State Budgets: The Role of the Federal Government Is Increasingly Important

07/06/2011 10:40 am ET | Updated Sep 05, 2011

Following up on state fiscal challenges, our CBPP team has an important new figure showing that while state revenues are getting better, they're doing so a lot more slowly than in the past.


So I'm like... why? Are there structural changes -- ways in the which the underlying relationship between growth and state revenues have changed -- in play here?

To examine this possibility, I ran a very simple model of state revenues controlling for GDP growth. I ran the model through 2007q1, and predicted revenues through 2011q1. The blue line is real revenues and the red line controls for GDP growth (ignore the green line for now).

Up until the 2000s the fit is actually pretty good, as the predictions closely follow the actual revenue levels. But in this recession and the last one, the model breaks down.


Of course, you can see that in the first figure above. What's interesting here is that you get the same result even controlling for overall GDP growth. That is, you can't blame the weak revenue recovery on slow growth. Something else must be going on. For example, if states have followed the federal model and hollowed out their tax code (by lowering rates or narrowing the base), you'd get a picture like the one from the model.

Also, as my CBPP colleague Nick Johnson suggested, the fact that the last two downturns bit into household wealth -- like asset appreciation -- is important in this context (and GDP doesn't capture the full spate of wealth effects, e.g., it leaves out capital gains). Some states depend more on sales than income taxes, and since wealth losses whack consumption, that also hurts their coffers.

Adding net wealth to the model (green line) yields an interesting result: it explains little of the gap in the early 2000s recession but most of it in the recent downturn. My guess would be that has a lot to do with the scope and depth of the wealth losses. The stock market crash that precipitated the early 2000s downturn was particularly tough on high-end wealth relative to the housing bust of the Great Recession. In the latter case, you hit a lot more people in the middle class with a negative wealth effect that fed directly into state (and local) revenues.

Again, this means that federal countercyclical policy is not just important to help states through rough patches. It's increasingly important.

This post originally appeared at Jared Bernstein's On The Economy blog.