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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Email: glenn.follette@frb.gov andrea.kusko@frb.gov and byron.f.lutz@frb.gov
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The views expressed are those of the authors and do not necessarily represent those of the Board of Governors or other members of its staff

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.

2 However, tabulations of expected state budget balances as of spring 2008 pointto some deterioration infiscal 2008, and many states have reported sizable short falls in revenues in fiscal 2009. Data for local governments collected by the National League of Cities (2008) also point to strong budget balances in 2006 and 2007, although the organization’s most recent report warned that cities’ fiscal conditions have weakened dram atically since that time.

GOVERNMENT BUDGETS AND THE MACROECONOMY
State and local budgets return to the news with every cyclical downturn. 3
Two questions are ever present:
(1) how much does the weakening of the economy hurt budget balances and
(2) how much do actions taken to satisfy balanced budget
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1 These data are for fiscal years. For most states and many localities, the fiscal year extends from July 1 of a calendar year to June 30 of the following
calendar year. Fiscal years are designated by the calendar year in which they end.
2 Despite their conceptual differences, the NASBO and NIPA indicators have generally shown the same broad trends In recent years, however,
the year- end balances reported by NASBO seem higher than would be consistent with the published NIPA data, and it is not clear why this discrepancy
has occurred. Nonetheless, we interpret the NASBO indicator (as well assimilar assessments from the National Conference of State Legislatures)
as suggesting that states may be somewhat better positioned to weather the emerging fiscal strains than a straight reading of the NIPA data
would suggest.
3 For example, see Louis Uchitelle, “Think the Economy is Bad? Wait Till the States Cut Back,” New York Times,June 1, 2008.




requirements cut into overall employment and economic activity? Unfortunately, no single analytical apparatus provides satisfactory answers to both questions; thus, we rely on separate tools to answer these questions.
To assess the effect of the business cycle on state and local budgets, we use a high-employment budget framework that allows us to separate NIPA net saving into its cyclical and non-cyclical components; our measure is based on the methodology developed for the federal budget by Frank de Leeuw et al (1980), refined by Cohen and Follette (2000), and subsequently applied to the state and local sector by Knight, Kusko, and Rubin (2003). To assess the effects of state and local budgetary actions on the broader economy, we adapt the “fiscal impetus” measure developed by Cohen (1987) for the federal government; this measure combines information from various sources to provide a summary indicator of the sector’s discretionary budgetary actions.

High-Employment Budget
The high-employment budget methodology allows us to strip out the effects ofcyclical macroeconomic developments on actual budget outcomes and thus provides an indication of the path the budget would have followed had the economy continually operated at its potential level. (Potential GDP must be estimated and is defined as the level of economic activity consistent with high and sustainable levels of resource utilization—of both labor and capital.) The high-employment cyclical adjustment reflects the automatic change in revenues and expenditures produced by cyclical swings in economic activity, i.e. deviations in actual GDP from potential GDP. By design, it is unaffected by the actions governments take to offset the automatic changes in revenue or expenditures, such as tax rate increases in response to falling receipts. Using this methodology, we can divide NIPA net saving into a “non-cyclical” component, which corresponds to the budget path associated with high-employment (or potential) GDP, and a “cyclical” component, which is the difference between actual net saving and high-employment net saving. To construct our measure of the high-employment budget, we use the NIPA data on state and local net saving and the Congressional Budget Office’s (CBO 2008a) estimates of potential GDP; we follow the procedure detailed in Cohen and Follette