Plain Sense Economics

State and local governments have a particularly hard time during economic downturns. The Wall Street Journal, in this article on June 3 reminds us how state tax revenues decline quickly and recover slowly during recessions. This graphic from the article shows that it can take as long as five years for revenues to reach pre-recession levels.

Wall Street Journal 6/3/09

Revenues to state and local governments are sensitive to economic conditions. Sales taxes are tied to purchases, of course. Income tax revenue is often more problematic. If a state, like Oregon or California, has a progressive income tax structure (higher income citizens pay a higher tax rate) then when incomes drop not only do taxes go down but they go down even faster as people fall into lower tax brackets. Oregon is particularly vulnerable because it does not have a sales tax. California has been buffeted by this phenomenon – seeing wide swings in revenue as economic cycles pass through.

On the costs side economic recessions increase demand for state and local services and programs. These are part of automatic stabilizers, and help a bit with increasing aggregate demand. They cost money, however.

And yet, unlike the federal government most state and local governments are prohibited from running or planning a deficit. They must operate in the black, even in the face of seriously declining revenue and increasing costs.

Not a pretty picture.