Economic snapshot | Budget Taxes and Public Investment

State and local budget shortfalls will cause heavy drag on growth

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by Ethan Pollack

The recession has led to large budget shortfalls for state and local governments, which unlike the federal government, cannot run deficits. To balance their budgets, they must cut spending and/or raise taxes. These actions depress consumer demand, cause job losses (a majority of which will be in the private sector), and in general create a drag on the economy.

After drawing down rainy day funds, states face a two-year $357 billion budget shortfall for the fiscal years 2010 (which began in July) and 2011, while local governments face an additional $80 billion shortfall. The American Recovery and Reinvestment Act passed last February has provided much-needed relief, but its $106 billion in aid to states totals only about 25% of the $437 billion state and local shortfall. The rest of the $331 billion has to be met by spending cuts and tax increases.

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Spending cuts would be particularly harmful to the economy.  Not only do they deprive individuals of needed public services like health care, transportation, education, and safety, they also fall disproportionately on the backs of low-income individuals, who respond by cutting their spending. Businesses’ sales then fall, forcing firms to slash wages or lay off workers, and these workers then cut their own consumer spending. As a result, each dollar of spending reduction by state and local governments leads to $1.41 in lost economic activity.

Without additional state and local budget relief, current and future shortfalls will cause millions of job losses and likely contribute to a drawn-out and painful recovery.

See more work by Andrew Fieldhouse and Ethan Pollack