measures to smooth the transition.

measures to smooth the transition. However, they will likely transfer some of the pain to
local governments through reductions in aid.
Will this time be different than previous slowdowns? Yes, it always is. One
major consideration in applying our results to the current situation is that our analysis is
geared to identifying the regular effects of the business cycle on state and local budgets
and thus probably does not capture the full effects of the downturn in the housing market.
These include the stresses on local budgets caused by the drop in home prices, the
reduction in sales tax receipts associated with the exceptional weakness in retail sales of
items related to housing, and the loss of real-estate transactions taxes and fees.13
Moreover, personal income taxes have been bolstered in recent years by strong
collections of capital gains taxes. If capital gains receipts weaken in 2009—as seems
likely in light of the performance of the stock market in 2008—state and local budgets
could come under even more pressure than a high-employment budget analysis would
suggest.
CONCLUSION
Our analysis yields two major conclusions. One is that macroeconomic developments
contribute importantly to swings in state and local net saving—albeit much less than at
the federal level: We estimate that, in today’s economy, a 1 percent drop in GDP relative
to potential—roughly equal to a ½ percentage point rise in the unemployment rate—
would lower state and local net saving about $13 billion. If, for example, governments
wanted to maintain their prior net saving positions in the face of the weaker economy,
they would have to raise own-source revenues by 1 percent, cut current expenditures a
comparable amount (in dollar terms), or undertake a combination of the two. Our second
conclusion is that while actions taken by state and local governments to keep budgets on
track may have substantial effects on individual programs and populations, the impact of
these actions on overall economic activity is relatively modest. The modest effect
probably owes in part to the ability of state and local governments to spread budget-repair
efforts over a period of several years as well as the fact that balanced budget
13 See Lutz (2008) for a discussion of the effects of home prices on local tax revenue.
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requirements help keep the sector’s expenditures and revenues from getting too far off
track.