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INSIGHTi State and Local Fiscal Conditions and Economic Shocks Updated June 10, 2020 Policymakers’ attention to the current economic recession has included its potential effect on state and local governments. This Insight summarizes the underlying forces affecting state and local finances following a negative economic shock, examines tools available to them in response to such forces, and briefly discusses federal assistance offered in recent recessions. State and Local Finances and Economic Shocks State and local governments are an integral part of U.S. economic activity, with $3.7 trillion in 2017 spending (19% of GDP). Federal, state, and local government revenues tend to increase when the economy is growing (as taxes are paid on increased economic output) and decrease when the economy is not growing. Unlike at the federal level, state and local governments must routinely balance their operating budgets, typically every one or two years. All else equal, state and local governments therefore must offset reductions in revenues caused by negative economic shocks with increases in revenues, reductions in spending, or a combination of the two. Balanced budget requirements can limit state and local ability to meet increased spending program demands during economic downturns. In contrast, the federal government has typically enacted larger spending increases in response to economic shocks. Table 1 shows federal, state, and local spending levels in the years leading up to and during the Great Recession. Measured as a share of economic output, federal outlays were 21% larger during the period FY2009 through FY2011 than during the FY2006FY2008 period. State and local operating expenditures rose by 8% over the same timeframe. Table 1. Government Spending Before and During the Great Recession, FY2006-FY2011 (as a percentage of GDP) FY2006-FY2008 FY2009-FY2011 State and Local Operating Expenditures 13.9 15.0 Federal Expenditures 19.6 23.7 Source: U.S. Census Bureau and Office of Management and Budget. Congressional Research Service https://crsreports.congress.gov IN11258 CRS INSIGHT Prepared for Members and Committees of Congress Congressional Research Service 2 The timing of economic effects can prove to be an additional challenge for state and local financing. About 70% of state and local government spending is devoted to education, general welfare, health, and infrastructure programs, for which demand tends to increase shortly after a negative economic shock occurs. A substantial portion of state and local revenues, meanwhile, are collected from taxes on income and property, which can see more lagged effects from an economic downturn. For state and local policymakers, this means that any early action taken to address spending needs may need to be supplemented later on if there is a lagged reduction in revenues, all while working within budgetary restrictions. Responding to Economic Shocks There are a few sources of assistance available to state and local governments to address budget shortfalls that do not require outside intervention. Rainy day funds are budget accounts that are designed to assist in closing funding gaps when revenues are insufficient to meet spending demands. All 50 state governments have at least one rainy day fund, and recent estimates projected there to be roughly $62 billion (or 2.5% to 3.0% of annual state government spending) in those funds at the end of 2019. However, use of rainy day funds alone would likely be insufficient to bridge state financing gaps from a moderate or severe recession. Moreover, there is scant evidence of rainy day fund use at the local level. State and local governments may also consider increasing the relative amount of resources they devote to their capital budgets, which are not typically subject to the balancing restrictions of operating accounts. Capital budgets are generally restricted to funding projects related to infrastructure and land maintenance and construction, and research has found limited practical ability to move projects from operating to capital accounts. Capital projects typically involve substantial levels of government borrowing, for which costs may increase in recessions due to an increase in the perceived credit risk of state and local government bonds. The potential for automatic increased federal support of state and local governments undergoing poor economic circumstances is limited. Federal government transfers are the single largest source of state and local government revenue, and the federal contribution for some of those programs is determined by formula under current law. For many of the largest transfer programs, however, federal contributions either have increased only in cases of unique economic harm to the state or locality (as has been the case in the past with Medicaid) or are insensitive to economic conditions (as is true for TANF). Additional Federal Support The federal government may intervene to provide fiscal support to state and local governments in times of economic hardship. Assistance may be offered in the form of increased support for established programs or through the creation of new programs. The American Recovery and Reinvestment Act of 2009 (P.L. 111-5), passed during the Great Recession, provided $192 billion in direct state and local government transfers, including $54 billion for a state fiscal stabilization fund. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (P.L. 108-27), enacted following the recession in the early 2000s, provided a total of $20 billion to state and local governments, including $10 billion in direct assistance payments. The economic assistance in recently enacted legislation included federal assistance for state and local governments. The CARES Act (P.L. 116-136) allocated $150 billion in direct payments to state and local governments through the Coronavirus Relief Fund. The CARES Act also provided the Federal Reserve with the capacity to support outstanding state and local debt issuances through the Municipal Liquidity Facility: Treasury has invested an initial $35 billion in the facility, with amounts used to support shortterm debt from states and large localities that meet minimum credit standards. Other state and local assistance, including increased support for Medicaid and domestic food assistance programs, was Congressional Research Service 3 provided for elsewhere in the CARES Act, as well as in the Families First Coronavirus Response Act (P.L. 116-127) and the Paycheck Protection Program and Healthcare Enhancement Act (P.L. 116-139). Author Information Grant A. Driessen Analyst in Public Finance Disclaimer This document was prepared by the Congressional Research Service (CRS). CRS serves as nonpartisan shared staff to congressional committees and Members of Congress. It operates solely at the behest of and under the direction of Congress. Information in a CRS Report should not be relied upon for purposes other than public understanding of information that has been provided by CRS to Members of Congress in connection with CRS’s institutional role. CRS Reports, as a work of the United States Government, are not subject to copyright protection in the United States. Any CRS Report may be reproduced and distributed in its entirety without permission from CRS. However, as a CRS Report may include copyrighted images or material from a third party, you may need to obtain the permission of the copyright holder if you wish to copy or otherwise use copyrighted material. IN11258 · VERSION 2 · UPDATED