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Daniel Carroll |

Research Economist

Daniel Carroll

Daniel Carroll is a research economist in the Research Department of the Federal Reserve Bank of Cleveland. His primary research interests are macroeconomics, public finance, and political economy. Currently, he is studying the implications of progressive income taxation for the distributions of wealth and income.

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06.25.10

Economic Trends

Recession Shrinks State and Local Governments

Daniel Carroll

State and local governments make up a large portion of our economy, together accounting for 11.8 percent of GDP last year. State and local government employees represent roughly 15 percent of the total nonfarm labor force, a number seven times that of federal government employees and larger than the manufacturing and construction workforces combined. Because of its large relative size, changes in the state and local government sector can have a significant impact on the economy. For this reason, there may be reason for concern over the recent contracting trend in state and local budgets.

In 2008, growth in state and local tax revenues began to slow, and in 2009 it fell sharply (5.5 percent). Although a 22 percent increase in federal aid shored up this shortfall, it underscores the challenge facing state and local governments in the near future even as the national economy begins recovering from its most recent downturn.

Unlike the federal government, which can issue long-term debt during recessions to cover budget shortfalls, nearly every U.S. state has some sort of balanced budget amendment which requires that current revenues equal expenditures on operating budgets over some fixed, short horizon (usually one or two years). This makes a slow recovery especially problematic. Because state and local governments are not permitted to deficit finance these expenditures, they do not have time to wait for tax revenues to return to their pre-recession levels. Reluctant to lay off workers, state and local governments turned first to hiring freezes or restricting labor hours of employed workers through furloughs. Some reorganized their labor forces, cutting positions but offering laid-off workers a lower-paying job in another area.

These policies could account for the slow pace of decline in total jobs between mid-2008 and mid-2009. Since the second half of 2009, however, the number of state and local government jobs has been declining much more precipitously. Since its high in September 2008, the number of state and local government employees has fallen by more than 1 percent. Although this figure may seem small when compared to the national rate of nearly 10 percent, for the government sector this is a large movement. In fact, it is the largest decline within a two-year period since the series declined by 3.1 percent between December 1980 and August 1982. With tax revenues still far below trend level, state and local governments will continue to rely heavily on federal aid to avoid more layoffs.

Not only are state and local governments cutting jobs, but they are also decreasing capital investment. In the first quarter of 2010, gross investment by state and local governments fell by 5.4 percent from the previous quarter and reached its lowest level since the first quarter of 2007. This is remarkable given that capital expenditures are not usually constrained by balanced budget amendments and perhaps signals that state and local governments are anticipating tight tax revenues for a considerable period.

The cuts in labor and investment by state and local governments suggest that even as the economy and the private sector pull out of the recession, state and local government will lag behind and could act as a drag on the overall recovery.