States Are Finally Overcoming the Fiscal Headwinds
Policy + Politics

States Are Finally Overcoming the Fiscal Headwinds


There was an important subtext to last week’s news that the economy grew at 2.3 percent during the last quarter.

During the past four years, fiscal belt-tightening by federal, state and local government created a drag on the overall economy, according to economic analysts. Spending dropped sharply in 2009 and continued to slump through mid-2013 – meaning cuts in labor and social programs and loss of construction projects.

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But the good news last week was that this picture is changing. Slightly more robust federal, state and local spending were responsible for about two-tenths of a percentage point of the overall 2.3 percent national economic growth spurt in April, May and June.

While 0.22 points of growth may not seem like much to the average American, it suggests that state and local governments have finally crossed the line from being a drag on the economy to becoming a modest engine of growth.

Or as Louise Sheiner, a senior fellow in economic studies at the Hutchins Center on Fiscal and Monetary Policy, put it late last week, “The fiscal headwinds are finally behind us.”

“Overall, fiscal policies have been about neutral (zero) over the past year,” she wrote in a blog post for the Brookings Institute. “Fiscal policy is no longer a source of contraction for the economy, but neither is it a source of strength.”

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This progress – albeit it minor – was documented by the Hutchins Center’s Fiscal Impact Measure – a device that estimates the effect of federal, state and local spending and taxes on inflation-adjusted growth in the Gross Domestic Product.

As the chart below indicates, the trend in federal, state and local spending, taxes and transfer payments at all levels of government have been in a trough for the past four years. Now they have broken into positive territory.

The comeback in state and local government spending and economic expansion after the worst recession in modern history has been a mixed picture at best. A number of studies by think tanks have heralded a comeback in the state and local tax base, and an increased willingness of officials to expand their workforces and launch new projects.

Related: States Are Spending More as Economy Improves

Late last year, a report by the National Association of State Budget Officers forecasted “moderate growth and stability of state budgets in fiscal 2015.” The study said general fund spending and revenues were projected to increase for the fifth consecutive year, based on the enacted budgets of the states.

Other states and cities, still reeling from budget shortfalls and underfunded employee pension programs, continue to tread water or struggle to avoid budget deficits. Moreover, a recent analysis of Labor Department data by the Associated General Contractors of America shows that construction employment declined in 25 states between May and June amid uncertainty over the prospects for new long-term federal highway legislation.

As Sheiner noted in her analysis, state and local governments still appear very cautious about hiring and investment. “In the second quarter of this year, spending jumped sharply, but that followed a weak first quarter that was likely affected by weather,” she wrote. “Over the past year, the positive contribution of state and local governments to GDP growth has averaged one-tenth of a percentage point, while GDP growth averaged 2.3 percent.”

Finally, a tightening of federal assistance to the states was also a big culprit in the economic contraction in recent year.  The economy paid a price for the end of the federal stimulus and tax breaks enacted by Congress and President Obama in 2009 during the worst of the recession.

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State and local governments also suffered from the impact of tight spending caps and across the board cuts mandated by the 2011 Budget Control Act.  Although Congress and President Obama agreed to temporarily lift those caps during the past two years, they will be restored on domestic and defense spending in the coming fiscal year unless the White House and Congress cut a deal to allow for more spending.

“All told, federal spending lowered real GDP growth by an average of 0.35 percentage points per year between 2011 and 2013,” according to Sheiner. “Over the past year, real federal spending has been about unchanged, neither adding to nor subtracting from real GDP growth. Similarly, taxes and transfers at all levels of government have been a roughly neutral factor in recent quarters.”