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July 15, 1990

eCONOMIC
GOMM6NTCIRY
Federal Reserve Bank of Cleveland

State and Local Red Ink:
Crisis or Opportunity?
by Brian A. Cromwell and Irene A. Wirkus

A he 1980s saw a significant restructuring in the roles of state and local
governments within our federal system.
Whereas the 1960s and 1970s witnessed
a dramatic increase in federal aid and a
corresponding expansion of federal
scope and responsibility for providing
local public services, this trend reversed
during the 1980s in response to federal
budgetary stress and to the change in
political philosophy that resulted in the
election of President Reagan. State and
local governments, which had expanded
their own spending in response to the
availability of federal aid, were forced to
either scale back services or raise their
own revenues to provide for them.
This restructuring has not been accomplished without political and fiscal
stress. With no federal safety net, state
and local governments are more vulnerable to economic fluctuations.
Despite the sustained national economic expansion of the past decade, a
growing number of state governments
have reported red ink as a result of
regional slowdowns. Dependent on
their own resources, state and local
governments have had to rely on "rainy
day" funds to respond to unexpected
regional developments. Those that inadequately prepared for economic
surprises are now suffering the consequences—witness Massachusetts.
This Economic Commentary reviews
the current fiscal stress in the state and

ISSN 0428-1276

local sector, links this stress to the
changing role of the federal government, and discusses the costs and
benefits of restructuring. There are
strong arguments for the idea that the
federal government can, through support of the state and local sector, enhance economic efficiency and provide
for greater equity in our society. The
record of federal programs in achieving
these goals, however, is mixed. Often,
federal funding is unrelated to real
state- and local-level needs.
On the other hand, some analysts
believe that reduced federal dollars in
state and local government coffers will
result in a more efficient public sector
with no sacrifice in equity. They argue
that federal aid can distort the cost of
government expenditures as perceived
by state and local governments, leading
to higher levels of spending. Cutbacks
force state and local decisionmakers to
weigh the costs and benefits of public
expenditures more accurately and,
through that process, to better reflect
the preferences of their constituents.
• Overview of Fiscal Health
The aggregate surplus of state and
local governments, a commonly cited
indicator of fiscal well-being reported
in the National Income and Product
Accounts (NIPA), provides little cause
for concern about the fiscal health of
those governments (table 1). The state
and local sector has consistently shown

Have the Reagan-era cutbacks in
federal aid to state and local governments resulted in decreased economic
efficiency and social equity, or have
they had just the opposite effect, as
some economic analysts would argue?

a surplus throughout the 1980s, ranging from $26.8 billion in 1980 to a
peak of $65.1 billion in 1985, and
standing at $44.3 billion in 1989.
The NIPA accounts, however, mask two
important considerations: (1) the inclusion in the surplus of net contributions
to social insurance funds, which do not
finance current operating expenses, and
(2) the considerable variation in fiscal
conditions across states and localities.
Excluding net contributions to social
insurance funds from the aggregate
figures substantially alters the picture.
The most recent NIPA estimates show
an operating shortfall of $33 billion in
1989, which marks the third consecutive year of mounting red ink.
In many respects, a state or local
government deficit is more alarming
than a federal one of equal proportion,
because most state and local governments are required by law to balance
their budgets. Consequently, they must
operate more like a business or

household, typically setting aside a
rainy day fund and trying to maintain a
budget surplus of at least 5 percent of
expenditures. If a deficit persists, the
state or local government could go into
a form of bankruptcy.
The latest survey of state budget
officers projects total year-end balances
to be only $8.3 billion, or 3.0 percent of
expenditures in 1990, a $4.3 billion
drop from 1989. Of these ending balances, general funds account for $5.7
billion, while rainy day funds account
for $2.5 billion. Although more than
half of the states (29) ended fiscal year
(FY) 1989 with balances of more than
5 percent of expenditures, it is estimated
that the number of states in this
category will decline to 20 in FY 1990.
By the end of FY 1991, 39 states will
hold less than 5 percent of expenditures,
and 12 will hold balances of less than 1
percent.'
Nationwide, 30 states and the District of
Columbia passed tax measures that
increased net revenues by $4.9 billion
in FY 1990. Twenty states have reduced
or proposed to reduce enacted 1990 budgets by a total of $2.6 billion. For FY
1991, an additional $4.9 billion in revenues from new taxes has been proposed.
More than 50 percent of the recommended increase is accounted for by just
two states, New Jersey and New York.
Budgetary conditions vary significantly
across states and regions in response to
regional economic fluctuations and
surprises. For example, in the Northeast, state governments that projected
continued high levels of growth in
incomes are experiencing a shortfall in
revenues due to a regional slowdown.
While Hurricane Hugo had a negative
effect on the South Carolina government, the employment of cleanup crews
for the Exxon oil spill had a positive effect on Alaska's budget.
• The Changing Federal Role
The decade of the 1960s was a boom
period for the national economy, as
well as for state and local governments.
A "golden age" of federal assistance
began in 1964 with programs such as

the Economic Opportunity Act, Medicaid, the Elementary and Secondary
Education Act, the Manpower Training
and Development Act, the Comprehensive Employment and Training Act,
Community Development Block
Grants, the Law Enforcement Assistance Administration, and the Economic Development Administration.
This expansion of federal largesse culminated in October 1972 with the signing of the "State and Local Fiscal Assistance Act," popularly known as general
revenue sharing, which provided unearmarked federal funds for local expenditures. As shown in table 2 and figure 1,
state and local revenues and expenditures grew as a result of the expansion
in federal aid, reaching a peak in the
mid-1970s. By 1978, state and local
revenues had reached 14.9 percent of
GNP, an increase of 5.4 percentage
points from 1960, with federal grants
contributing 2.2 percentage points of
this increase. At its peak, federal aid
comprised 26.5 percent of state and local
expenditures, an increase of 444 percent
in real terms from the 1960 level.
Unlike the previous two decades, the
1980s were a period of slow growth in
the state and local sector. State and
local spending, which had grown at a
4.4 percent annual rate between 1960
and 1978, slowed to a 2.7 percent
growth rate and was flat as a percentage of GNP. This turnaround was
initiated in part by the Proposition 13
tax revolt in California, which sparked
other state and local governments to
implement a series of controls on taxes
and expenditures. More important,
however, the change resulted from a
dramatic reversal in the federal role in
financing state and local governments.
Receipts of state and local governments
from their own tax sources, which had
been steadily rising as a share of GNP,
changed little during the 1980s. As
shown in figure 2, a decrease in property tax revenues was offset by increases
in sales, income, and other tax
revenues. But while state and local tax
revenues remained stagnant, a major
reversal in federal assistance occurred.

By the end of the decade, federal aid
declined by 16 percent in real terms
from the 1978 peak. Federal grants as a
share of GNP fell from 3.6 percent in
1978 to 2.3 percent in 1989, a one-third
decline. The net result was a 0.6 percent
decrease in state and local revenues as a
share of GNP. To put the decline into
perspective, 1.1 percentage points as a
share of GNP represented $58 billion in
the $5,233 billion 1989 economy. This
more than accounts for the current
operating deficit of $33 billion mentioned above.
The traditional roles of state and local
governments suffered the largest cutbacks in federal support. Assistance for
general government purposes—for
example, police, fire protection, parks,
and libraries—fell by more than 50 percent as a share of GNP, being replaced
by payments to individuals through programs such as Medicaid, which are
administered by state and local governments. By 1989, these payments had expanded to comprise more than half of
all federal dollars taken in. Federal assistance for capital investments remained
stable over the period in real terms.
The Bush Administration's proposed
budget for FY 1991 continues this
trend. Federal payments to individuals
via state and local governments are
projected to continue to rise in real
terms (eventually comprising 65 percent of federal assistance in 1995).
Funds for general government will
remain unchanged, while aid for capital investment is projected to decline.
• The Case for Federal Assistance
Traditional arguments for a federal role
in providing state and local services
involve both equity and efficiency considerations. Citing equity grounds, a
federal government can redistribute
resources from wealthy states to poor
areas. Federal funding of education, for
example, is often justified by its proponents as necessary to level wide disparities in educational spending across
the nation. Similar arguments are made
for federal involvement in health and
welfare programs.

TABLE 1

AGGREGATE STATE AND LOCAL SURPLUS/DEFICIT
(Billions of dollars)
Social Insurance
Contributions
27.1
30.0
36.9
43.1
44.8
51.3
57.2
63.7
71.1
78.0

Total

Year
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989

26.8
34.1
35.1
47.5
64.6
65.1
62.8
51.3
49.7
44.3

Some analysts also contend that areas
of the country undergoing transition
and economic restructuring merit assistance, through federal funding, from
areas experiencing growth, with the
better-off areas implicitly insuring
themselves against future downturns. It
is also argued that the federal revenue
system is more progressive than state
and local tax instruments, suggesting
that federal financing is more desirable
on equity grounds.

Operating
Budget
-0.3
4.1

-1.7
4.4

19.8
13.8
5.6

-12.4
-21.4
-33.8

SOURCE: National Income and and Product Accoun s.

TABLE 2

STATE AND LOCAL REVENUES
(Percent of GNP)
Other
Taxes

Social
Insurance

Federal

0.5

1.5

0.6

0.6
.1
.4

1.7
1.8
2.1

.6
.6
.8
.8

2.1
2.3
2.7
2.6

0.7
0.9
1.0
1.1
1.1
1.1
1.1

1.4
1.6
2.4
3.3
3.6
3.4

Total

Sales
Tax

Property
Tax

Income

Year

1960
1965
1970
1975
1978a
1980
1985
1989

9.5
10.8
13.0
14.7
14.9
14.3
14.5
14.3

2.3
2.5
3.1
3.3
3.2
3.0
3.3
3.3

3.0
3.3
3.5
3.3
3.0
2.5
2.7
2.7

Tax

Aid

2.7
2.3

a. Peak.
SOURCE: Authors' calculations.

FIGURE 1 CHANGE IN STATE
AND LOCAL REVENUES, 1960-78

FIGURE 2 CHANGE IN STATE
AND LOCAL REVENUES, 1978-89

Percent of GNP
6.0

Percent of GNP

SOURCE: Authors' calculations.

Efficiency arguments for a major
federal role in providing domestic government services emphasize the comparative advantage of the federal government in raising revenues. Tax tools
of the federal government (principally
the income tax) are perceived to be
more efficient than sales and property
taxes in terms of minimizing economic
distortions. In addition, there may be
economies of scale (efficiencies that
result from a larger scale of operations)
in the administrative structure of the federal government for raising revenues.
Federal assistance can also enhance
efficiency because some potential benefits of state and local spending spill
over beyond the boundaries of a local
jurisdiction. These external benefits,
however, might not be perceived by
local decisionmakers, leading to an
underprovision of the public good.
Federal support for increased expenditures can alleviate this underprovision.
For example, transportation networks
built by state governments benefit travelers and promote commerce nationwide. Examples of such infrastructure
built by states with federal assistance
include highways, airports, and watertransportation networks.
• The Case Against Federal
Assistance
Several studies argue that, overall,
federal aid has not measured up to its
potential of enhancing efficiency and
equity. Results show that federal aid allocation is not significantly related to
any measure of local fiscal capacity or
effort. Stein and Hamm examined more
than 35,000 municipal governments for
the years 1977 and 1982 and found an

"absence of a strong or even modest
federal effort to redistribute aid monies
to the modest and lowest capability
communities."" State governments, on
the other hand, have been shown to target aid more effectively to distressed
communities, suggesting that shifting
responsibilities from the federal to the
state level could potentially enhance
equity. Current court-ordered reforms
in Kentucky and Texas for equalizing
school expenditures across districts
point toward the ability of states to
address equity considerations.
Another factor to consider is the potential gain in efficiency that results from
healthy competition among local
governments. Several economists,
including two Nobel laureates, contend
that competition among the 80,000
U.S. state and local governmental units
for citizens/taxpayers acts as a check
on bureaucratic inefficiency and
government overspending.
It is also argued that federal intervention can reduce the responsiveness of
state and local governments by distorting the costs and benefits of public
services. Both matching and unconditional federal grants act to create an
oversupply of public goods and, by
shielding taxpayers from the true costs
of public services, dilute the efficiency
of competitive federalism.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

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Material may be reprinted provided that
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Empirical evidence suggests that increased federal aid reduces the variation in level of public expenditures
across states but increases the overall
level of such expenditures.

• Footnotes
1. See Marcia A. Howard, Fiscal Survey of
the Stares, Washington, D.C.: National Governors' Association and National Association
of State Budget Officers, March 1990.
2. See State Budget & Tax News, vol. 9, no.
5 (March 8, 1990), p. 11.

• Conclusion
The current fiscal crisis facing state and
local governments has forced those
governments to make some tough
choices between raising revenues or cutting expenditures. The hard-line stance
taken by the federal government against
raising general revenue taxes has been
compensated for by tax increases at the
local level. Still, less reliance on the
federal trough may have long-term
benefits. For example, state and local
governments now face the true cost of
providing public services and must
weigh the costs and benefits of public
expenditures through politically challenging budget processes.
A result of this transition is likely to be
greater variation in public services that
more accurately reflect the preferences
of local citizens. To the extent that
federal aid was never effectively targeted toward distressed areas, and that
state-level programs can incorporate
redistributive elements, the overall
equity of our federal system can be
preserved while efficiency is enhanced.

3. See Robert M. Stein and Keith E. Hamm,
"A Comparative Analysis of the Targeting
Capacity of State and Federal Intergovernmental Aid Allocations," Social Science
Quarterly, vol. 68 (September 1987), pp.
447-65. A discussion of this article and other
targeting studies, and a general review of fiscal federalism, appear in Thomas R. Dye,
American Federalism: Competition Among
Governments, Lexington, Mass.: Lexington
Books, 1990.
4. See James M. Buchanan, "Why Does
Government Grow?" and other articles in
Thomas E. Borcherding, ed., Budgets and
Bureaucrats: The Sources of Government
Growth, Durham, N.C.: Duke University
Press, 1977. Also see Milton Friedman, Free
to Choose, New York: Harcourt Brace
Jovanovich, 1980.

Brian A. Cromwell is an economist at the
Federal Resene Bank of Cleveland. Irene A.
Wirkus was an intern at the Bank and is o
May 1990 graduate of the School of Public
and Environmental Affairs, Indiana University. The authors would like to thank Randall
Eherts for helpful advice and Kristin Smalley
for research assistance.
The views stated herein are those of the
authors and not necessarily those of the
Federal Reseire Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.

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