The typical analysis of state and local government finances is that they are primarily a function of the economy. When the economy is growing well, and especially when it is growing faster than expected, local and state government finances prosper. When the economy grows, more people are employed and employees have larger paychecks. State income and sales tax revenues increase. Property tax receipts go up because the price of housing increases. Irrespective of government policies–whether of the right or the left–a “rising tide lifts all boats,” or at least all government boats. Historically, the state of the economy usually has driven government tax revenues in good times and bad.
The conventional analysis may be changing–and in a way that may lead to unanticipated fiscal shortfalls in many state and local government agencies even in the coming, 2019-20, fiscal year. The first problem is that the stock market is headed lower. Though historically local and state government budgets have been mostly influenced by the economy, now the stock market may play as large, if not a larger, role.
Every public employee pension fund in the United States is actuarially unsound. Within California, CalPERS, CalSTRS, and the many county public employee pension plans all project continuing, year in and year out, returns on investment of approximately 7%. This means that the stock market would have to double every 10 years for already underfunded public employee pension funds to remain able to pay their guaranteed benefits.
There is no way this is going to happen. The current projected actuarial return of 7% means that the stock market would have to be close to 100,000 in 2038 for pension funds to be able to pay their benefits, which is very unlikely. In the short run, the emerging bear market will require state and local pension funds to reduce their anticipated rates of return, and this will cause every government agency in the state to feel pain. A long-term diminishment in the return on investment of even one half of one percent has been estimated to cost state and local governments $5 to 10 billion per year. It is already projected–assuming an actuarial return of 7% per year on investments–that the cost of public employee retirement contributions will close to double for state and local agencies between now and 2024. If the rate of return declines as well, these costs will grow even higher.
But it gets worse. Among the elements of the federal tax reform act of 2017 was to cap the amount of a home mortgage the interest for which can be deducted at $750,000 (the amount previously had been $1 million). This makes home purchases above $750,000 effectively, after taxes, more expensive. Moreover, another aspect of the 2017 tax reform was to cap deduction of state and local taxes at $10,000, which also makes the effective cost of owning property more, since property taxes above this amount can no longer be deducted. Finally, although increasing interest rates affect all sectors of the economy, they may influence housing the most. Moreover, increased interest rates will also have a negative effect on real estate prices, thereby resulting in lower property tax revenues than projected.
There remains, finally, the overall state of the economy, apart from the stock market and real estate prices. Here, too, in large part as a result of increasing interest rates and the trade war and general instability fostered by President Trump, the rate of economic growth appears to be declining to about half of what it recently has been–from about three to three and a half percent annual growth to about one and a half to one and three quarters percent annual growth. This, too, will diminish local and state government income.
The days of fiscal wine and roses for local and state governments are over. Long term trends are finally catching up with state and local government spending and receipts. Reform of public employee pensions is long overdue and general tightening of government expenditures will also be required–starting in the 2019-20 fiscal year. Further increases in state and local taxes are unlikely in a diminishing economy.
Lanny Ebenstein teaches in the Department of Economics at UCSB. He is the author of the first biographies of Milton Friedman and Friedrich Hayek. His most recent book, Chicagonomics: The Evolution of Chicago Free Market Economics (2015), was an “Editors’ Choice Selection” in the New York Times Book Review.
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