Can Healing State Finances Offset the Federal Fiscal Mess?

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Source: http://www.flickr.com/photos/teegardin/

Here we are, 11 days into a partial shutdown of the U.S. federal government and just six days away from exceeding our borrowing limit. This is what happens when the political equivalents of the Hatfields and McCoys occupy Congress.

Factoring out the political circus, the U.S. economy actually seems to be meandering toward recovery. The labor market has improved steadily, if modestly, since headline unemployment peaked at 10 percent in October 2010; inflation has remained in check (it’s low, if anything); and the housing market has been a boon for overall growth.

As the economists at the U.S. Federal Reserve would put it, the economy is improving at “a moderate rate.” Whether the ongoing shutdown and debt ceiling brinkmanship will derail the economy remains to be seen.

But with the political environment in Washington so toxic, it can be difficult to muster any economic optimism. Confidence in the economy, as measured by Gallup’s Economic Confidence Index, has plummeted pretty much since the beginning of September. The index read -15 at the beginning of last month and has since fallen to -35, its lowest level since 2011.

This dramatic decline has been fueled, unsurprisingly, by pessimism over the toxic political situation in Washington. Government is a massive contributor to overall economic activity — total government spending approached $3.5 trillion in 2013, equal to nearly 40 percent of gross domestic product — and employs nearly 7 percent of the population.

With this in mind, the partial shutdown has been bad but not catastrophic. However, the federal government only takes in enough money to pay about two-thirds of its bills. This means that if no deal is passed to increase the borrowing limit, approximately one-third of the nation’s financial obligations will be unmet. Government spending will decline enormously overnight and send a shockwave throughout the economy.

This situation — let alone the specter of a default on U.S. sovereign debt — is why CNN has an armageddon clock dramatically ticking away relentlessly onscreen.

But while the federal government trips incompetently over itself and embarrasses the country, there is still some good news coming out of the woodwork. Take, for example, a recent report compiled by the the Rockefeller Institute of Government, which shows that after being ravaged by the late-2000s recession, fiscal houses at the state level are looking pretty good.

The story at the state level is obviously variable, but a majority of states are reporting strong and sustained increases in tax revenues. It’s not necessarily the best way to diagnose the health of an economy, but outside of a tax hike, tax revenues only increase when people are making more money (income tax) and property values are climbing (property tax).

And while tax increases can certainly explain some gains — and “accelerated” income from future higher taxes, or the fear of future higher taxes can explain others — overall state tax revenues have increased for 13 consecutive quarters, surging 8.6 percent on the year in the first quarter of 2013.

Fig 1

Source: http://www.rockinst.org/newsroom/revenue_reports/2013/2013-08-08-SRR_92.pdf

To be clear, improved economic activity is not at the heart of the first-quarter pop. The Rockefeller Institute report says, “Due to uncertainty about the ‘fiscal cliff,’ many high income taxpayers sought to avoid the possible higher income tax rates and ‘accelerated’ their capital gains realizations,” considerably increasing income tax revenue for the past two quarters.

Growth in tax receipts has also slowed. The average annual increase in tax receipts over the past four quarters was 3.5 percent, down from 3.9 percent a year ago and 4.4 percent two years ago. But the data, however modest, still indicate that state finances are healing. This is a marked improvement from forecasts made during the financial crisis, which predicted a flood of municipal bankruptcies. Of those there have a been a few (most notably Detroit), but the overall condition appears to be improving.

Fig 2

Source: http://www.rockinst.org/newsroom/revenue_reports/2013/2013-08-08-SRR_92.pdf

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