States are under long-term stress, not in a short-term crisis

29 Mar 2011 by Jim Fickett.

State and local tax revenues have been growing at something close to trend rate. The big problems are long-term ones, for example that the growth rate in transfer programs like Medicaid exceeds the growth rate of tax revenues, and that public retirement programs have made promises not yet backed by funding. Investors should be prepared for long-term headwinds, but not too worried by headlines about short-term crises.

Last week the Bureau of Economic Analysis released state and local government budget data through Q4 of 2010. Looking at the data over a long period makes it quite clear that many of the problems states and cities are facing were in the making long before the financial crisis. Here is the income side of the equation:

(Data from NIPA table 3.3. Click for larger image.)

Along the length of “Tax receipts” curve, I have plotted a curve with a constant growth rate of 1.55% per quarter. This shows that growth in tax receipts was clearly above trend from 2003 to 2007, and then dropped suddenly. A big part of the state budget problems is due to the fact that not enough of the boom time revenues were saved. Note also, with respect to income, that the current growth in tax revenue is pretty close to trend. So although current adjustments are indeed difficult (and with more coming when the extra help with Medicaid runs out), it is not quite so bad as you might think from the howls of pain.

Here is the expenditure side of the equation:

Note that consumption is still growing. So, although more cuts will likely be necessary when the special Medicaid programs end, it is not quite the situation the newspapers portray, of never ending cuts.

Consumption (which includes wages and salaries) is growing only slowly now for two main reasons. First, state and local governments tend to delay painful decisions, using up rainy day funds instead of making cuts, for as long as possible, so the adjustments to much earlier falls in revenue are still going on. And second, “Transfers to persons”, including Medicaid and other social programs, have lately been rapidly rising.

However growth in the cost of social programs, though often portrayed in the news as a short-term phenomenon resulting from the crisis, is really a long-term trend. It is clear in the graph that recent rises are not far out of line with the longer term. It is a long-term problem, and a serious one, that the compound annual growth rate of “Transfers to persons”, over the last thirty years, has been 2.0% per quarter, while the growth in tax revenues has been 1.5% per quarter. Something will have to give.

My main point with all this is to say that investors should expect ongoing stress for a long time, but should probably not expect a short-term crisis, nor many defaults.