We have raised our estimate for fourth-quarter real GDP growth to 4% (annualized),from 3% previously. This is based on this

week’s s

tronger-than-expected data on trade,inventories, and retail sales. However, westill expect growth to slow in 2010.One reason is the weakness in the state andlocal government sector. In July weestimated that state and local efforts tobalance FY 2010 budgets would exert a dragworth 0.6%-0.7% of GDP from mid-2009through mid-2010 as the stimulus in theAmerican Recovery and Reinvestment Act(ARRA) provided only a partial offset tolarge state revenue shortfalls. This estimateis on track judging from the latest data.In particular, last spring

’s budget g

aps werewider than we thought, income and sales taxreceipts have continued to fall well below

budget officers’ projections, and outlays for

health and income support programs havebeen higher than expected.Looking ahead, we expect the state and localbudget gaps to persist, and the associatedgrowth drag is apt to intensify if the federalstimulus winds down after 2010, as nowspecified by law. Already, 30 states projectgaps totaling $55bn for FY 2011, and thisnumber is likely to rise significantly.In response, talk of extending the state andlocal components of ARRA has surfaced inWashington; the House included a provisionto extend Medicaid help in its health reformbill, and President Obama suggested that theeducation block grants might also beextended. Together these measures could beworth tens of billions if they pass.

State Income Taxes Disappoint

1.3-12.5-11.4-16.4-20-15-10-50510-20-15-10-50510Percent change, year agoPercent change, year ago

Fiscal Year Q3 Data

BudgetOfficers'ExpectGS Estimate(July 2009)NIPARockefellerInstitute+** Midpoint of -10%to -15% range.

Income Taxes

State Fiscal Drag Will Persist

-31.0-71.8-38.7-5.7-41.1-74.1-55.5-68.8-30.6

-200-150-100-500-200-150-100-500FY2009FY2010FY2011FY2012???State Budget Gaps:Source: National Conference of State Legislature. Our estimates.Billions of dollarsBillions of dollars

-102.7

Offsetby ARRARemainder Known by Nov'09 (Nov '08 for FY '09)Announced After Nov '08

Five months ago we estimated that state and localgovernments would exert a drag of 0.6-0.7 percentagepoints on annualized real GDP growth between mid-2009 and mid-2010, a period that corresponds to fiscalyear (FY) 2010 for most of these jurisdictions.

Thisprojection was predicated on: (1) an observation thatfederal fiscal stimulus under the American Recoveryand Reinvestment Act (ARRA) would offset only partof the shortfalls state governments faced in attemptingto balance their budgets, and (2) a judgment that taxrevenues would continue to fall short of expectationsas the fiscal year unfolded, reflecting the depth of therecession. Together, these two factors implied thelikelihood of $80-$100bn in fiscal restraint to bringand keep these budgets in balance.This estimate is about on track judging from theinformation that has come to light since midyear. Inparticular:

1. State budget gaps going into FY 2010 wereeven larger than we thought.

In April, theNational Conference of State Legislatures(NCSL) estimated that these gaps totaled $121bn.This was the latest figure available for our Julyanalysis, but it has since risen to $146bn.

Inother words, state governments had to carve out$25bn more in tax hikes or spending cuts than wehad expected as they finished work on FY 2010budgets, a figure worth close to 0.2% of GDP.

2. Income and sales tax revenues have started the

fiscal year well below state budget officers’

expectations.

In July, we said that theseexpectations

—

up 1.3% for income taxes and 3%for sales taxes

—

seemed unrealistically high giventhe depth of the recession and the normaltendency for tax revenues to lag economic turningpoints. Data for the third quarter support thisskepticism. As shown in Exhibit 1, year-to-yearchanges in both categories were deeply negativeaccording to the Rockefeller Institute of Government, which tracks state revenue. Figuresin the national income and product accounts,which add in local government revenues, were

See “The State and Local Sector: What a (Fiscal)Drag!,”

US Economics Analyst

, July 10, 2009.

As noted in our July piece, this figure is the aggregateof the largest shortfalls faced by states at any timethroughout the budget season. While its componentsrefer to different points in time, this is a realisticestimate of the amount of budget-cutting that isrequired at a time, such as now, when favorablerevisions are apt to be few and far between.

also down sharply. This was the basis for our fullfiscal year estimates, and for both categories it isclear that the year is off to a very weak start. Theevidence on corporate taxes

—

not shown

—

ismore mixed but also less important as these leviescomprise only about 4% of state tax revenue.

3. As a result, most budget officers have loweredtheir sights on general revenues for FY 2010.

According to the NCSL, 39 states plus PuertoRico now expect general revenues to fall in FY2010, and at least 9 expect setbacks of more than5%. Of the 10 states indicating that generalrevenue might beat their projections, several

—

including California

—

have cited tax law changes(rather than economic conditions) as the principalreason. Judging from the data presented in

Exhibit 1:

State Income Taxes Disappoint…

1.3-12.5-11.4-16.4-20-15-10-50510-20-15-10-50510Percent change, year agoPercent change, year ago

Fiscal Year Q3 Data

BudgetOfficers'ExpectGS Estimate(July 2009)NIPARockefellerInstitute+** Midpoint of -10%to -15% range.

Income Taxes

…So do State Sales Tax Receipts

3.0-2.0-8.2-5.9-10-50510-10-50510Percent change, year agoSource: NASBO. Rockefeller Insitute. Commerce Dept. Our estimates.

Fiscal Year Q3 Data

BudgetOfficers'ExpectGS Estimate(July 2009)NIPARockefellerInstitute

Sales Taxes

+Percent change, year ago

Exhibit 1, the reduced expectations for the groupas a whole still embody an implicit assumptionthat year-to-year tax flows will improve over thenext three quarters. This is not unreasonable foran economy that is slowly coming back to life, butthe risks still lie to the downside. For example,the Rockefeller Institute reports that tax flows inthe fourth quarter remain depressed according toits contacts.

4. Spending has also surprised to the high side.

Although revenue shortfalls have been the mainfactor causing budget gaps to reemerge during thefiscal year, state governments have had to spendmore on Medicaid and other public supportprograms, the need for which rises as theeconomy weakens. Almost two-fifths of thestates reported this as a problem.

5. Together, surprises on both sides of the ledgerhave opened up a new mid-year budget gap of at least $28bn.

We say “at least” because 15

states have not yet revised estimates; the $28bnfigure comes from the other 36 that have done so(counting Puerto Rico among those that now seenew shortfalls). Of the missing 15, only a few areapt to avoid midcourse corrections, and some of the 36 will probably find that their gaps are evenwider than they now anticipate.We therefore see a high risk of more disappointmentsin coming months. The potential is illustrated in theleftmost bar of Exhibit 2, which shows how forecastsof the aggregate state budget gap evolved for FY2009. Of the final $103bn shortfall, only $72bn wasforeseen when the NCSL conducted its November2008 survey (shaded areas of the bar). Of course, theinterval from then until the April 2009 survey was oneof extremely rapid deterioration in economic activitywhereas now most forecasters

—

ourselves included

—

expect the upturn to continue in coming months. Thatsaid, official forecasts of state budget gaps have a wellestablished history of undue optimism early in arecovery. In 2002 and 2003, for example, officialbudget estimates were also much too high.

The exhibit also shows that federal fiscal stimulus (inthe light grey portion of each bar) is now likely to fillonly about half of the gap that the budget officerscurrently expect for FY 2010, leaving a net drag of $74bn, or just about ½% of GDP (the dark segment).Our 0.6%-0.7% estimate of the ultimate FY 2010 dragthus allows for $15bn-$30bn in adverse budgetsurprises in coming months (the hollow segment withthe question mark), a range that has usually beenexceeded during similar phases of the business cycle.

ee Figure 1 in “State Budget Update: April 2009,”

National Conference of State Legislatures, April 2009.

The most important message from Exhibit 2 is theprospect that the state (and local) fiscal drag willpersist into FY 2011 and FY 2012 and likely increaseas the help currently being provided under ARRAfades out midway through the next fiscal year (end of calendar 2010). The November NCSL survey showsthat 30 states (plus Puerto Rico) estimate an aggregategap of $55bn for FY 2011. Since most of theseestimates appear to treat ARRA funds as receipts, the$55bn total can be regarded as a preliminary estimateof the net state and local drag for FY 2011. While thisis smaller than the $74bn FY 2010 drag, it is bound tosurpass that figure as the other 20 states formulatetheir projections. Among the missing: several largestates

—

Illinois, Massachusetts, North Carolina, andPennsylvania

—

and one smaller one (Oregon) withsevere financial difficulties.Notably, the projections show the gap rising further inFY 2012, to $69bn for just 20 states. By that time, the

federal government’s countercyclical support to state

and local jurisdictions will be down to tag ends, atleast as the law currently stands.While the $69bn point estimate for FY 2012 cannot betaken at face value given the number of missing statesand the distant horizon, we can be reasonably sure thatstate and local finances will pose a significant obstacleto US growth that far into the future, if not longer.After all, these governments face most of the samecyclical and structural budget issues that bedevil thefederal policymakers. From a cyclical standpoint theGreat Recession has put a serious dent in the tax baseand saddled the economy with the highest jobless ratein almost 30 years. As a result, outlays for incomesupport are apt to remain high for several years, while

Exhibit 2: State Fiscal Drag Will Persist

-31.0-71.8-38.7-5.7-41.1-74.1-55.5-68.8-30.6

-200-150-100-500-200-150-100-500FY2009FY2010FY2011FY2012???State Budget Gaps:Source: National Conference of State Legislature. Our estimates.Billions of dollarsBillions of dollars

-102.7

Offsetby ARRARemainder Known by Nov'09 (Nov '08 for FY '09)Announced After Nov '08