By Rom Badilla, CFA
Last week, we looked at how the resistance to spend by state and local governments has weighed on the building of new projects and infrastructure. While supply from refunding continues to chug along, the lack of appetite to spend has led to diminished new supply in the municipal bond market.
This reluctance to spend at the state and local level has much greater significance for the broader economy. According to Deutsche Bank's Chief Economist Joseph LaVorgna, municipal spending and employment have been a significant drag on economic growth. In the bank's latest U.S. Daily Economic Notes, he wrote:
"Though most analysts have focused on the upcoming "fiscal cliff" at the federal level, state and local (S&L) government spending is actually over 40% greater than federal spending, accounting for over 10% of real GDP (compared to 7.5% for the former). For the labor market, S&L employment is vastly more important, accounting for 14% of nonfarm payrolls compared 2.1% at the federal level. Up to this point in the recovery, S&L spending has on average subtracted approximately 0.4 percentage points from real GDP growth per quarter."
As you would expect, the biggest driver of S&L spending is revenue growth. The more money you bring in, the more latitude you have to spend. According to Deutsche Bank, revenue growth at the state and local level tends to lead spending by approximately seven quarters. So the question is what can we expect going forward?
Deutsche Bank's analysis shows that S&L revenues are improving as the economy continues to recover and as the consumer gets back on track.
According to the latest Census data from Q1, state tax revenues increased 5.5% compared to the same period last year. These gains were mainly due to 5.2% growth in individual income taxes and 4.5% growth in sales tax receipts (these two components comprise over 60% of total state revenues).
While revenues are improving, the bigger issue is housing. Since property taxes play an important role in local revenues, the housing crash and the search for the bottom continue to weigh on S&L governments.
The problem has been local government tax receipts, which continue to suffer the lagged effects of the housing downturn. Local government revenues were down -3.7% year-on-year in Q1 and have now contracted for five out of the last nine quarters. Property taxes account for approximately 80% of local revenues and tend to lag house prices by a substantial period - approximately three years.
As the economy shakes off the excess inventory that hangs over the market, coupled with improving lending conditions for some, the trough in the housing market is certainly a lot closer today than several years ago, assuming that it hasn't bottomed already. If a rebound does occur soon which ultimately leads to increases in revenue, state and local governments may be able to reverse the tide of budget cuts and layoffs. While this may take time to develop, given the lag that Deutsche Bank has indicated, any kind of improvement may partially offset the decline at the federal level.
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