AbstractWe examine the interplay of

Abstract
We examine the interplay of the economy and state and local budgets by developing and examining two measures of fiscal policy: the high-employment budget and fiscal impetus. We find that a 1 percentage point
increase in cyclical GDP results in a 0.1 percentage point increase in NIPA-based net saving through the automatic response of taxes and expenditures. State and local budget policies are found to be modestly
pro-cyclical. Stimulus to aggregate demand is about 0.2 percentage point less following a business cycle peak than it is during the period before the business cycle peak

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State and Local Finances and the Macroeconomy:
The High-Employment Budget and Fiscal Impetus
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INTRODUCTION
Once again, states and localities are facing budgetary pressures and are being forced to take actions to get their fiscal houses in order. Indeed, as measured in the National Income and Product Accounts (NIPA), the sector has posted sizable deficits in its aggregate operating budget inrecent quarters after having experienced a substantial improvement in budget conditions between 2002 and 2006. In this paper, we review recent developments affecting the sector and introduce some analytical tools that can help quantify the interactions between state and local budgetsand the broader economy. We then use these tools to examine previous episodes of “budget repair” for insights about how the adjustment process plays out and how it affects the broader economy.

RECENT STATE AND LOCAL BUDGET DEVELOPMENTS
The fiscal condition of state and local governments lost some luster in 2007 after having improved significantly over the preceding few years; the difficulties have continued—and, in some cases, intensified in 2008. Although some governments—especially those in agricultural and energy-producing regions—continue to enjoy strong
fiscal positions, others are reporting sizable shortfalls in revenues as a consequence of the macroeconomic slowdown and the downturn in real estate markets. Moreover, these difficulties have been compounded by rapid increases in energy and construction prices, along with ongoing pressure from Medicaid outlays.

Our analysis is based on data from the NIPA. These data are aggregated across all state and local governmental units in the United States and are published on a quarterly basis by the Bureau of Economic Analysis (BEA);they are available through the second quarter of 2008 although the figures for recent years are subject to substantial revision. The key summary measure in the NIPA is net saving, which is the difference between current receipts and current expenditures and is broadly similar to the surplus or deficit in an operating budget. As Figure 1 indicates, the recent peak in net saving occurred in 2006, when it was equal to 0.4 percent of potential GDP ($46 billion)—similar to the levels reached in the late 1990s in dollar terms but somewhat smaller as a percent of GDP.

However, net saving fell markedly in 2007 and turned sharply negative in the first half of 2008 as revenue increases tailed off after a period of hefty gains and as nominal expenditures—especially on energy and health care—soared. Information collected by the National Association of State Budget Officers (NASBO) is also useful in assessing the sector’s fiscal condition and is presented in Figure 2.
1 In the NASBO framework, the main summary indicator of the fiscal condition of the states is the aggregate balance at year-end in their general and rainy day (budget stabilization) funds. The year-end balance is a combination of stocks and flows. It captures both the flow from this year’s new saving—revenues less expenditures—and the accumulated stock of savings from prior years. According to NASBO (2008), state balances at the end of fiscal 2006 were at a 30-year high (relative to expenditures) and emained elevated in fiscal 2007.