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Local and state finances receive very little national attention. Across the most recent economic crisis local government finances have taken an epic battering. The situation in California has received some attention, less than it deserves. The terrible toll of past policy and present economic weakness has not been drawn out into the light of debate.

This short article seeks to start the conversation for three reasons. First, the financial condition in our 50 states, 3000 counties and 36,000 municipalities is severe. Second, state and local governments employ almost 10% of the US population and have been firing folks at a brisk clip. Third, contraction in state and local government hiring, spending and service provision threatens to lower economic growth and retard the income and opportunity expansion that state and local finances badly need.

We are early into a decentralized, local austerity program similar to the packages being debated and implemented in the eurozone.

How Bad Is It?

Bad. The states are in serious difficulty. As the recession began in late 2007 states were already spending at a fairly high clip and taxing at relatively low rate levels. As recession took hold demands for state services- direct and through aid to localities- increased sharply. States rely heavily on income and sales taxes. Consumption fell, employment fell and wages were stagnant to down. This reduced major sources of revenue.

US states continue to face record demands for services, pension costs and health care costs. States have unfunded health and pension liability claims that run many hundreds of billions to trillions of dollars. Revenues are significantly down from 2007 levels. From 2003-2007 states were beneficiaries of revenues from booming construction, housing markets and retail spending. Housing has been in the worst recession in living memory and the average house price is off more than 27% since 2006.

Declining personal income tax receipts, falling corporate income tax receipts and declines in sales tax have created one of the largest declines in income to US states in modern history. 2010 is shaping up to be a better revenue year than 2009. However, there will be widespread and long term deficits in most states. States face over $110billion in budget shortfall in 2011. Many states have been getting by through a combination of federal assistance and issuing federally subsidized bonds- Build America Bonds. These two short term measures will be trailing off across 2011.

Direct stimulus will be declining across the next 12 months. This will occur as localities will come to states with enhanced demands. For some localities there will be talk of emergency assistance to prevent issues with bond repayment. Clearly, the vast majority of municipal bond obligations will be paid in full and on time. There are vast differences in the ability of different authorities and localities to honor financial commitments. Vastly different state and local laws, procedures and financial situations define the muni space. Thus, there are both enticing opportunities and some serious risks hiding in a space that is often under differentiated by investors. Localities that are highly reliant on state level assistance and Build America Bonds are likely to have a tumultuous 2011.

Localities relay on state assistance for nearly $1 in every$3 that they spend. Local government and authorities depend heavily on property taxes for the balance of their income- in some cases sales taxes. The massive decline in property values in the US over the last few years will begin to put pressure on already stretched local and municipal budgets. It takes several years for falling property prices to show up in declining revenue to localities. Property is reassessed only every few years. State aid will be in decline as Federal stimulus to states will trail off this year and states are in dire financial health. Local areas spend more than half their budgets on education and social services. These budgets are under significant and growing pressures.

Like states, most municipalities have a fiscal year that ends in June and begins in July. Look for battles over wages, benefits and employment levels to heat up this spring. Massive pressure to lower costs and employment at the state and local level are here and are likely to grow more intense soon. Lastly it looks like Christmas 2010 will mark a high point for online retailers. This phenomenon is likely to create less local and state tax revenues despite an uptick in total consumer spending. Much internet purchase allows buyers to reduce or eliminate sales tax and generally does less for local business activity.

According to research from the Congressional Budget Office (CBO), local governments have cut their spending by 2% and reduced their workforces by 241,000 since the start of this recession. [[i]] Bureau of Labor Statistics (BLS) data shows that states have reduced their payrolls by 166,000 between November of 2009 and November 2010. [[ii]]

There is every indication that these trends, state and local, will continue and are likely to become more dramatic. As payrolls are cut we should expect less service provision despite the continued high demand for services. This is a recipe for stresses in public educational institutions, law enforcement, colleges, universities, infrastructure and other social services. The reductions in spending and employment at the state and local levels will reduce economic growth. Reduced growth is likely to acutely affect lower income populations.

Rising local property taxes, rising sales taxes and declining services at the state and local level are regressive. Taxes that land hard on lower and middle income households will rise and services to these households will fall. This is likely to create slower economic recovery and might result in higher crime and discontentment rates.

Headwinds

The most recent tax bill reduces the income tax levels on more affluent Americans, for 2 years. This is likely to hurt localities. Municipal bond markets are how localities and local authorities- schools, utilities, water facilities- raise money for projects. Municipalities sell bonds to spend above revenues. Investor income from these bonds is usually double or triple tax exempt. The higher the investor’s tax rate, the more appealing municipal bonds are. Cutting the tax rate on higher income earners lowers the appeal of municipal bonds.

Additionally, there is growing worry that we are likely to see rising defaults or attempts to renegotiating debts from municipalities over the next 6 to 18 months. Our recent tax cut will further complicate the present difficulties in the municipal bond market. A Federal Program- part of the stimulus- has been subsidizing the interest cost of local bond issuers, Build America Bonds. This is set to expire after 2011.

There is every reason to believe that states and localities will continue to reduce spending and employment. This will mean fewer and more stressed budgets and personnel dealing with historically high levels of need. At risk communities are already suffering from weak labor markets, low wages and the end of unemployment benefits. We are likely to see public sector unions weakened.

There is a great coming fight about public sector pension benefits. Beginning in February and March 2011 there will be several rounds of contentious and dramatic suggestions of social spending cuts as Congress is required to debate and vote on raising the national debt ceiling. Federal and state finances are precarious. Less help at more political cost will be the order of the day after April 2011.

The vast majority of municipal obligations will be paid in full and on time. However, general conditions will strain and politicize local budgets, pension funding issues and bond payments. Payments that rely on state help, Build America Bonds, or bottom up economic recovery are poorly positioned.

Across 2011 investors will be rewarded for deep knowledge about the particular conditions surrounding the municipal debt in their portfolios. The reward to disaggregating the municipal credit market will be robust in 2011. Got local knowledge?


[i] Congressional Budget Office, Economic and Budget Issue Brief December 2010 (see here).

[ii] BLS. Table B.1 (here).

Source: Municipal Debt: Got Local Knowledge?