The going gets tough:State and local governmentsconfront the nineties

Linda M. Aguilar, Richard H. Mattoon,

and William A. Testa

Fear of recessionary fallout iseverywhere. All levels ofgovernment are scrambling toshore up revenues and limitspending, especially in hard

hit regions such as the Northeast and Califor-nia. This fiscal storm comes in the wake of aprosperous period for many state and localeconomies. Despite dwindling aid from thefederal government, eight years of nationaleconomic growth enabled most state and localgovernments to expand programs for educa-tion, public welfare, infrastructure, and the en-vironment. As revenues picked up, somestates found themselves facing an enviablechoice of options, from accelerating spendingto reducing taxes or rebuilding reserves.

Options were much more limited for theSeventh District states of Illinois, Indiana,Iowa, Michigan, and Wisconsin. The SeventhDistrict has traditionally relied on its largemanufacturing and farm base for growth, twosectors that did not perform particularly wellin the early 1980s. Because of unrelentingfiscal stress, District budgets were forced tomaintain slow to moderate growth.

This article begins by presenting evidenceof the current fiscal pressure on state and localgovernments nationwide. Trends in state andlocal revenues and expenditures are examined,as well as the role that declining federal aidhas had in leading to the current fiscal pinch.

The focus then turns to why the SeventhDistrict's fiscal track record has followed adifferent pattern from the rest of the U.S. Theanswer lies in the District's economic perform-

ance in the 1980s, in conjunction with discre-tionary measures taken by District govern-ments to maintain balanced budgets in re-sponse to the District's slower revenue growth.

Led by manufacturing and agriculture, theDistrict's economy enjoyed a resurgence in thelatter half of the 1980s. Combined with pru-dent budgeting practices which were carriedover from the leaner times of the early 1980s,District governments were able to rebuild theirformerly strong fiscal positions by 1989.

Prudent budget management will help theDistrict during the 1990s, but it will be a lim-ited tool during an era in which state and localgovernments continue to become more relianton their own source revenues. As Districtgovernments confront the challenges of the1990s—rising service needs and federalturnbacks-governments will first need toshore up budget balances which are now erod-ing under the weight of economic recession.

Evidence of nationwide fiscal pressureOne common measure of a state's fiscal

soundness is its ability to end the year with asurplus of general funds.' The larger the stategovernment's surplus as a percentage of ex-penditures, the greater the cushion with whichto respond to economic shocks and spendingpressures. Most experts cite either a 3 percentor 5 percent surplus as evidence of prudent

Linda M. Aguilar and Richard H. Mattoon areregional economists at the Federal Reserve Bank ofChicago. William A. Testa is a senior regionaleconomist and research officer at the FederalReserve Bank of Chicago.

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FIGURE 1

State and local governmentsurplus or deficit

billion dollars (seasonally adjusted)80

Total excludingSocial Insurance Fund

budget management. Over the 1978-1989period, the U.S. average general fund endingbalance as a percentage of expenditures forstate governments (excluding local govern-ments) ranged from as high as 9 percent in1980, to an estimated low of 1.1 percent in1989. 2

A more comprehensive measure of fiscalsoundness is the size of the state and localgovernment sector's budget surplus or deficit(see Figure 1). This figure, a product of theNational Income and Product Accounts(NIPA), is the net of receipts and expendituresfor all state and local governments, includingcities, towns, counties, school districts, andspecial purpose districts.' In the early to mid-1980s, when the economy was recoveringfrom the back-to-back recessions of 1980 and1981-1982, the state and local surplus grewfrom $25.7 billion in the first quarter of 1980to $68.5 billion in the first quarter of 1986.Since then, with only a few quarterly aberra-tions, the surplus has been decreasing. As ameasure of fiscal soundness, this surplus mustbe viewed with some caution because it in-cludes the states' social insurance funds (SIF).Social insurance funds include employee pen-sion funds and unemployment insurance,which are not part of current operating funds.Since the beginning of 1987, the surplus ex-cluding SIF actually fell into the red and, dur-ing the first two quarters of 1990, the deficitexceeded $30 billion.

Evidence of deteriorating financial condi-tion has also emerged for municipal govern-ments. As reported in a 1990 survey of cityfinancial conditions, 4 54 percent of the citiessurveyed reported expenditures outpacingrevenues in fiscal year 1990 (FY90). Twenty-two percent of the cities in the U.S. expectedgeneral fund revenues to decline, compared to11 percent in 1989 (see Table 1). Althoughbudgetary woes have been widely-reported tobe centered in the Northeast region—espe-cially Philadelphia, New York City, and thestate of Massachusetts—the recent municipalsurvey shows a geographically dispersed pat-tern of fiscal stress, with every region expect-ing similar declines in revenues in FY90 overFY89.

As shown in Table 1, declines in cityexpenditures are less dramatic, reflecting thereluctance to make expenditure cuts even inthe face of declining revenues. However, evenhere the fiscal pressure on the South andNortheast is shown by the increase from FY88-89 to FY89-90 in the percentage of cities re-porting reduced spending. In contrast, thepercentage of cities reporting reduced spend-ing fell in the Midwest and West.

The current fiscal pressure on state andlocal governments obviously has a great dealto do with the slowing national economy.However, the pattern of revenue and expendi-ture growth that occurred in the 1980s, alongwith changes in federal aid, are also primarycontributors to the current situation.

Causes of spending andrevenue pressure

Much of the decade saw a significant gainin virtually all state and local revenue sources,especially in those tax sources that move intandem with swings in state and local econo-mies. But since 1987, state revenue gainshave slowed while demands for governmentservices have continued to grow.

Why was revenue growth strong up until1987? The early 1980s found the nation in arecession. Faced with slumping revenues andreduced federal aid, states acted, often with alag, to boost many of their largest tax sourcesby raising tax rates and user fees and by ex-panding the legal bases of taxation. Increasesin sales, individual income, and business taxeswere particularly popular. From 1981 to 1983,28 states from every region in the nation, in-

18 ECONOMIC PERSPECTIVES

Cities with declining general revenue

Percent of citiesFY88 to 89 FY89 to 90

Total 11 22

Northeast 13 21

Midwest 9 22

South 10 22

West 12 21

Lower city spending by region

Percent of citiesFY88 to 89 FY89 to 90

Total 10 10Northeast 3 10

Midwest 11 8

South 11 13

West 14 10

SOURCE: City Fiscal Conditions in 1990, NationalLeague of Cities.

TABLE 1

cluding all of the District states except forIowa, increased either their personal incometax rates or expanded their income tax base.Thirty states throughout the U.S. chose toincrease their sales tax.'

As the economic recovery set in, thosestates that raised taxes were able to garnerlarge revenue increases as higher personalincomes and expanding consumer confidencehelped fuel growth in both of these tax bases.The east and west coast states benefited themost as their regional economies were particu-larly robust emerging from the recession. Thecombination of higher tax rates and rapid ex-pansion in the underlying tax base led to im-pressive revenue growth on both coasts.

From 1982 to 1986, state and local re-ceipts grew by 19 percent even after adjustingfor inflation (see Table 2). Especially largegains were realized in sales and personal in-come tax revenues which represent the twolargest revenue sources for most state govern-ments. During this period, income tax reve-nues increased nearly 25 percent and sales taxrevenues posted a 21 percent gain.

On the local level, property values in-creased rapidly during this period as new con-struction and higher market values for real

estate (particularly on the east coast) pushedlocal property tax revenues upward. Propertytax revenues, which usually lag rising propertyvalues by several years, increased 18 percentduring the period 1982 to 1986.

By the end of 1985, evidence of this im-proving fiscal health was apparent. Manystates that had begun the decade in such diffi-cult straits found themselves in exceptionalfiscal shape. Only two states found it neces-sary to cut their budgets in 1985 as comparedwith 39 in 1983. Revenues had grown suffi-ciently to allow 14 states (seven on the eastcoast) to cut their income tax and four states tocut their sales tax. 6

However, not all sources of state and localrevenue were robust over this period. From1982 to 1986, federal grants increased by only6 percent—by far the smallest percentageincrease of any of the principal revenuesources. A national policy of "New Federal-ism" was designed and implemented to decen-tralize government and to increase fiscalresponsibility at the state and local levels.An important aspect of this policy was to re-duce state and local government reliance onfederal aid.

On top of the revenue pressures beingexerted by falling federal aid throughout thedecade, state and local own source revenuesbegan to decelerate in 1986. As shown inTable 2, state and local revenues grew by 9percent from 1986 to 1990, a sharp contrastfrom the 19 percent growth of the prior fouryears. By 1988, strains in state revenue sys-tems were increasingly visible. Six states(California, Delaware, Kentucky, Massachu-setts, New Jersey, and West Virginia) foundthat they had overestimated their personalincome tax receipts. Twelve (Connecticut,Massachusetts, Michigan, Wisconsin, Mis-souri, North Dakota, South Carolina, Virginia,Arizona, Colorado, Utah, and Kentucky)found that sales tax forecasts had been opti-mistic.' The sales tax and personal incometax, which had grown more than 20 percentduring the earlier period, fell to growth rates of10 percent and 18 percent respectively duringthe 1986-90 period. The property tax alsobegan to falter. The growth rate in propertytaxes fell from 18 percent to 9 percent.'

The revenue bulge during the 1982-86period was large enough to allow state andlocal governments in many sections of the

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TABLE 2

State and local government receipts(Billions of constant dollars)

Year Percent change

1982 1986 1990 1982-86 1986-90

Total* 434.1 516.8 565.1 19.1 9.4

Own source tax revenues

Income 50.8 63.3 74.8 24.6 18.2

Sales 95.0 114.7 126.7 20.7 10.5

Property 81.8 96.9 106.2 18.4 9.6

Corporate 10.0 15.7 16.7 57.0 6.4

Federal grants-in-aid 85.0 90.4 93.9 6.4 3.9

*Total state and local government receipts.NOTE: Figures adjusted to 1982$ using the state and local government purchase deflator.SOURCE: Survey of Current Business, second quarter data, U.S. Department of Commerce.

country to expand government services andprograms, even though federal grant moneywas experiencing sluggish growth. As thegrowth rates in revenues slowed, states had toface the problem of spending commitmentsthat had been taken on during periods of rapidrevenue expansion.

Trends in state and local expenditures

State and local governments respond,albeit imperfectly, to the current needs andwants of their constituencies. In the 1980s anumber of issues became increasingly impor-tant to citizens who pressured all levels ofgovernment to respond with additional spend-ing. These issues include the betterment of theU.S. education system, regulation and enforce-ment of environmental laws relating to cleanair and water, recycling, and reduced pesticideuse, and demographic issues such as care forthe elderly and the indigent and a burgeoningprison population. 9

Despite reduced federal aid and volatilerevenue flows, changing constituent needs, andfederally-mandated program pressures, thecomposition of state and local spending bycategory remained fairly stable in the 1980s.Public welfare and health and hospital pro-grams remained more or less constant, claim-ing 12 percent and 9 percent shares respec-tively. Over the 1980-1989 period, the shareof state and local general expenditures used foreducation fell only slightly, from 36 percent in

1980 to 34 percent in 1989. Another programarea with heavy federal participation, transpor-tation (highway, air, water, etc.), also lost asmall share, falling from 10 percent of totalgeneral expenditures in 1980 to less than 9percent in 1989. The areas with increasedshares include police and corrections, govern-ment administration, and interest on generaldebt. Police and corrections increased theirshare 1 percentage point, government admini-stration .5 percent, and interest on general debt2 percent.

State expenditure patterns may not remainso stable in the 1990s. As budgets becomeeven tighter, states will be forced to focus theirdollars on the most critical state- or region-specific program needs and trim back pro-grams that are less essential.

The 1990s will find state and local gov-ernments facing increasing levels of federalmandates and turnbacks. States have acceptedincreased responsibility for several programseither because they have been required bymandates to do so, or in response to constitu-ent pressures. Programs such as Medicaid,with recent expenditure growth of 15 to 20percent per year, have proven to be particu-larly costly despite limited federal reimburse-ment. Further, in order to comply with court-mandated standards in areas like prison re-form, states have undertaken expensive con-struction programs, often without the benefitof federal aid. These pressures come in addi-

20

ECONOMIC PERSPECTIVES

tion to fulfilling their own long-standing serv-ice responsibilities.

Regional effects of the New Federalism

The 1980s saw a change in the directionand nature of federal funds flowing back tostates and municipalities. Whether intentionalor not, changes in federal spending policies inthe 1980s exerted pressures that were unevenacross regions. Federal spending by region ofimpact can be defined for our purposes toinclude state and local grants, salaries andwages of federal employees, procurement(mostly defense spending), and direct pay-ments to individuals.

On the state and local level, the NewFederalism meant that funding for discretion-ary grant programs (block-type grants that canbe used for a variety of purposes) was sharplyreduced in favor of categorical spending with arestricted or limited purpose, and direct pay-ments to individuals. Federal spending in-creased for Medicaid and Aid to Families withDependent Children throughout the decade.However, even this increased spending wasnot sufficient to forestall fiscal pressure whenstate caseloads grew faster than had beenbudgeted. In general, grant programs thatfocused on older, more urban regions of thecountry, suffered the biggest cuts. Among theprograms affected were the Urban Develop-ment Action Grant Program (which was elimi-nated in 1988), the Community DevelopmentBlock Grant Program (cut 25 percent from1981 to 1988), General Revenue Sharing(eliminated for the states in 1980 and for mu-nicipalities in 1986), the Environmental Pro-tection Agency wastewater treatment program(cut 36 percent), and the Urban Mass TransitAdministration Program (cut 13 percent).'°

Beginning in 1981, federal budget priori-ties were shifting away from federal grantsaltogether. Instead, spending on procurementcomprised a growing share of the federalbudget. In New England and California, theincrease in procurement spending served as asignificant economic stimulus, thereby helpingto soften the blow from the reduction in discre-tionary aid. Both Connecticut and Massachu-setts, two states widely hailed as among thestrongest economic performers in the nationduring the mid-1980s, benefitted substantiallyfrom the national build-up in defense spend-ing. One report estimated that every federal

defense-related dollar of tax money originatingin Connecticut and Massachusetts returned$1.93 and $1.66, respectively, in procurement.Similarly, California enjoyed a return of $1.60.In contrast, the return for Seventh Districtstates ranged from a high of $.72 in Indiana toa low of $.30 in Illinois. Partly as a result ofthe shift in federal spending toward procure-ment and the unequal distribution of benefitsfrom this shift, cumulative federal spending(all sources) from 1981 to 1988 for the Mid-west was $19,537 per capita as compared with$28,722 for New England."

Regional patterns: SeventhDistrict focus

Seventh District states did not share in thesame rapid revenue and expenditure growththat characterized the two coasts throughoutmuch of the decade of the 1980s. However,the gap between District and national revenueand expenditure growth narrowed considerablyduring the second half of the decade due tomore recent economic conditions favorable tothe Seventh District.

Using ending year balances as an indicatorof fiscal health, the Seventh District outper-formed the U.S. average for FY87, FY88, andFY89. 12 While projections of year-end bal-ances are highly imperfect, 13 District statesthemselves had expected robust year-end bal-ances for FY91 prior to the current economicslowdown. Revised figures indicate that whileDistrict states will not reach their optimisticprojections, their fiscal condition is stillstronger than that of most of the states on thetwo coasts (see Figure 2). As of early 1991,only Michigan appears to have been affectedprofoundly by the recession as reflected by theneed for tax increases or significant budgetcuts in order to end the current budget year inbalance. However, evidence of increasedfiscal pressure could be found in all Districtstates. District states are experiencing increas-ing expenditure demands for programs thathistorically grow during recessions. Programssuch as Medicaid are growing much faster thanFY91 budgets had predicted. However whencompared to the rest of the nation, Districtrevenue growth estimates have held up rea-sonably well.

One of the underlying reasons for theDistrict's fiscal strength relative to other dis-tricts through FY91 can be traced to a resur-

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FIGURE 3

Impact of past recessions onmanufacturing employment

FIGURE 2

Projected 1991 deficits as a percent of spending(Before corrective action)

la I 1 tit ,

till 11 1.111LiNone

0 to3% rill

'4in

3 to 5%

1111 Over 5%

SOURCE: The National Conference of State Legislatures.

I 1

gent strength in economic conditions in theSeventh District, while other regional econo-mies such as the Northeast and South havefaltered. This development is a reversal offortunes from the early 1980s when the Dis-trict economy, and resulting fiscal conditions,were sorely strained.

Rebuilding the SeventhDistrict economy

In the early 1980s, the bottom fell out ofthe District's economy. The twin pillars of theregion's economic base, manufacturing andagriculture, experienced a deterioration ofconditions the likes of which had not beenseen in the post-war era. From peak-to-trough,one-quarter of the region's manufacturing jobsevaporated (see Figure 3), although some jobswere subsequently regained beginning in 1983as the U.S. consumer led the nation and theworld out of its economic doldrums. Still,District manufacturing was slow to recoverfrom the one-time onslaught of overseas com-petition accompanied by a rising dollar. Incontrast, many of the nation's coastal regionswere gaining manufacturing jobs in high techindustries such as computers and electronicsand in defense-related industries, many of

which were impervious to the rapidly escalat-ing trade deficit.

District agricultural fortunes also experi-enced a downturn in the early 1980s that wasboth sharp and extended. 14 Led by risingworld demand for grains, District exportssurged in the 1970s. The result was a specula-

22

ECONOMIC PERSPECTIVES

tive boom by District farmers in both landvalues and capital spending. A decline inworld demand in the early 1980s, accompa-nied by a rising U.S. dollar and severaldroughts, led to a severe shrinkage in farmexports and earnings. In turn, high debt levelsand stagnant earnings in the farm sector con-tributed to the woes of District manufacturersof farm machinery and equipment.

Beginning in early 1985, the value of thedollar began to fall from its lofty heights.Still, the District's core manufacturing indus-tries continued to stagnate in 1986. But by theend of 1986 and into 1987, two forces wereigniting a District recovery. The falling valueof the dollar finally began to stimulate foreignexports. Chemicals, industrial machinery, andequipment sales increased. At the same time,the extended U.S. expansion lent its force todomestic sales of capital goods as manufactur-ers here and abroad could no longer profitablydelay expansions in their capacity. Real, grossnonresidential investment rose by 2.5 percentin 1987 followed by a whopping 8.3 percentrise in 1988. This resurgence was most appar-ent in capital goods states, such as Illinois,Iowa, and especially Wisconsin.

At the same time, economic growth in thecoastal regions of the U.S. began to cool asdefense spending on advanced weapons sys-tems was curtailed and the once red-hot finan-cial services industries began to experiencedifficulties. Overall, the nation's economicgrowth tapered off in 1989 and into the firsthalf of 1990, but the engines of growth, andtheir regional impacts, remained much thesame. As a result, and despite the problems ofthe domestic auto makers, District economicfortunes continued to improve. For the mostpart, revenue growth was responsive to eco-nomic expansion, affording the District's gov-ernments some slack in fiscal pressure.

Rebuilding the District'sfiscal structure

In addition to a turnaround in the generaleconomic environment, the District states alsobenefited from their governments' discretion-ary fiscal strategies and actions presumablyundertaken to preserve fiscal balance andintegrity. By FY87, three Seventh Districtstates (Iowa, Indiana, and Michigan) hadadopted budget stabilization funds. Wisconsinproposed establishing a budget stabilization

fund in its FY90 and FY91 budget proposal;Illinois alone has no budget stabilization fund.

Low debt levels can be another exampleof prudent fiscal policy. Government debtlevels are an important gauge of fiscal sound-ness because debt reflects claims on the futurerevenue and income of the state. Often, stateswith declining tax revenues will turn to bond-ing and other debt instruments in order tosustain selected program initiatives. Increasesin the amount of tax and other revenues beingdedicated to retiring debt can often signal thata state is experiencing fiscal trouble. This isnot to say that higher levels of bonding arenecessarily an indicator of stress. Capitalinvestment in assets with long lives and atten-dant economic benefit can be a rewarding useof taxpayer money. 15 However, the use ofdebt to meet current expenditures rather thanlong-term capital projects during a rough eco-nomic period usually indicates fiscal stress.

In comparison to the rest of the U.S., theDistrict has avoided this pitfall reasonablywell. Despite revenue growth that ran belowthe U.S. average throughout most of the 1980s,District states were more restrained in expand-ing their use of debt than the rest of the U.S.From FY80 to FY88, total state and local debtin the District grew by 72 percent. By com-parison total debt for the rest of the nationgrew by 112 percent.

Even better evidence of the District'sfiscal restraint is provided by the comparisonbetween the rest of the nation and the Districtin terms of the change in per capita debt and indebt as a percentage of personal income overthe 1981-88 period. By 1988, the District'sper capita debt was over $1000 less than thenation as a whole. Similarly in 1988, debt asa percentage of personal income stood at 13.6percent for the District while the figure for therest of the nation stood at 21.1 percent (seeTable 3). These relatively low debt levelspotentially position the District better for the1990s in two ways. First the District is betterpositioned to use debt to withstand a budgetaryshortfall. Second, District states may be ableto use debt to invest in public projects such astransportation infrastructure, which couldenhance the region's economic competitive-ness in the 1990s. 16

A review of the District's spending in the1980s suggests that District states have acted,either by design or in reaction to adversity, to

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FIGURE 4

Spending per $1000 personal income(Seventh District relative to the U.S.)

index, rest of U.S =11.04

1.02

1.00

0.98

0.96

0.94

0.921979 '81 '83 '85 '87

SOURCE: Bureau of Economic Analysis andBureau of the Census.

'89

TABLE 3

State and local government debt

Percent changetotal debt

Debt per capita(in dollars)

Debt as apercent of income

FY80 vs. FY88 FY80 FY88 FY80 FY88

Illinois 70.6 1444.1 2423.4 13.7 14.8

Indiana 84.7 797.5 1455.4 8.9 10.5

Iowa 96.4 821.2 1658.8 8.8 11.7

Michigan 67.3 1264.9 2121.8 12.7 13.8

Wisconsin 67.0 1297.7 2100.3 13.8 14.4

District 72.1 1215.9 2074.4 12.3 13.6

Rest of U.S. 112.0 1674.7 3232.3 17.6 21.1

SOURCE: Government Finance, 1979 -80, 1987 -88, U.S. Department of Commerce Bureau of Census.

keep their spending within their ability topay-so-called "fiscal capacity"."

The personal income of state residents isan easily understood and broad-based measureof a region's fiscal capacity. A government'sability to spend should be closely related to theincome level of its constituents. Of coursethe specific tax bases available to govern-ments-property, sales, income, etc.-moredirectly relate to government revenues, andthese often restrain revenue growth. Nonethe-less, higher income states should be able toadjust their tax and revenue systems, subject tocitizen approval, in order to generate publicrevenue.

"Expenditure effort" measures the extentto which state and local governments utilize orstress their underlying fiscal capacity (that is,economic base). Government spending per$1000 of personal income is one such measureof expenditure effort. In most situations a lowexpenditure per $1000 personal income isdesirable, other things equal, because it meansthat government services put less strain on thetax base, and constituents have more discre-tionary income.

In 1979, the Seventh District had levels ofexpenditure effort equal to or slightly belowthe rest of the nation (see Figure 4). Expendi-ture effort began to rise during the 1981-82recession and continued into 1983, pushingabove the effort of the remainder of the nationby approximately two percentage points. Inperspective, the District's relative rise in ex-penditure effort was notably moderate in light

of its profound drop in economic conditions.During hard times, demands for income sup-port programs and social welfare services risesharply in tandem with the needs of unem-ployed and underemployed constituents. Atthe same time, the economic base for tax reve-nues slides in sync with the general economy.In this context, a much larger increase in theDistrict's government expenditure effort wouldnot have been surprising.

The pattern of government spending be-havior over the remainder of the decade (seeFigure 4) shows that the District's rising ex-penditure effort was cyclical and recession-related. As the District economy recovered

24 ECONOMIC PERSPECTIVES

TABLE 4

State and local spending increase(decrease) per $1000 personal

income vs. rest of U.S.

Type of expenditure

FY 80-89

SeventhDistrict

Restof U.S.

General expenditures: 4.51 11.82

Education 1.32 1.36Public welfare 0.95 1.68Health and hospital 0.35 1.36

Transportation:

Highways (2.40) (1.31)

Air 0.44 0.16Other 0.00 0.03

Police (0.03) 0.43Corrections 1.31 2.09

Environment:Natural resources* 0.06 0.17

Sewerage (0.96) (0.41)Sanitation (0.02) 0.60Interest on general debt 2.41 4.35

*Includes parks and recreation.SOURCE: Government Finances, U.S. Depart-ment of Commerce, various years.

from its economic shock, expenditure effortrelative to the remainder of the nation easedback below the nation by fiscal year 1985. Bythe late 1980s, when the District economybegan to perform especially well under theinfluence of surging exports and capital spend-ing, its expenditure effort had come full circle.In fiscal 1979, prior to the region's economictravails, District expenditure effort stood 4percent below the rest of nation; by fiscal1989, it rested at 5 percent below the nation.

The District's relative improvement inexpenditure effort is explained in part by in-creased spending in other regions. From 1980to 1989, District expenditures per $1000 ofpersonal income climbed by $4.50 while, inthe remainder of the nation, the climb ex-ceeded $11 (see Table 4).

Public finance enters the 1990s

The 1980s were a volatile decade for stateand local government finance. The beginningof the decade found a nationwide recessioncreating severe fiscal pressure, accompaniedby state and local budget deficits, and ulti-mately leading to tax rate hikes. Also, federalgovernment aid to the states was restructuredand significantly limited during the 1980s.

From a national perspective, the 1980sfound states (particularly on the two coasts)emerging from the early years of budget defi-cits and tax increases with record surpluses bythe middle of the decade. Fueled by economicexpansion, state revenues grew while statesresponded by initiating new or reviving de-layed program initiatives.

By the end of the decade the same stressesthat characterized the earlier part of the dec-ade returned. The slowing economy meantslower revenue growth while program commit-ments continued to grow. As a group, thestates entered the 1990s on shaky ground.

The 1990s—issues facing all states

Most observers believe that the 1990s willbe more challenging for the states than the1980s. Expenditure pressures in the areas ofhealth care, school finances, and correctionswill continue to grow. Demographic changes,such as increases in the number of the elderly,will also increase spending demands. On therevenue side, short term prospects provide norelief. The forecast for slower personal in-come growth will cut into state revenue

growth unless economic expansion revivesmore forcefully. Neither can the federal gov-ernment be expected to come to the rescue.The most recent five year financial plan forfederal spending places the burden of dealingwith issues such as education, infrastructure,home health care, drug abuse, and the home-less squarely on state and local governments.1 8

And federal aid is unlikely to increase in themidst of federal budget problems. Instead, itis more likely that the federal government willfurther hinder states by usurping potentialrevenue sources and increasing program man-dates without accompanying financial support.

Increasing interest in offering a tax envi-ronment that is attractive to business develop-ment and expansion will put pressure on legis-latures and local policy makers to limit orforego tax rate hikes. In the absence of highertax rates, state and local governments mayinvestigate ways to broaden the tax base, suchas limiting tax exemptions or extending cur-rent taxes to new bases (for example, extend-ing sales taxes to cover more services). Theseindicators point to a decade of difficult options

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for state governments. State governments mayrespond to slow growth and fiscal pressure byreducing state aid to local government, therebyincreasing fiscal pressure on local government.

Finally, reduced federal aid and increasingdebt costs will force all states to take a hardlook at their budgets and focus their dollarsonly on programs with paybacks specific totheir needs. No longer will states try to pleaseeveryone with programs covering an array ofservices. States will be forced to scale backtheir program offerings and keep only pro-grams that serve the greatest need.

The Seventh District faces the 1990s

Ironically, the District's slow economicperformance throughout much of the 1980smay have helped improve the fiscal position ofthe District in the 1990s. As noted earlier,slower growth in District states constrainedDistrict policy makers, resulting in moderatespending increases, stabilized revenue, andlower debt.

However, this is not to say that the Dis-trict enters the 1990s with any fewer chal-lenges than the states as a whole. All of theabove expenditure and revenue trends willaffect District states to a certain degree.Clearly the current national economic slow-down is affecting District states as recession-related spending increases and revenue growthmoderates. Further, there are some other issuesthat are especially important to District policymakers. The District's economy continues tospecialize in durable goods manufacturingindustries which means that the current reces-sion will be felt more keenly here than in theremainder of the country. As the state govern-ment fiscal year draws to a close, a budgetsqueeze across District states is emerging.

Following a stressful beginning, there isgood news and bad news concerning the Dis-trict's prospects for economic and fiscal pros-perity in the remainder of the 1990s. First thebad news. The outlook for the region's per-sonal income growth, hence income and salestax revenues, is not robust. The latest forecastfrom the Department of Commerce placespersonal income growth for the District belownational levels. Personal income is projectedto grow an average of 26.2 percent in the U.S.from 1988 to 2000; with District states' growthrates ranging from 24.4 percent in Indiana, 24percent in Wisconsin, 23.7 percent in Iowa,

21.8 percent in Michigan, and 21.6 percent inIllinois. With income growing more slowlythan the U.S. average, it is unlikely that Dis-trict revenue performance will exceed nationalgrowth rates. Lower revenues will continue torestrain District expenditures.

Population growth also presents a chal-lenge to the District. While the U.S. popula-tion grew by just over 10 percent from 1980 to1990, growth in District states ranged from 4.3percent in Wisconsin, 1.3 percent in Indiana,.72 percent in Michigan, and .35 percent inIllinois. Iowa's population actually declined4.3 percent. Relatively low population growthwill affect the District in two ways. First, theDistrict's share of those federal funds that aredriven by population formulas will decline.Second, it will reduce the District's politicalinfluence by reducing the number of congres-sional seats held by District states. Figurespublished by the Northeast-Midwest Institute'indicate that District states will lose five seatsin Congress when the results of the 1990 cen-sus are concluded. The effects are even morepronounced when the slower growth rate inDistrict population is considered in a longertime frame. Since 1940, District states haverelinquished 12 congressional seats to otherparts of the country. This pattern of slowpopulation growth is expected to hold throughthe 1990s. The Department of Commerceprojects the District's population to grow byroughly 6 percent from 1988 to 2000, whilethe U.S. population as a whole will grow by8.9 percent.

On a more encouraging note, the District'sslow economic performance in the 1980scaused District states to adopt fiscal policiesfavoring moderate budget increases with lessdependency on rapid revenue growth.

Further, a potential advantage exists in theDistrict's low debt levels. District states havebeen slow to increase their bonding levels untilrecently. As a result, debt could be used toincrease fiscal and economic capacity in twoways. First, investment in infrastructure canimprove a state's economic attractiveness bycreating the capacity for economic expansion.Second, prudent debt use can be an economicstimulus during slow economic times whenother fiscal tools of government are con-strained. More active but judicious use of debtcapacity can pump state and local governmentdollars into the economy without having to

26 ECONOMIC PERSPECTIVES

pay for the liability immediately. In the longrun, total fiscal capacity can potentially beincreased as the economy expands in responseto better infrastructure. Moreover, the expenseof the liability can be spread over future tax-payers who will also share in the returns fromcapital investment and enhanced public serv-ices in any case.

Conclusion

Prudent budget management has helpedthe District states. To cite Michigan, this statewas running nearly an $800 million deficit in1982. By 1985, it had pulled itself out of thered and begun a $419 million budget stabiliza-tion fund. But even prudent budget manage-ment has its limitations in the face of a slump-ing economy. Declines in the state's automo-tive industry are already being felt in the cur-rent fiscal year. FY91 finds Michigan back inthe red, facing a potential $650 million budget

deficit. Similarly, Illinois, despite tight budgetpractices, finds itself struggling to maintain asmall monthly balance in its general fund andis looking to cut FY92 spending significantly.

Such volatility highlights the fact that theDistrict states can still fall victim to the sameills they faced at the beginning of the 1980s—a still heavy reliance on manufacturing and theproblems inherent in a cyclically-sensitive andindustrially-mature economy.

No one can predict the future with com-plete accuracy, but efficient and effectivebudget management will be the key tools stateand local governments will need to thrive (orsurvive) in the 1990s. As state and local gov-ernments grow more dependent on their ownsources of revenues, budget management willrequire that governments respond quickly tolocal and regional economic conditions inorder to preserve their fiscal health.

FOOTNOTES

'A state's general fund normally includes only expensesand revenues associated with the operation of the state, thatis, the administration of the state agencies such as Employ-ment and Training, Human Services, etc. Many states havespecial funds that are single-purpose funds such as univer-sity or capital funds which are not considered generalfunds.

'National Governors Association and National Associationof State Budget Officers, Fiscal Survey of the States,October 1988, p. 33.

'Specifically, this figure is comprised of general funds, ownsource receipts, plus contributions for social insurance andfederal grants-in-aid, less purchases of goods and services,transfer payments to individuals, net interest paid (lessdividends received), and subsidies.

'National League of Cities, City Fiscal Conditions in 1990.

'Advisory Commission on Intergovernmental Relations,Significant Features of Fiscal Federalism 1985-1986,Table 53, February 1986.

6 lbid.

'National Governors Association and National Associationof State Budget Officers, Fiscal Survey of the States,October 1988.

'Slow growth in property tax figures also reflects nationalefforts to reduce reliance on the property tax by increasingstate assistance for municipal programs such as education.

'For a more complete discussion, particularly of the impactof increased prison expenditures, see Laura Rubin, "TheCurrent Fiscal Situation in State and Local Governments,"Federal Reserve Bulletin, December 1990, pp. 1009-1018.

''Keith Laughlin, The Flow of Federal Funds 1981-1988,Northeast-Midwest Institute, March 1990,

"Ibid.

'National Governors Association and the National Asso-ciation of State Budget Officers, Fiscal Survey of the States,October 1988.

"Other surveys of state fiscal position include the NationalConference of State Legislatures survey and the StateBudget and Tax News, Tax Watch list.

"Gary L. Benjamin, "Agriculture and the Great LakesRegion," The Great Lakes Economy Looking North andSouth, Federal Reserve Bank of Chicago, Chapter 9 (forth-coming).

"Moreover, it can be argued that debt-financing of longterm assets such as roads and bridges are appropriately andequitably financed through a mechanism that spreads thetax burden across the generations who ultimately consumepublic services.

'For more on this topic, see David Aschauer, "Is PublicExpenditure Productive?" and "Is Government SpendingStimulative?," Staff Memoranda, SM-88-7 and SM-88-3,Federal Reserve Bank of Chicago, 1988.

FEDERAL RESERVE BANK OF CHICAGO 27

"Many efforts have been undertaken to construct moreexpansive measures of state ability to tap revenues orspend. For example, the particular mix of economic basewithin a state reflects the extent to which a state can shifttax burdens to residents of other states, that is, so-called"tax exporting". For a discussion see Advisory Commis-sion on Intergovernmental Relations, Measuring StateFiscal Capacity: Alternative Methods and Their Uses, M-150, Washington, D.C., 1986.

"State Budget and Tax News, Vol. 9, Issue 20, October 17,1990, p. 5.

19 Keith Laughlin, "Census Results Cast Shadow on Re-gion's Funding Fights," Northeast-Midwest EconomicReview, February 4, 1991, p. 11-13.

REFERENCES

Advisory Commission on IntergovernmentalRelations, Measuring State Fiscal Capacity:Alternative Methods and Their Uses, M-150,Washington, D.C., 1986.

, Significant Fea-tures of Fiscal Federalism 1985-1986, Table53, February 1986.

Aschauer, David, "Is Public ExpenditureProductive?" and "Is Government SpendingStimulative?," Staff Memoranda, SM-88-7and SM-88-3, Federal Reserve Bank ofChicago, 1988.

Benjamin, Gary L., "Agriculture and theGreat Lakes Region," The Great Lakes Econ-omy Looking North and South, Federal Re-serve Bank of Chicago, Chapter 9 (forthcom-ing).

Laughlin, Keith, The Flow of Federal Funds1981-1988, Northeast-Midwest Institute,March 1990.

, "Census ResultsCast Shadow on Region's Funding Fight,"Northeast-Midwest Economic Review, Febru-ary 4, 1991.

National Governors Association and Na-tional Association of State Budget Officers,Fiscal Survey of the States, October 1988.

National League of Cities, City Fiscal Condi-tions in 1990.

Rubin, Laura, "The Current Fiscal Situationin State and Local Governments," FederalReserve Bulletin, December 1990.

State Policy Research, Inc., State Budget andTax News, Vol. 9, Issue 20, October 17, 1990.

28 ECONOMIC PERSPECJIN'ES