Fiscal Stress Faced by Local Governments

December 9, 2010

In 2009, the expenditures of local governments—including counties, cities, towns, school districts, and special districts—equaled 8.7 percent of gross domestic product, and those governments employed just over 9 percent of the labor force. Those governments, which play a significant role in people’s lives and in the nation’s economy, have not been immune to the weak economic conditions of the past few years. Many are facing significant budgetary challenges (often termed “fiscal stress”) and have been compelled to constrain spending and services.

Today, CBO published an issue brief entitled Fiscal Stress Faced by Local Governments, describing the economic conditions and budgeting practices that can lead to fiscal stress at the local level. The brief also reviews the options available to local governments, state governments, and the federal government for addressing such financial difficulty. Last, the brief examines two options that local governments very rarely use—defaulting on their debt or filing for bankruptcy.

Causes of Fiscal Stress for Local Governments

Local governments vary considerably in size, purpose, spending, and revenue sources. Collectively, local governments derive nearly one-third of their revenues from state aid, about one-quarter from property taxes, one-tenth from sales and other taxes, and most of the remainder from fees and miscellaneous revenues; only 4 percent represents direct aid from the federal government.

Fiscal stress—a gap between projected revenues and expenditures—can be short term, in the case of transitory economic shocks or long term, in the case of structural budget imbalance. Weak economic conditions lead to short-term fiscal stress for local governments by reducing their tax revenues, lessening the state aid they receive, increasing the demand for some services, and triggering investment losses. A relatively constant source of local funds—property taxes—may not provide adequate revenue over the next few years because of the dramatic drop in housing prices nationally. Further, although state governments provided 30 percent of revenues for local governments in 2008, state revenues—primarily from income and sales taxes—have plummeted during the weak economic conditions of the past two years. States have consequently cut the amounts provided to local governments.

Long-term imbalances in local budgets arise from a variety of sources that can be difficult to disentangle. Political dynamics, demographic shifts, and inadequate budgetary or financial controls may contribute to long-term imbalances.

Local Governments’ Responses to Fiscal Stress

Municipal governments can take a variety of actions in response to fiscal stress, including:

  • Decreasing Spending: Local governments reduced spending in real (inflation-adjusted) terms by 0.6 percent in 2008 and by 1.9 percent in 2009. Since 1970, local governments have rarely reduced their workforces, but they did so by 241,000 employees, or 1.7 percent, between December 2007, when the recession began, and November 2010.
  • Increasing Taxes and Fees: Despite the decline in property values over the past four years, some combination of tax rate increases, lagged updates of the assessed values to which local property tax rates are applied, and expansion of the tax base through new construction has led to increased property tax collections over that period. However, such collections will probably fall in the next few years as the drop in property values is reflected in assessed values; local governments might then decide to increase taxes and fees to make up for the losses, depending on the laws in particular states.
  • Shifting the Timing of Payments: Local governments can delay scheduled payments or undertake other temporary measures that balance their budgets in one year by pushing costs into subsequent years. Postponing contributions to pension or health care funds may represent a short-term shift in payments.
  • Borrowing: Local governments can borrow to cope with fiscal stress. Like delaying payments, borrowing postpones rather than resolves the need to pay for expenses, and it may increase those expenses because of debt-service costs. The most common forms of borrowing include the use of short-term debt to fund operating deficits and the use of long-term debt to fund capital expenses or contributions to pension or health care funds.

Responses of States and the Federal Government to Local Governments’ Fiscal Stress

Before decreasing spending or increasing taxes or fees, most local governments seek additional aid from state governments. State aid takes many forms, including increased revenue sharing, additional grants, and the provision of debt guarantees. States can help alleviate changes in revenues caused by local shifts in population by redistributing revenues from one jurisdiction to another. Alternatively, states can adjust taxes that cross jurisdictions, such as commuter or nonresident income taxes, to reduce the incentives for people to move to new areas. In the event of severe fiscal stress, a state may opt to take an active role in overseeing the finances or management of a municipality.

The federal government assists local governments through grants, loans, debt guarantees, and certain provisions of the tax code. Federal aid is rarely provided to local governments specifically because they are experiencing fiscal stress, but aid has been provided recently for local governments in areas that were affected by the economic and housing downturns and by natural disasters. For example, in August 2010, the Congress provided $10 billion for aid to the states, almost all of which was required to be conveyed to local school districts to fund jobs in education.

This brief was prepared by Elizabeth Cove Delisle of CBO’s Budget Analysis Division.