ultimately will have to be corrected through tax increases or reductions in expenditures.

The General Fund Budgets

The general fund budgets of state and local governments--their main operating accounts--also have shown deterioration over the last several years. Among the states, general fund budgets represent an average of 60 percent of total outlays (excluding social insurance funds). The composition of the state general fund budgets varies considerably. (1) On the expenditure side, the budgets include compensation for employees as well as outlays for nondurable goods, other services, and interest expenses; but they typically exclude most spending for construction, which is usually reported in a separate capital account. (In contrast, cities and other local governments often include construction in their general fund budgets.)

In every state except Vermont, the general fund budget is required constitutionally or statutorily to be balanced, either within each fiscal year or over a two-year period. Typically, a balanced budget requires that revenues be at least as large as outlays, but states may use surpluses from the preceding fiscal year to achieve balance in the current year. If a shortfall is anticipated during the planning stages of a budget, which occur during the legislative session preceding a given fiscal year, state governments usually cut spending and increase taxes, fees, and charges. Proceeds of short-term debt offerings, and occasionally bonds, have been used by some states to cover shortfalls and "balance" their general fund budgets. Balancing techniques employed when shortfalls appear toward the end of the fiscal year include the postponement of certain payments until after the end of the year or the acceleration of some receipts into the year. In addition, certain functions may be moved outside the realm of the general fund budget. Thus, although a simple comparison of expected outlays and receipts from current resources may imply a deficit, considerable fiscal maneuvering can produce a balance," maneuvering that has been characterized as "the twilight zone of state fiscal procedures." (2)