This insight was published on July 21, 2010. RISK MANAGER SUBSCRIBERS have access to SELECT MACRO content in real-time.
Conclusion: Bearish data points regarding state and local government budgets spell incremental trouble for U.S. GDP growth in 2H10 and 2011.
The first sentence of the executive summary of the latest National Association of State Budget Officers (NASBO) Fiscal Survey of State Budgets reads: “Fiscal 2010 presented the most difficult challenge for States’ financial management since the Great Depression and fiscal 2011 is expected to present states with similar challenges.”
The reason many (if not all) States around the country have such long faces is because they are having to do just the opposite with their budgets: shorten them. As mandated by federal law, every State except Vermont is required to balance its budget and as a result of declining sales, personal income, and corporate income tax collection (80% of States’ general fund revenue) States and municipalities have had to undertake very drastic measures to combat this – including laying off over 200,000 state and local government employees since June 2009.
The pain is likely to intensify, with States facing a $140 billion budget gap in fiscal 2011, according to the Center of Budget and Policy Priorities. Federal stimulus is expected to fall by $55 billion and recently, the Senate failed to pass a measure to provide States $16 billion for extra Medicaid funding. Furthermore, States have already spent 89% of their American Recovery and Reinvestment Act of 2009 funds, which accounted 30% of state spending in 2010.
Despite the erosion of Federal government spending tailwinds, Governor’s recommended budgets imply a 3.7% Y/Y increase in spending, which, by law, has to stem from their estimates of an 3.9% Y/Y increase in tax collections in 2011. Easy comps are what they are (tax collections declined -2.3% Y/Y in fiscal 2010), but the fiscal 2011 budget implies a 2Y-trend increase of 0.8%.
An increase of any magnitude seems lofty based on current trends regarding state level personal income taxes (see: 9.5% unemployment and jobless claims hovering well above the 400,000/week needed to see improvement in employment). Perhaps that’s why fiscal 2010 revenue collection from sales, personal income taxes, and corporate income taxes are below original projections in 46 States. Expect that trend to continue in fiscal 2011 if we have any semblance of slowing growth and/or federal government austerity in 2H10.
Luckily for local governments, which have been feeling the negative effects of State budget balancing, they mark revenue collection to model, particularly regarding property taxes. As I pointed out in a note back in April, home appraisals for municipal property tax collection (roughly 35% of local government revenue) lag market prices by 2-3 years. As a result, property tax revenue has been positive throughout the housing downturn.
Well, that tailwind is becoming a headwind and a rather large one at that. Recent data shows that 1Q10 marks the first time property tax receipts declined on a Y/Y basis since 2Q03. Backtrack three years from 1Q10, and we see the first of an accelerating series of declines in housing prices. Again, this will become a major 3-5 year headwind for local government tax receipts – especially when factoring in our bearish outlook for housing prices in the next 12-18 months (see: Hedgeye’s Q3 Macro Theme of Housing Headwinds). Expect this to be a double tax on the consumer as falling home values are paired with rising property tax rates as municipalities across the country hike property taxes to try to hold flat income from this important source of revenue.
In summary, waning federal funding, slowing tax receipts, and declining home prices will put additional strain on State and local government budgets, which have an incremental negative effect on the U.S. economy at large. Job cuts at the state and municipality level are affecting all areas of the economy – from public transportation to private companies that work with state governments. Research from the Center on Budget and Policy Priorities suggests that a total of 900,000 private sector jobs could be lost as a result of State and local government cost shedding. All told, further job losses will make it even more difficult for State and local governments to meet revenue estimates, which will force them to cut even further.
As a result of this self-perpetuating cycle, U.S. GDP growth in 2H10 and 2011 may end up even lower than our current 1.7% forecast.