## 1. Number of States with Balanced Budget Rules

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---

### Introduction: macro-fiscal context and motivation
- General government gross debt in the United States increased from 67.2 percent of GDP in 2007, to 102.9 percent of GDP in 2011.
- For comparison, during the same period the average gross government debt for advanced G-20 countries rose from 80.5 percent of GDP to 110.3 percent of GDP.
- The paper examines how the Great Recession of 2007–08 impacted U.S. subnational finance, with primary focus on state governments and where relevant local governments (counties, cities, towns, school districts, and special districts).

### Scope and nature of Balanced Budget Rules (BBRs)
- States (with the exception of Vermont) in the U.S. are subject to balanced budget rules.
- Historical origin: state debt crisis of the early 1840s led to constitutional or statutory limits on state and local borrowing (e.g., 1846 New York Constitution).
- Two complementary institutional features emerged:
  - Legal borrowing limits and a federal no-bailout stance, which reduced defaults.
  - Provisions to set aside revenue to service future debt obligations, analogous to PAYGO.
- Typical design and coverage:
  - BBRs typically apply to the operating budget (General Fund subject to annual or biannual appropriations) and often allow borrowing for capital budgets.
  - A BBR can mean one or more of the following:
    - (i) the governor must propose a balanced budget;
    - (ii) state legislation must enact a balanced budget;
    - (iii) no deficit can be carried from one fiscal year into the next.
  - BBRs are implemented through a network of constitutional and statutory provisions; their design varies significantly across states.

### Stylized facts on subnational debt and BBRs
- Historical debt patterns:
  - Outstanding state and local debt hovered around 10 percent of national GDP in the first two decades of the 20th century, peaked at 34 percent of GDP during the Great Depression, and fell below 10 percent of GDP during World War II.
- Cross-state variation at start of crisis (2008, fiscal year ending June 30, 2009):
  - State and local debt ratios ranged from 6 percent of gross state product in Wyoming to almost 25 percent of gross state product in Massachusetts.
- Median and recent levels:
  - Median net tax-supported debt since 1991 has been around 2.5 percent of personal income, rising to 2.8 percent in 2011.
  - Only in six states did the debt-to-personal income ratio rise by more than one percentage point between 2007 and 2011.

### How BBRs influence borrowing behavior and fiscal outcomes
- Empirical findings summarized:
  - Constitutional restraints can be effective instruments of fiscal discipline.
  - General-obligation bond yields are more sensitive to fiscal news in states with laxer fiscal rules.
  - Bond markets respond differently to expenditure and tax limits:
    - Expenditure limits can reduce borrowing costs marginally.
    - Tax limitations can raise borrowing costs substantially.
- Cross-state comparisons:
  - States with the same BBR stringency can have very different debt levels, and states with similar debt levels can have very different BBR stringencies.
  - Example: in states classified in the highest BBR stringency category, the debt ratio ranges from 10 percent to 24 percent of GDP.

### Observed exceptions to strict no-borrowing practice
- BBRs do not fully prohibit borrowing because:
  - They often cover only part of the budget (primarily the General Fund) and permit capital borrowing.
  - Some states have borrowed to finance current deficits in past recessions: Louisiana in 1988, Connecticut in 1991, Illinois in 2011.
  - Executives in some states can borrow short term for cash-management purposes.
  - Some states have recognized underfunded pension contributions as explicit liabilities, effectively increasing measured debt (examples: New York, Virginia).

### Implications and interpretation
- Arguments in favor of strict BBRs:
  - Helped prevent state and local authorities from accumulating large debts that could threaten macroeconomic stability.
  - The U.S. municipal bonds market continued to provide financing at reasonable cost.
- Counterarguments:
  - Tight borrowing limits forced sharp spending cuts and tax increases during downturns that at times conflicted with federal stimulus efforts.
- Overall textual conclusion:
  - There is scope for improving the flexibility of subnational fiscal policy during downturns without abandoning the long tradition of fiscal discipline embedded in BBRs.

---

### Box 1. The Great Recession and Local Governments — Overview and key dynamics
- Local governments were hit somewhat less critically than state governments, but fiscal pressures are likely to mount.
- Revenue and employment impacts:
  - National home prices fell by 27 percent between the end of June 2006 and the end of June 2010, while property tax collection increased by 31 percent during the same period.
  - About one third of local government revenue comes in the form of state aid, which has been falling as states cope with fiscal stress.
  - Local governments reduced expenditure by close to 3 percent in real terms during FY 2008–2009.
  - Local governments cut their labor force by about 2 percent between the end of 2007 and the end of 2010.
- Borrowing and spreads (end-2008):
  - AAA-rated municipal debt over Treasuries was less than 1 percentage point.
  - Spread of BBB-rated bonds exceeded 5 percentage points.

### Box 1 — Tax revenue: patterns and drivers
- Largest nominal and real decline in state and local tax collection occurred in Q1 2009 (largest since at least 1963).
- Elasticities (Follette and Lutz, 2010):
  - Elasticity of total state and local government receipts (including federal grants) averaged 0.6 percent during 1986–2008 (0.8 percent excluding grants).
  - Total federal elasticity was 1.6 in the same period.
- Income and property tax behavior:
  - Income tax collection growth peaked at 17 percent in 2005, and then collapsed at a similar rate in 2009 before partial recovery in 2010.
  - Property tax collection was relatively stable and even picked up during 2008–09; only at the end of 2010 did property tax revenue growth turn negative in real terms.
- Shares (2011 Q1):
  - Property taxes represent almost 80 percent of local tax collection, while property taxes account for a marginal share in state tax collection.
  - Income tax and sales tax shares are much higher for states.
- State-level variation (2010 vs 2007):
  - Only eight states had tax collection exceeding 2007 levels (including Alaska, North Dakota, and Wyoming).
  - Four states (Arizona, Lousiana, South Carolina, and New Mexico) had 2010 tax collection more than 20 percent below 2007.
- Net enacted tax changes estimated by Johnson and others (2010):
  - Enacted tax changes during 2008–2009 added US$32 billion to states’ revenue versus US$87 billion lost due to the recession.

### Box 1 — Expenditure and automatic stabilizers
- Automatic stabilizers on the expenditure side are small relative to revenue effects:
  - Follette and Lutz (2010) estimate overall sensitivity of gross state and local expenditure is about 0.04 percent of GDP per percentage point change in the unemployment rate.
  - Taking offsetting federal transfers into account, cyclical sensitivity is less than 0.02 percent of GDP.
- Real mandatory spending (about 40 percent of total spending) grew markedly; by Q4 2010 mandatory spending reached about 120 percent of the precrisis level (2007 Q4 = 100 index basis).
- Real discretionary (consumption) spending has been gradually but persistently falling since 2007.
- Medicaid:
  - Total Medicaid expenditures rose from US$303 billion in 2008 to US$353 billion in 2010.
  - Medicaid enrollment grew by about 6 percent on average in FY 2009–2011.
  - FY 2012 growth of total Medicaid spending projected to decline to around 3 percent because of a 13 percent decrease in federal funding, while the growth of state-funded Medicare is projected to increase by over 18 percent.

### Box 1 — Long-term fiscal impact: pensions and health care
- GAO (2012) estimate: closing the state and local government fiscal gap over the next 50 years would require measures equivalent to a 12.7 percent reduction in current state and local government expenditures.
- Pension investment and contributions:
  - Investment losses in states’ pension plans approached 20 percent in FY 2009 (partly recovered in FY 2010).
  - Actual contribution of US$73 billion in FY 2009 was 63 percent of the recommended US$117 billion; FY 2008 had a similar US$36 billion shortfall.
- Unfunded pension liability under alternative discount rates:
  - Using an 8 percent discount rate yields a gap of about US$1.2 trillion (half from pension benefits, half from retiree health care and other benefits).
  - Using a March 2011 riskless rate of 4.38 percent would raise the unfunded pension liability to US$2.4 trillion.
  - Using the March 2011 corporate bond yield of 5.22 percent yields an unfunded pension gap of US$1.8 trillion.
- GAO simulations: health-related state and local government costs could increase from 3.9 percent of GDP in 2012 to over 7 percent of GDP by 2060.
- Policy responses by states: reducing benefits for future (and in some cases current and retired) employees; increasing member contributions; moving toward hybrid defined benefit-defined contribution systems.

### Box 1 — States’ responses to the crisis (FY 2008–FY 2012)
- Measures to close budget gaps (totaling almost US$600 billion) by category:
  - Spending cuts: 44%
  - Emergency federal aid: 24%
  - Taxes and fees: 16%
  - Rainy day funds and reserves: 9%
  - Other: 7%
- Rainy day funds:
  - Total end-year balances exceeded US$65 billion in 2006–07 (over 10 percent of total state expenditure), but fell to about half that amount in 2009.
  - In FY2010/FY2011 about one half of the states had total end-year balances representing less than 5 percent of annual expenditures; Alaska and Texas alone accounted for over one half of rainy day fund balances in FY2010–FY2011.
- Revenue raising (FY 2010 enacted):
  - About US$11 billion in personal income taxes.
  - Over US$7 billion in general sales taxes.
  - Close to US$24 billion for all taxes and fees (about 2 ¾ percent of 2010 state tax revenue).
  - An additional US$6 billion increase was enacted in FY2011.
- Number of states with enacted net tax increases:
  - FY 2009: 14
  - FY 2010: 29
  - FY 2011: 23
  - FY 2012 (proposed): 12
  - FY2010 breakdowns: Sales = 12 states; Personal income = 13 states; Fees = 19 states; Corporate income = 6 states.
- Spending cuts and employment:
  - Total nominal general fund spending fell by almost 4 percent in FY 2009 and by close to 6 percent in FY 2010—the first nominal decrease since 1983.
  - State and local employment began to decline gradually in 2009; job shedding continued during 2010–11; employment stabilized but showed no growth (index: January 2007 = 100 base).
- Federal assistance:
  - ARRA and other federal measures provided nearly US$140 billion over two and a half years (including increased federal share of Medicaid and State Fiscal Stabilization Fund).
  - Federal grants grew from about 30 percent of state tax receipts to over 40 percent in 2010; in 2011 federal transfers covered over one half of state budget shortfalls.
  - ARRA transfers projected to disappear in FY 2013.

### Box 1 — Was there too much austerity at the state level?
- Fiscal roles and net borrowing:
  - Federal government allowed automatic stabilizers and provided discretionary stimulus; most state and local governments raised revenues and cut spending.
  - Federal government borrowing increased rapidly in 2008, while state and local governments’ net borrowing remained largely unchanged during the crisis.
- Contribution to GDP growth:
  - State and local fiscal tightening produced a negative contribution to real GDP growth; federal government contribution was mostly positive.
- Procyclicality evidence:
  - Follette and Lutz (2010) estimate discretionary federal actions boosted aggregate demand by 1 percent in both 2008 and 2009, while state and local fiscal policy actions had a negligible impact in 2008 and a contractionary impact of about ½ percent in 2009 (excluding federal grants).
  - States with stricter balanced budget rules (BBRs) run more procyclical expenditure policies (Kondo and Svec, 2009).
- International observation: subnational procyclical responses occurred in several advanced economies with fiscal rules restricting subnational discretion, including the United States, France, United Kingdom, Spain, and others.

---

### CONCLUSIONS

### Evidence on procyclicality of subnational fiscal policy
- Blöchliger and others (2010) measure the procyclicality of the fiscal stance by the correlation coefficient between subcentral net lending and the output gap (no lag, one-year lag, two-year lag over a 30-year period starting from the 1980s).
  - According to all three measures, the U.S. coefficient is large (highest, or among the highest, in the OECD countries), negative, and statistically significant.
- Cross-country summary (Growth of Pure Fiscal Expenditure and Real GDP Growth, Compound Annual Growth Rates, 2007 Q4–2010 Q1) — selected entries:
  - Australia: Consolidated 7.37; Central 6.4; State and Local 7.94; Real GDP 2.17
  - Iceland: Consolidated -2.17; Central 0.05; State and Local -5.25; Real GDP -5.68
  - Norway: Consolidated 3.82; Central 2.54; State and Local 5.14; Real GDP -0.37
  - Sweden: Consolidated 1.39; Central 1.55; State and Local 1.4; Real GDP -1.04
  - United Kingdom: Consolidated 3.41; Central 3.18; State and Local 3.78; Real GDP -2.01
  - United States: Consolidated 1.49; Central 5.38; State and Local -0.83; Real GDP -0.39
- Definition: Pure fiscal expenditure = real consumption and real investment at each level of government; at the consolidated level equal to G in national income identity and excludes transfers.

### Balanced budget requirements (BBRs) and state policy during the crisis
- Critiques cited:
  - BBRs forced states to raise taxes or slash spending when the economy sagged, producing fiscal drag in 2009–10.
  - Concerns include adverse short-term effects on economic activity and longer-term impacts on public services, education, infrastructure maintenance, and investment.
  - Petacchi and Weber (2012) note unintended consequences of stricter BBRs: increased resort to public asset sales and accounting gimmicks.
- Assessment against major reform:
  - The paper concludes concerns do not provide a strong case for revamping states’ balanced budget rules for several reasons:
    - It is not clear BBRs are the only or main cause of procyclical tightening; other constraints (limits on state debt and debt service) also affect fiscal discretion.
    - A more important driver appears to be long historical roots of states’ fiscal discipline and political aversion to profligacy.
    - The federal government cannot easily mitigate procyclical tightening by easing state rules.
    - The history of solid fiscal discipline and relatively low debt has brought benefits: little risk of widespread defaults; municipal borrowing costs remained relatively low.
    - Following a spike in municipal bond yields in 2008 and a temporary increase in late 2010, AAA-rated, A-rated and BAA-rated municipal bond yields have generally been declining.
    - States’ constitutional priorities (repayment of bonds prioritized over other spending) and the absence of a state bankruptcy option contribute to market calm; during 2011 most governors opposed allowing states to declare bankruptcy.

### Options to mitigate procyclicality while retaining fiscal discipline
- Identified measures and reforms that preserve discipline while improving flexibility:
  - More active use of rainy day funds:
    - Revisit criteria for accumulation so balances better match budgetary impact of shocks.
    - Specify proportion of adjustment carried by drawing down rainy day funds.
  - Extending federal assistance to states:
    - In FY 2012, about US$6 billion worth of federal emergency assistance to states remains.
    - Arguments include that prior stimulus portions allocated to states were effective; counterarguments note increasing federal grants led to reductions in state and local borrowing.
  - Making federal grants to local governments less procyclical by insulating them from volatility of the national tax base.
  - Reducing costly tax competition among states (Pollin and Thompson (2011) estimate costs up to US$70 billion annually).
  - Better management of investment spending:
    - Proposals to smooth cyclical fluctuations by increasing infrastructure construction during weak private demand.
    - Consider revenue stability when reviewing state tax systems to mitigate budgetary volatility.
  - Adopting a more conservative approach to spending during periods of strong revenue performance to avoid treating temporary revenue increases as permanent.

### Overall assessment and outlook
- The Great Recession caused an unprecedented shortfall in tax revenue for state and local governments since World War II.
- Recovery characteristics and fiscal outlook:
  - State and local government employment broadly stabilized but had not yet begun to increase; tax and nontax revenues were recovering slowly and in most states remained below precrisis levels as a percent of GDP.
  - Recovery from a balance sheet crisis typically takes much longer than from a standard cyclical slowdown; weak growth implies a weak tax base and slow revenue recovery.
  - Local tax collection will continue to be affected for several years by lagged responses to falling house prices.
  - Growing political pressure to reduce the federal deficit means states and municipalities can expect less federal assistance going forward.
- Defaults and bankruptcy history:
  - Despite pessimistic predictions, the Great Recession did not produce widespread financial distress or a massive wave of defaults among U.S. state and municipal issuers.
  - Since 1980 there have been only 259 municipal bankruptcies, with less than 0.5 percent of the 55,000 government entities issuing debt.
  - Out of 18,400 municipal bond issues rated by Moody’s between 1970 and 2009, only 54 defaulted.
- Final policy emphasis:
  - Far-reaching changes to current borrowing rules are unlikely and unnecessary.
  - Improvements in the tradeoff between fiscal flexibility and fiscal discipline can be achieved within existing BBRs and debt limits by:
    - More flexible use of budgetary reserves in rainy day funds (more accumulation during booms, more use in lean times).
    - More active countercyclical implementation of public investment.
    - More conservative spending approaches during periods of strong revenue performance.
    - Reforms to state tax systems that reduce revenue volatility induced by cyclical fluctuations.

*Source: _wp12184 — 1. Number of States with Balanced Budget Rules; Box 1. The Great Recession and Local Governments; Conclusions.*

### 1. Number of States with Balanced Budget Rules .....................................................................8

### 1. Number of States with Balanced Budget Rules

### Introduction: macro-fiscal context and motivation
- General government gross debt in the United States increased from 67.2 percent of GDP in 2007, to 102.9 percent of GDP in 2011.
- For comparison, during the same period the average gross government debt for advanced G-20 countries rose from 80.5 percent of GDP to 110.3 percent of GDP.
- The paper examines how the Great Recession of 2007–08 impacted U.S. subnational finance, with primary focus on state governments and where relevant local governments (counties, cities, towns, school districts, and special districts).

### Scope and nature of Balanced Budget Rules (BBRs)
- States (with the exception of Vermont) in the U.S. are subject to balanced budget rules.
- Historical origin: state debt crisis of the early 1840s led to constitutional or statutory limits on state and local borrowing (e.g., 1846 New York Constitution).
- Two complementary institutional features emerged:
  - Legal borrowing limits and a federal no-bailout stance, which reduced defaults.
  - Provisions to set aside revenue to service future debt obligations, analogous to PAYGO.
- BBRs typically apply to the operating budget (General Fund subject to annual or biannual appropriations) and often allow borrowing for capital budgets.
- A BBR can mean one or more of the following:
  - (i) the governor must propose a balanced budget;
  - (ii) state legislation must enact a balanced budget;
  - (iii) no deficit can be carried from one fiscal year into the next.
- BBRs are implemented through a network of constitutional and statutory provisions; their design varies significantly across states.

### Stylized facts on subnational debt and BBRs
- Outstanding state and local debt hovered around 10 percent of national GDP in the first two decades of the 20th century, peaked at 34 percent of GDP during the Great Depression, and fell below 10 percent of GDP during World War II.
- At the start of the 2007–08 crisis (2008), state and local debt ratios varied widely across states: from 6 percent of gross state product in Wyoming to almost 25 percent of gross state product in Massachusetts (fiscal year ending June 30, 2009).
- Median net tax-supported debt since 1991 has been around 2.5 percent of personal income, rising to 2.8 percent in 2011.
- Only in six states did the debt-to-personal income ratio rise by more than one percentage point between 2007 and 2011.

### How BBRs influence borrowing behavior and fiscal outcomes
- Empirical literature broadly supports the view that budget rules matter for borrowing behavior and fiscal discipline.
- Findings cited:
  - Constitutional restraints can be effective instruments of fiscal discipline.
  - General-obligation bond yields are more sensitive to fiscal news in states with laxer fiscal rules.
  - Bond markets respond differently to expenditure and tax limits: expenditure limits can reduce borrowing costs marginally, while tax limitations can raise borrowing costs substantially.
- Cross-state comparisons show ambiguous relationships:
  - States with the same BBR stringency can have very different debt levels, and states with similar debt levels can have very different BBR stringencies.
  - Example: in states classified in the highest BBR stringency category, the debt ratio ranges from 10 percent to 24 percent of GDP.

### Observed exceptions to strict no-borrowing practice
- BBRs do not fully prohibit borrowing because:
  - They often cover only part of the budget (primarily the General Fund) and permit capital borrowing.
  - Some states have borrowed to finance current deficits in past recessions: Louisiana in 1988, Connecticut in 1991, Illinois in 2011.
  - Executives in some states can borrow short term for cash-management purposes.
  - Some states have recognized underfunded pension contributions as explicit liabilities, effectively increasing measured debt (examples: New York, Virginia).

### Implications and interpretation
- Pro side of strict BBRs:
  - Helped prevent state and local authorities from accumulating large debts that could threaten macroeconomic stability.
  - The U.S. municipal bonds market continued to provide financing at reasonable cost.
- Con side of strict BBRs:
  - Tight borrowing limits forced sharp spending cuts and tax increases during downturns that at times conflicted with federal stimulus efforts.
- Overall conclusion drawn in the text:
  - There is scope for improving the flexibility of subnational fiscal policy during downturns without abandoning the long tradition of fiscal discipline embedded in BBRs.

*Source: _wp12184 - 1. Number of States with Balanced Budget Rules .....................................................................8*

### Box 1. The Great Recession and Local Governments

### Box 1. The Great Recession and Local Governments

### Overview and key dynamics
- Local governments were hit somewhat less critically than state governments, but fiscal pressures are likely to mount.
- Local governments experienced a smaller fall in tax revenue than the states, due largely to a high reliance on property taxes.
- National home prices fell by 27 percent between the end of June 2006 and the end of June 2010, while property tax collection increased by 31 percent during the same period.
- About one third of local government revenue comes in the form of state aid, which has been falling as states cope with fiscal stress.
- Local governments reduced expenditure by close to 3 percent in real terms during FY 2008–2009.
- Local governments cut their labor force by about 2 percent between the end of 2007 and the end of 2010.
- Local governments can borrow short term (usually 12–18 months) to finance operating deficits, or long term to finance capital spending; borrowing costs differentiated credit risk (end-2008 spread: AAA-rated municipal debt over Treasuries was less than 1 percentage point, while the spread of BBB-rated bonds exceeded 5 percentage points).

### Tax revenue: patterns and drivers
- The main impact of the Great Recession on state and local government finances was a decline in tax revenue.
- In the first quarter of 2009, state and local government tax collection recorded the largest nominal and real decline since at least 1963.
- Elasticities: Follette and Lutz (2010) estimate elasticity of total state and local government receipts (including federal grants) averaged 0.6 percent during 1986–2008 (0.8 percent excluding grants); total federal elasticity was 1.6 in the same period.
- Income tax collection growth peaked at 17 percent in 2005, and then collapsed at a similar rate in 2009 before partial recovery in 2010.
- Property tax collection was relatively stable and even picked up during 2008–09; only at the end of 2010 did property tax revenue growth turn negative in real terms (four-quarter YOY changes).
- Lagged responses: income and sales taxes react almost instantaneously to weaker economic activity; property taxes respond with a delay to changes in housing prices—explaining why local tax revenue held up early in the crisis.
- Shares (2011 Q1): property taxes represent almost 80 percent of local tax collection, while property taxes account for a marginal share in state tax collection; income tax and sales tax shares are much higher for states.
- State-level variation: in 2010 only eight states had tax collection exceeding 2007 levels (including Alaska, North Dakota, and Wyoming); in four states (Arizona, Lousiana, South Carolina, and New Mexico) 2010 tax collection remained more than 20 percent below 2007.
- Johnson and others (2010) estimated enacted tax changes during 2008–2009 added US$32 billion to states’ revenue versus US$87 billion lost due to the recession.

### Expenditure and automatic stabilizers
- Automatic stabilizers on the expenditure side are small relative to revenue effects: Follette and Lutz (2010) estimate overall sensitivity of gross state and local expenditure is about 0.04 percent of GDP per percentage point change in the unemployment rate; taking offsetting federal transfers into account, cyclical sensitivity is less than 0.02 percent of GDP.
- Real mandatory spending (about 40 percent of total spending) grew markedly; by Q4 2010 mandatory spending reached about 120 percent of the precrisis level (2007 Q4 = 100 index basis).
- Real discretionary (consumption) spending has been gradually but persistently falling since 2007.
- Medicaid: total Medicaid expenditures rose from US$303 billion in 2008 to US$353 billion in 2010.
- Medicaid enrollment grew by about 6 percent on average in FY 2009–2011; FY 2012 growth of total Medicaid spending projected to decline to around 3 percent because of a 13 percent decrease in federal funding, while the growth of state-funded Medicare is projected to increase by over 18 percent.

### Long-term fiscal impact: pensions and health care
- GAO (2012) estimates that closing the state and local government fiscal gap over the next 50 years would require measures equivalent to a 12.7 percent reduction in current state and local government expenditures.
- Investment losses in states’ pension plans approached 20 percent in FY 2009 (partly recovered in FY 2010).
- Actual pension contributions: actual contribution of US$73 billion in FY 2009 was 63 percent of the recommended US$117 billion; FY 2008 had a similar US$36 billion shortfall.
- Unfunded pension liability depends on discount rate assumptions:
  - Using an 8 percent discount rate yields a gap of about US$1.2 trillion (half from pension benefits, half from retiree health care and other benefits).
  - Using a March 2011 riskless rate of 4.38 percent would raise the unfunded pension liability to US$2.4 trillion.
  - Using the March 2011 corporate bond yield of 5.22 percent yields an unfunded pension gap of US$1.8 trillion.
- Growing health care costs are a major driver of long-term deterioration: GAO simulations show health-related state and local government costs could increase from 3.9 percent of GDP in 2012 to over 7 percent of GDP by 2060.
- Policy responses by states to reduce pension obligations include reducing benefits for future (and in some cases current and retired) employees; increasing member contributions; and moving toward hybrid defined benefit-defined contribution systems.

### States’ responses to the crisis (FY 2008–FY 2012)
- Five broad categories of measures to close budget gaps (totaling almost US$600 billion): spending cuts (44%), emergency federal aid (24%), taxes and fees (16%), rainy day funds and reserves (9%), other (7%).
- Rainy day funds: total end-year balances exceeded US$65 billion in 2006–07 (over 10 percent of total state expenditure), but fell to about half that amount in 2009.
- Distribution of end-year balances: in FY2010/FY2011 about one half of the states had total end-year balances representing less than 5 percent of annual expenditures; Alaska and Texas alone accounted for over one half of rainy day fund balances in FY2010–FY2011.
- Revenue raising: FY 2010 enacted tax increases included about US$11 billion in personal income taxes, over US$7 billion in general sales taxes, and close to US$24 billion for all taxes and fees (about 2 ¾ percent of 2010 state tax revenue); an additional US$6 billion increase was enacted in FY2011.
- Number of states with enacted net tax increases: Total states with positive net tax changes — FY 2009: 14; FY 2010: 29; FY 2011: 23; FY 2012 (proposed): 12. (Breakdowns: Sales FY2010 = 12 states; Personal income FY2010 = 13 states; Fees FY2010 = 19 states; Corporate income FY2010 = 6 states.)
- Spending cuts: total nominal general fund spending fell by almost 4 percent in FY 2009 and by close to 6 percent in FY 2010—the first nominal decrease since 1983.
- Employment effects: state and local employment began to decline gradually in 2009; job shedding continued during 2010–11; state and local employment has stabilized but shown no growth thus far (index: January 2007 = 100 base used for comparison).
- Federal assistance: ARRA and other federal measures provided nearly US$140 billion over two and a half years (including increased federal share of Medicaid and State Fiscal Stabilization Fund); federal grants grew from about 30 percent of state tax receipts to over 40 percent in 2010; in 2011 federal transfers covered over one half of state budget shortfalls. ARRA transfers projected to disappear in FY 2013.

### Was there too much austerity at the state level?
- Fiscal responses differed across levels: federal government allowed automatic stabilizers and provided discretionary stimulus; most state and local governments raised revenues and cut spending.
- Net borrowing: federal government borrowing increased rapidly in 2008, while state and local governments’ net borrowing remained largely unchanged during the crisis.
- Contribution to GDP growth: state and local fiscal tightening produced a negative contribution to real GDP growth, in contrast to a mostly positive contribution from the federal government; the combined contribution of all levels of government was volatile and declining annually.
- Procyclicality assessment:
  - Empirical evidence suggests state and local policies weakened aggregate demand and exacerbated the decline in demand during the Great Recession.
  - Follette and Lutz (2010) estimate discretionary federal actions boosted aggregate demand by 1 percent in both 2008 and 2009, while state and local fiscal policy actions had a negligible impact in 2008 and a contractionary impact of about ½ percent in 2009 (excluding federal grants).
  - States with stricter balanced budget rules (BBRs) run more procyclical expenditure policies (Kondo and Svec, 2009).
- International comparison: subnational procyclical responses during the crisis occurred in several advanced economies with fiscal rules restricting subnational discretion; examples listed included the United States, France, United Kingdom, Spain, and others (Table categorization in source).

*Source: Box 1. The Great Recession and Local Governments (excerpts from the provided IMF working paper).*

### conclusions. Blöchliger and others (2010) measure the procyclicality of the fiscal stance by

### CONCLUSIONS

### Evidence on procyclicality of subnational fiscal policy
- Blöchliger and others (2010) measure the procyclicality of the fiscal stance by looking at the correlation coefficient between subcentral net lending and the output gap (with no lag, a one-year lag, and a two-year lag covering a 30-year period starting from the 1980s). According to all three measures, the U.S. coefficient is large (highest, or among the highest, in the OECD countries), negative, and statistically significant.
- For the sample of OECD countries, the average coefficient is positive at the state level without a lag and with a one-year lag, and at the local level without a lag.
- Aizenman and Pasricha (2011) examined fiscal stimulus at consolidated and subnational levels during the Great Recession (Table 5). The United States was the only country in their sample that had a positive consolidated stimulus, but a negative stimulus at the state and local levels.
- IMF (2012a), using disaggregated data for eight advanced and emerging economies to assess policy response to nationwide and asymmetric shocks, found evidence of the procyclicality of subnational revenue and expenditure policies in response to nationwide shocks, with the exception of Germany.
- Table 5 (Growth of Pure Fiscal Expenditure and Real GDP Growth, Compound Annual Growth Rates, 2007 Q4–2010 Q1) reports:
  - Australia: Consolidated 7.37; Central 6.4; State and Local 7.94; Real GDP 2.17
  - Iceland: Consolidated -2.17; Central 0.05; State and Local -5.25; Real GDP -5.68
  - Norway: Consolidated 3.82; Central 2.54; State and Local 5.14; Real GDP -0.37
  - Sweden: Consolidated 1.39; Central 1.55; State and Local 1.4; Real GDP -1.04
  - United Kingdom: Consolidated 3.41; Central 3.18; State and Local 3.78; Real GDP -2.01
  - United States: Consolidated 1.49; Central 5.38; State and Local -0.83; Real GDP -0.39
- Pure fiscal expenditure is defined as real consumption and real investment at each level of government. At the consolidated level, it is equal to G in national income identity and excludes transfers.

### Balanced budget requirements (BBRs) and state policy during the crisis
- Sometime substantial state budget cuts and revenue increases during and after the crisis led some economists to question the appropriateness of balanced budget requirements at the state level.
- Quoted critique: “Nearly all of our states have balanced budget requirements. That means when the economy sags, states are forced to raise taxes or slash spending at just the wrong time, providing a fiscal drag when what is needed is a countercyclical policy to stimulate the economy. In fact, the fiscal drag from the states in 2009-10 was barely countered by the federal stimulus plan. That meant the federal stimulus provided was nowhere near what was needed ...” (Ornstein (2011) and other commentators referenced).
- Concerns raised include adverse short-term effects on economic activity and longer-term impacts on public services, education, infrastructure maintenance, and investment.
- Petacchi and Weber (2012) highlight unintended consequences of stricter BBRs: increased resort to public asset sales and accounting gimmicks in affected states.

### Assessment of whether BBRs warrant major reform
- The paper concludes that concerns do not provide a strong case for revamping states’ balanced budget rules for several reasons:
  - It is not clear that BBRs are the only, or main, cause of procyclical tightening. Other constraints—limits on state debt and debt service—also affect fiscal discretion, though these mainly affect issuance of general obligation bonds while capital-project debt issuance could proceed without limits.
  - A more important driver appears to be the long historical roots of states’ fiscal discipline and strong political aversion to profligate fiscal management. State fiscal rules were introduced by states themselves, not imposed by the federal government, and modalities vary across states.
  - The federal government cannot easily mitigate procyclical tightening by easing state rules, as was done in some other countries.
  - The history of solid fiscal discipline and relatively low debt has brought benefits: despite turbulence in the municipal bond market at end-2010 and early 2011, there is little risk that state—and most local—governments would default. Municipal borrowing costs have remained relatively low.
  - Following a spike in municipal bond yields in 2008 and a temporary increase in late 2010, AAA-rated, A-rated and BAA-rated municipal bond yields have generally been declining, in contrast to local governments in many other countries.
  - States’ constitutional priorities (repayment of bonds prioritized over other spending) and the absence of a state bankruptcy option contribute to market calm; during 2011 debates most governors opposed allowing states to declare bankruptcy, fearing higher borrowing costs.

### Options to mitigate procyclicality while retaining fiscal discipline
- The paper identifies scope for mitigating BBR shortcomings without revamping rules, through improved fiscal management and targeted reforms:
  - A more active use of rainy day funds. Williams and others (2011) argue some states were too conservative in using rainy day funds and should have used remaining balances instead of further spending cuts in FY 2012 budgets. Criteria for accumulation could be revisited so balances better match budgetary impact of shocks, and the proportion of adjustment carried by drawing down rainy day funds could be specified.
  - Extending federal assistance to states. In FY 2012, about US$6 billion worth of federal emergency assistance to states remains. Oliff, Williams, and Johnson (2010) warned that phasing out federal assistance would eliminate a large number of state jobs and seriously hurt education reform. Bernstein argues that the portion of the previous fiscal stimulus allocated to states was the most effective. (Cogan and Taylor (2011) counter that increasing federal grants led to corresponding reductions in state and local borrowing.)
  - Making federal grants to local governments less procyclical by insulating them from volatility of the national tax base (Rodden and Wibels, 2010).
  - Reducing costly tax competition among states. Pollin and Thompson (2011) estimate tax competition costs up to US$70 billion annually, a sizeable portion of budget gaps.
  - Better management of investment spending. Bernanke (2010) and Pollin and Thompson (2011) propose managing capital budgets to smooth cyclical fluctuations by increasing infrastructure construction during weak private demand. Bernanke also suggests revenue stability be considered when reviewing state tax systems to mitigate budgetary volatility.
  - Adopting a more conservative approach to spending during periods of strong revenue performance to avoid treating temporary revenue increases as permanent commitments.

### Overall assessment and outlook
- The Great Recession caused an unprecedented shortfall in tax revenue for state and local governments since World War II due to weaker growth, falling employment and incomes, and declining housing prices.
- State and local government employment broadly stabilized but had not yet begun to increase; tax and nontax revenues were recovering slowly and in most states remained below precrisis levels as a percent of GDP. Most states continued to cut spending in FY 2012 budgets.
- The recovery from a balance sheet crisis typically takes much longer than from a standard cyclical slowdown; weak growth in output, employment, and income implies a weak tax base and slow recovery in state and local revenues. Local tax collection will continue to be adversely affected for several years by lagged responses to falling house prices; even a rapid housing-market recovery would not immediately translate into higher property tax collection.
- Growing political pressure to reduce the federal deficit means states and municipalities can expect less federal assistance going forward.
- Despite pessimistic predictions, the Great Recession did not produce widespread financial distress or a massive wave of defaults among U.S. state and municipal issuers. Examples of isolated financial stress include Alabama, Harrisburg, and Vallejo.
- Historical evidence: since 1980 there have been only 259 municipal bankruptcies, with less than 0.5 percent of the 55,000 government entities issuing debt. Out of 18,400 municipal bond issues rated by Moody’s between 1970 and 2009, only 54 defaulted.
- The paper’s conclusion: far-reaching changes to current borrowing rules are unlikely and unnecessary. Improvements in the tradeoff between fiscal flexibility and fiscal discipline can be achieved within existing BBRs and debt limits by:
  - More flexible use of budgetary reserves in rainy day funds (more accumulation during booms, more use in lean times).
  - More active countercyclical implementation of public investment.
  - More conservative spending approaches during periods of strong revenue performance.
  - Reforms to state tax systems that reduce revenue volatility induced by cyclical fluctuations.

*Source: Conclusions section of _wp12184 (IMF working paper).*

### Section 3 of the National Income and Product Accounts has annual and quarterly data on

### Section 3 of the National Income and Product Accounts has annual and quarterly data on

### Data coverage (NIPA)
- Section 3 of the National Income and Product Accounts contains annual and quarterly data on state and local government receipts and expenditures (Tables 3.20–3.23).
- URL: http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=N#S3

### Reproductions and complementary tables
- NIPA data on state and local government budgets are also reproduced in the Economic Report of the President (Tables B-85 and B-86).
- URL: http://www.gpoaccess.gov/eop/tables11.html

### Employment data (BLS)
- The U.S. Department of Labor, Bureau of Labor Statistics’ Economic News Release contains data on federal, state, and local government employment in Table B-1.
- URL: http://stats.bls.gov/news.release/empsit.toc.htm

### Selected references cited in the source
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- Blöchliger, Hansjörg, and others, 2010, Sub-Central Governments and the Economic Crisis: Impact and Policy Responses (Paris: OECD).
- Boyd, Donald J. and L. Dadayan, 2009, “State Tax Decline in Early 2009 Was the Sharpest on Record,” The Nelson A. Rockefeller Institute of Government State Revenue Report 76 (Albany, New York).
- Center on Budget and Policy Priorities, 2011, “Testimony of Robert Greenstein, President, Center on Budget and Policy Priorities, before the House Judiciary Committee, May 13, 2011.
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- Cogan, John F., and John B. Taylor, 2011, “Was the Government Purchase Multiplier Actually Multiplied in the 2009 Stimulus Package?” Mimeo, Available via the Internet: www.stanford.edu/.../Cogan%20Taylor%20multiplicand%20Jan%202011%20rev.pdf
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- Government Accountability Office, 2012a, State and Local Fiscal Outlook, April, GAO-12-523SP (Washington: GAO).
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- Grinath, Arthur, John Joseph Wallis, and Richard Sylla, 1997, “Debt, Default and Revenue Structure: The American State Debt Crisis in the Early 1840s,” NBER Historical Paper 97 (Cambridge: National Bureau of Economic Research).
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- International Monetary Fund, 2011, United States Article IV Report, Selected Issues Papers, IMF Staff Country Report No. 11/202, Section VII, Fiscal Challenges Facing the U.S. State and Local Governments (Washington: IMF).
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- Johnson, Nicholas, Catherine Collins and Ashali Singham, 2010, State Tax Changes in Response to the Recession (Washington: Center on Budget and Policy Priorities).
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- Krugman, Paul, 2008, “Fifty Herbert Hoovers,” The New York Times (New York), December 29, p. A25.
- Lutz, Byron, Raven Molloy, and Hui Shan, 2010, “The Housing Cycle and State and Local Government Tax Revenue: Five Channels,” Finance and Economics Discussion Series 2010–43, (Washington: Federal Reserve Board).
- McNichol, Elizabeth, 2012, Out of Balance. Cuts in Services have Been States’ Primary Response to Budget Gaps, Harming the Nation’s Economy. (Washington: Center on Budget and Policy Priorities).
- Moody’s Investors Service, 2011, 2011 State Debt Medians Report, Special Comment, June 3 (New York: Moody’s U.S. Public Finance).
- National Association of State Budget Officers, 2008, Budget Processes in the States. (Washington: NASBO).
- National Association of State Budget Officers, 2009, Fiscal Year 2008 State Expenditure Report (Washington: NASBO).
- National Association of State Budget Officers, 2010, Fiscal Year 2010 State Expenditure Report (Washington: NASBO).
- National Conference of State Legislatures, 2010, “NCSL Fiscal Brief: State Balanced Budget Provisions.” October (Washington: NCSL).
- National Conference of State Legislatures, 2011a, “NCSL Fiscal Brief: How State Tax Policy Responds to Economic Recessions,” January (Washington: NCSL).
- National Conference of State Legislatures, 2011b, State Budget Update:, March 2011 (Washington: NCSL).
- National Conference of State Legislatures, 2012, State Budget Update: Spring 2012 (Washington: NCSL).
- National Governors Association and the National Association of State Budget Officers, 2009, The Fiscal Survey of States, December (Washington: NGA and NASBO).
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- Ornstein, Norman J., 2011, “Four Really Dumb Ideas That Should be Avoided” January 26, 2011 (Washington: American Enterprise Institute,) Available via the Internet: http://www.aei.org/article/103055
- Petacchi, Reining, and Joseph Weber, “The Unintended Consequences of Balanced Budget Requirements,” mimeo, April 2012. Available via the Internet: www.hbs.edu/units/am/.../Patacchi%20and%20Weber_AssetSale_2012.pdf
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- Tett, Gillian, 2012, “Pension Gap Spells Trouble for Muni Bondholders,” Financial Times (London), February 24.
- Williams, Erica, Michael Leachman, and Nicholas Johnson, 2011, “State Budget Cuts in the New Fiscal Year Are Unnecessarily Harmful,” July 28 (Washington: Center on Budget and Policy Priorities).
- Williams, John C., 2012, “The Slow Recovery: It’s Not Just Housing,” FRBSF Economic Letter No. 2012–11, April 9 (San Francisco: Federal Reserve Bank of San Francisco).
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*Content derived from the supplied source PDF section.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp12184.pdf_