Journal Issue

United States of America: Selected Issues

International Monetary Fund
Published Date:
August 2003
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V. Budget Crisis of State and Local Governments in the United States: Will it Hinder Economic Growth?1

1. Following a decade of strong revenue growth, state and local governments (SLGs) are now facing significant budget shortfalls for a third consecutive year. At a time when the federal government has embarked on expansionary fiscal policies to support economic activity, these shortfalls have raised concerns that corrective budgetary measures taken by SLGs could offset some of the federal stimulus and dampen economic activity. This chapter reviews the principal causes of the state and local fiscal crisis and attempts to quantify its macroeconomic implications.

A. State and Local Government Finances in the United States

2. The SLG sector represents an important and growing part of the overall economy. Current expenditures by SLGs have grown strongly in recent decades, accounting for nearly all of the 7 percent of GDP increase in general government spending since 1960 (Table 1).2 Moreover, SLG investment has remained essentially constant in relation to GDP over time, which—given the decline in federal investment—has also made SLGs the principal source of public investment. Growing SLG expenditures have been financed by tax and other revenue increases, amounting to 4½ percent of GDP since 1960, as well as an increase in federal grants of 2 percent of GDP. Indeed, federal grants have become significantly more important for SLGs, accounting for almost one quarter of total revenues in 2002 (Table 2).

Table 1.Government Revenues, Spending, and Investment(In percent of GDP)
Current receipts
General government 1/24.927.427.727.5
Federal government17.618.718.217.9
State and local governments8.011.311.412.5
Federal grants-in-aid to state and local governments0.
Current expenditures
General government 1/22.729.030.629.9
Federal government16.320.621.219.9
Federal grants-in-aid to state and local governments0.
State and local governments7.211.011.413.0
Gross Investment
General government5.
Federal government2.
State and local governments2.
Source: National Income and Product Accounts.

Excluding intergovernmental transfers.

Source: National Income and Product Accounts.

Excluding intergovernmental transfers.

Table 2.State and Local Governments: Composition of Receipts(In percent of total receipts)
Personal income tax receipts6.013.416.215.4
Corporate profits tax accruals3.
Sales taxes28.726.227.625.6
Property taxes38.421.724.320.5
Contributions for social insurance1.
Federal grants-in-aid9.522.816.823.4
Source: National Income and Product Accounts.
Source: National Income and Product Accounts.

3. SLG spending and federal grant receipts have increased strongly, partly in response to expenditure mandates by the federal government. In the United States, SLGs are the primary provider of government services such as education, public infrastructure, and public health and safety for which they receive grants, loans, and tax subsidies from the federal government. In recent years, however, over half of federal transfers have been directed toward income support and health care programs, including welfare, Medicaid, and education.3 This shift reflects a growing proportion of state expenditure being channeled toward these programs, owing to federal mandates that specify the level of services provided by the states. For example, states participating in Medicaid must administer their programs in a manner consistent with the requirements of the Medicaid Act, which specifies and defines categories of medical services for which federal reimbursement is allowed, and requires that states cover mandatory categories (O’Connell, et al., 2003).

4. However, there is little coordination of federal and state tax policies, with the result that states differ greatly in how taxes are raised. The Constitution grants federal and state governments independent taxing powers, and local governments derive their taxing powers from state governments. As a result, each level of government imposes and administers its taxes independently, and there are no tax-sharing arrangements between the federal and state governments (Stotsky and Sunley, 1997).4 However, states typically piggyback on the federal income tax code by using federal definitions of personal and corporate taxable income before applying state-specific adjustments. For corporate taxes, most states also use the depreciation schedule applied by the federal government. Nonetheless, the degree of conformity between federal and state tax systems differs significantly across states.

B. Recent Developments in State and Local Government Finances

5. The economic downturn in recent years has contributed to a significant deterioration in the fiscal position of state and local governments. At the end of the 1990s, SLGs were running substantial current surpluses—up to around ½ percent of GDP—benefiting from increased spending discipline and solid economic growth (Figure 1). With the economy weakening, however, state and local governments fell back into deficit in late 2000, with current deficits reaching a post-war peak of ½ percent of GDP in 2002. The budgetary situation appears to remain very difficult—a deficit exceeding ¾ percent of GDP seems likely in FY 2004, with almost 90 percent of states projecting revenue shortfalls that will exceed 5 percent of their general funds.5

Figure 1.State and Local Governments: Current Balances

6. The shift to deficits was partly caused by a sharp increase in cyclical and health-related spending (Figure 2a). Health-related spending grew by ½ percent of GDP during this period, mostly driven by Medicaid spending (Figure 2b, Table 3). This reflected in part the effects of higher demand for Medicaid during the recession, but decisions by many states to increase the generosity of the system during the 1990s, as well as broader pressures on U.S. health care costs, also played a major role (NASBO and NGA, 2003). Moreover, in response to a tighter labor market and rising unemployment rates, SLG spending on income-support and welfare programs rose by 0.1 percent of GDP between 1999 and 2002.

Table 3.State and Local Governments: Composition of Spending and Investment, 2002(In percent)
General public service9.69.3
Public order and safety14.14.6
Economic affairs8.337.7
Housing and community services0.68.9
Income security8.60.7
Source: National Income and Product Accounts.
Source: National Income and Product Accounts.

Figure 2.United States: Revenues and Expenditures of State and Local Governments

Source: Haver Analytics.

7. At the same time, a sharp drop in income tax collections hurt states on the revenue side. Corporate and personal income tax revenues represent roughly one fifth of total state receipts, and both these revenue sources declined by roughly ¼ percent of GDP during 2001–2002 (see Table 2). Other revenue sources, including sales and property taxes, remained relatively robust, reflecting the strength of consumer demand and the housing market.

8. Several factors have contributed to the sharp decline in income tax revenues:

  • The economic slowdown dampened labor incomes, and the collapse of the stock market severely eroded capital gains, especially in California and on the East Coast, where a considerable amount of personal wealth resides (Figure 2c).
  • States had responded to the revenue boom of the late 1990s by cutting tax rates, including on property, which left them more dependent on cyclically-sensitive revenue sources such as income tax (Figure 2d).6
  • Tax cuts at the federal level have also had a (relatively modest) effect on SLG revenues—the 2001 and 2003 tax cuts are estimated to lower state tax revenues by about $5 billion.7

C. Balanced Budget Rules and Fiscal Adjustment

9. Most states are obliged to maintain “balanced budgets,” but this requirement did not impose a hard fiscal constraint until recently. All states but one have balanced-budget requirements, determined either by state constitutions or state law.8 However, this constraint typically applies only to current budgets, and states are permitted to borrow to fund capital spending. Moreover, there is often some scope to circumvent balanced budget constraints on a temporary basis. For example, many states are only required to balance their budgets on an ex ante basis, and most states have scope to delay payments to shift spending into future years by building arrears (NASBO, 2002). In addition, until recently, states have been able to draw on significant reserve funds accumulated during the surplus years of the 1990s.

10. However, the depletion of reserve funds means that more difficult adjustments lie ahead. By the end of FY 2000, state reserve funds stood at about 10 percent of state expenditures, compared to less than 5 percent at the end of the 1980s (Table 4). In recent years, some 16 states have had to cover their deficits by drawing down these reserves, leaving overall reserve balances virtually exhausted by end-FY 2003. This has led some commentators to argue for an easing of legislative limits on the size of rainy-day funds; some studies estimate that states would need reserves of more than 18 percent of expenditures to accommodate a macroeconomic shock of the magnitude of the 1990–91 recession (Lav and Berube, 1999).

Table 4.State Government Budget Reserves(In billion of dollars, FY)
2000200120022003 1/
Total reserves 2/48.841.022.06.3
Source: Center for Budget and Policy Priorities, National Governors Association.


Sum of general fund balances and rainy-day funds.

Source: Center for Budget and Policy Priorities, National Governors Association.


Sum of general fund balances and rainy-day funds.

11. States have already made substantial adjustments to control budget deficits in FY 2002 and FY 2003. On the spending side, measures have included hiring freezes, cuts in spending for prisons, education, childcare, and support for local governments (NASBO and NGA, 2003). Medicaid spending has been largely excluded from cuts because of cost-sharing arrangements with the federal government, but states tightened eligibility requirements for optional participants and adopted several cost-saving measures.9 Little emphasis, so far, has been placed on tax hikes, but states may have some recourse to tobacco settlement funds, which amounted to $32 billion between 1998–2002 (Lindblom, 2003), to cover revenue shortfalls.

12. Nevertheless, states were also forced into higher borrowing, which in part appears to reflect efforts to reclassify operating expenses as capital expenditures.10 This has caused market debt owed by state and local governments to increase from 12 percent of GDP in 2000 to 14 percent in early 2003, still well below the 18 percent peak during the 1990–1991 recession (Figure 3). State credit ratings and risk premiums have not been significantly affected so far, except for several states that are facing more severe financial difficulties (Figure 4).11

Figure 3.State and Local Governments: Credit Market Debt

Figure 4.State and Local Budget Balances and Spreads on SLG Debt

13. Budget difficulties are expected to worsen in FY 2004. Surveys by the National Governors Association suggest that more cuts in program expenditures, including education, human, health services, and aid to local governments, are likely to take place. As a result, state spending is expected to fall by around ¼ percent in real terms in FY 2004. In addition, governors in 29 states have recommended tax and fee increases for FY 2004 with an expected yield of $17.5 billion (or 0.2 percent of GDP)—the largest since 1979.

D. How Much of a Drag on Growth?

14. The prospect of significant budgetary adjustments by SLGs raises questions about the possible effects on the broader macro-economy and the recovery. The policy response by SLGs is likely to be procyclical and work against the substantial stimulus that has been injected by the fiscal and monetary authorities at the federal level.

15. Such concerns are partly alleviated by the fact that the size of budget shortfalls is relatively modest. For example, the analysis of changes in structural balances of the general and federal governments indicates that the adjustment by SLGs necessary to satisfy their balance-budget requirements would result in a fiscal contraction of about ¼ percent of GDP in 2003, offsetting only a small part of a 1¾ percent of GDP fiscal stimulus injected at the federal level. Moreover, SLG policies are not expected to add to the slight withdrawal of federal stimulus in 2004 (Table 5).

Table 5.Fiscal Impulse By Level of Government(Calendar year data; in percent of GDP)
Change in actual balances (NIPA basis)
General government0.7-1.9-3.0-1.80.6
Federal government0.5-1.6-2.7-1.90.4
Change in structural balances
General government0.5-1.1-2.7-1.50.4
Federal government (budget basis)0.5-1.2-2.4-1.70.4
Sources: Budget of the U.S. Government, various issues; and Fund staff estimates.
Sources: Budget of the U.S. Government, various issues; and Fund staff estimates.

16. Significant uncertainty surrounds estimates of the impact of fiscal policy on output. Most estimates for the United States place fiscal multipliers in the range of 0.3–1.4 for spending increases and 0.2–1.3 for tax cuts (Hemming, et al., 2002).12 The low end of these ranges are consistent with the view that the demand-side effects of expansionary fiscal policy are offset by Ricardian effects—i.e., private saving rises in response to fiscal expansions as households prepare for higher future taxes. Indeed, some studies have suggested that fiscal multipliers can turn negative if fiscal policy increases uncertainty or is expected to crowd out private investment (Caballero and Pyndick, 1996; Krugman and Obstfeld, 1997).

17. The uncertainty that surrounds these multipliers is illustrated by the results of simple vector-autoregression (VAR) model. The VAR approach allows for feedback among macroeconomic and fiscal variables, and has been used in a number of studies to assess the effects of monetary and fiscal policies on output (e.g., Blanchard and Perotti, 2002). The model employed in this study uses quarterly data on the output gap and both federal and SLG fiscal variables, in order to be able to take into account feedbacks between policies at both levels of government. The specific fiscal variables were: tax revenues net of transfers to persons; public consumption expenditure; and federal grants to SLGs. Fiscal variables were expressed as a ratio to GDP and detrended, using an HP filter to exclude long-term trends in the fiscal variables. Revenues and expenditures were also adjusted to exclude intergovernmental transfers. Four lags were employed in the VAR estimation, as suggested by several information criteria tests.

18. The results indicate that SLG spending and tax policies could have a significant temporary impact on real GDP. A one standard deviation shock to the share of SLG consumption spending in GDP would reduce the output gap—hence increase GDP—by 0.4 percentage points immediately, with the effect slowly decreasing to almost zero by the fifth quarter.13 At the same time, a similar one standard deviation shock to SLG net taxes would have negligible effect on GDP in the first quarter, with the impact slowly building and reaching almost 0.4 percentage points in the fifth quarter. The effect of the tax shock dissipates completely after 6 quarters (Figure 5).14

Figure 5.United States: Dynamic Responses of the Output Gap to Fiscal Variables

Dotted lines indicate two standard deviation range

19. The results also indicate that fiscal policies of SLG have stronger impact on real GDP than the federal government. For example, a one percentage point increase in net federal taxes as a share of GDP would have no significant impact on the output gap, while similar increase in federal spending would reduce the output gap by about 0.2 percentage points in the first quarter. However, the latter effect would entirely dissipate after three quarters.


    Blanchard, O., and R.Perotti,2002, “An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output,” Quarterly Journal of Economics, Vol. 117, No. 4, pp. 1329–68.

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    Caballero, R., and P.Pyndick,1996, “Uncertainty, Investment, and Industry Evolution,” International Economic Review, Vol. 37, No. 3, pp. 641–62.

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    Financial Times, 2003, “U.S. States Borrow More to Ease Financial Crunch” (May12).

    Hemming, R., M.Kell, and S.Mahfouz,2002, “The Effectiveness of Fiscal Policy in Stimulating Economic Activity—A Review of Literature,” International Monetary Fund Working Paper No. 02/208.

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    Johnson, N.,2002, “The State Tax Cuts Of The 1990s, The Current Revenue Crisis, and Implications for State Services,” Center on Budget and Policy Priorities.

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    Johnson, N.,2003, “Federal Tax Changes Likely To Cost States Billions Of Dollars In Coming Years,” Center on Budget and Policy Priorities.

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    Krugman, P., and M.Obstfeld,1997, International Economics: Theory and Policy (4th ed.), Reading, Massachusetts: Addison-Wesley.

    Lav, I., and A.Berube,1999, “When it Rains, It Pours. A Look at the Adequacy of States Rainy Day Funds and Budget Reserves,” Center on Budget and Policy Priorities.

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    Leighton, K.,2003, “State Fiscal Relief Provides an Opportunity to Safeguard Medicaid Budgets,” Center on Budget and Policy Priorities.

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    Lindblom, E.,2003, “Actual Payments Received By The States From The Tobacco Settlements,” The National Center for Tobacco-Free Kids (January15).

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    McLaughlin, A.,2002, “Recent Federal Tax Legislation and the States,” National Conference of State Legislatures.

    NASBO (National Association of State Budget Officers), 2002, Budget Processes in the States, Washington, D.C.

    NASBO (National Association of State Budget Officers) and NGA (National Governors Association), 2003, The Fiscal Survey of States, Washington, D.C.

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    New York Times, 2003, “22 States Limiting Doctors’ Latitude in Medicaid Drug,” (June16).

    O’Connell, M., S.Watson, and B.Butler,2003, Introduction to Medicaid: Eligibility, Federal Mandates, Hearings and Litigation, Southern Disability Law Center.

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    Pesaran, H., and Y.Shin,1998, “Generalized Impulse Response Analysis in Linear Multivariate Models,” Economic Letters, Vol. 58, No. 1, pp. 17–29.

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    Rivlin, A.,2002, “Another State Fiscal Crisis: Is There a Better Way?,” Welfare Reforms and Beyond, Policy Brief No. 23, The Brookings Institution.

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    Standard & Poor’s, 2003, “No Relief for States under Bush Proposal; Credit Outlook Remains Bleak.”

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Prepared by Iryna Ivaschenko.


State and local governments are typically aggregated because the breakdown of data between these two levels of government varies across states (see Stotsky and Sunley (1997) and references therein). Local government expenditures were of roughly the same magnitude as those of state governments during 1960–1990.


Federal grants for Medicaid are currently administered on a cost-sharing basis, with the federal share varying across states—from 50 percent to 80 percent—depending on state’s per capita income. Welfare programs are financed on a block-grant basis.


Historically, state estate taxes have been set equal or above the federal estate tax credit—a credit that taxpayers receive against their federal estate tax liability for state estate and inheritance tax payments. However, the federal estate tax is scheduled for repeal beginning in 2005 under the Administration’s 2001 tax package.


In most states, the fiscal year runs from July 1 to June 30. The budgetary forecast for FY 2004 is based on data provided by 41 states to the National Conference of State Legislatures through April 2003; and on data from NASBO and NGA (2003).


Johnson (2002) estimates ongoing revenue losses from tax cuts at around $40 billion. See also Rivlin (2002).


Specifically, the following measures in the Economic Growth and Tax Relief Reconciliation Act of 2001 affected states taxable income base: the increased standard deduction, new rules for individual retirement accounts, and additional deductions for education expenses. In addition, the recently enacted Jobs and Growth Tax Relief Reconciliation Act of 2003 is likely to further reduce state tax revenues. The “bonus depreciation” tax break for corporations, additional deductions for small and mid-size businesses, and increases in deduction for married couples are estimated to cost states $3 billion in lost revenues, absent any measures by states to undo the effect (Johnson, 2003; McLaughlin, 2002).


Vermont does not have balanced-budget restrictions of any form.


These included tightening eligibility requirements and creating preferred drug lists. Currently 19 states have authorized the use of such lists, compared to three states two years ago, according to the National Conference of State Legislatures. Drug expenses are one of the largest Medicaid spending items (New York Times, 2003).


State and local governments can borrow to ease short-term revenue shortfalls. Stotsky and Sunley (1997) also note that some state governments used short-term borrowing to conceal deficits in their operating budgets.


Premiums have widened for California, New York State and New York City (Financial Times, 2003).


Most of these results were obtained for the general government.


Generalized impulses—a modification of the Cholesky factorization that does not depend on the VAR ordering—are used in the estimation. See Pesaran and Shin (1998) for details.


The estimation results should be interpreted with caution since most components of SLG budget data available in the National Income and Product Accounts (NIPA) are available only with a two-year lag and the most recent data are estimated. In addition, most quarterly data are being interpolated from the annual data.

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