Bonus Episode: State of the States

Episode Summary

Executive Summary: The discussion centered on the unusually strong fiscal position of state and local governments, driven by pre-pandemic discipline, strong tax collections, and federal aid. Speakers argued these governments are now a modest tailwind to GDP, though hiring remains constrained. Major long-term risks remain: pension and OPEB liabilities, Medicaid growth, unemployment insurance debts, and the 2026 expiration of federal relief funds.

Main Topics: State and local fiscal health is exceptionally strong (Priority: 5/5): Panelists agreed that states entered and emerged from the pandemic in their best financial shape in decades, with robust revenues and full rainy day funds, making them broadly recession-ready. State and local government as a modest macro tailwind (Priority: 5/5): The speakers argued that while state and local spending will support growth over the next few years, the effect will be small relative to the overall economy and constrained by inflation and staffing limits. Workforce shortages and efficiency pressures (Priority: 4/5): Local and state governments face persistent hiring problems, especially as retirements accelerate. The discussion emphasized technology, outsourcing, and process improvements as ways to do more with fewer workers. Long-term fiscal liabilities: pensions, OPEB, Medicaid (Priority: 5/5): Despite current strength, major structural issues remain, especially pension underfunding, retiree healthcare costs, and the growing share of budgets consumed by Medicaid and other social spending. Federal aid and infrastructure funds reshape near-term budgeting (Priority: 4/5): American Rescue Plan funds and infrastructure legislation are giving governments one-time resources that can be used for capital spending, technology upgrades, and tax relief, but not for permanent recurring commitments. Uneven conditions across states and cities (Priority: 4/5): Although the overall picture is strong, some jurisdictions—such as Illinois, Alaska, New York City, and certain transit systems—face distinct vulnerabilities and fiscal cliffs.

Key Arguments: State and local governments are in their strongest financial condition in the available data, largely because they entered COVID with healthy reserves and benefited from strong revenues and federal aid. The sector will likely contribute positively to GDP over the next several years, but the boost will be small and mostly one-time, not a major growth engine. Real spending growth is limited because inflation has outpaced budget growth, so nominal increases do not translate into much real expansion. Hiring shortages are structural; governments cannot simply rely on headcount growth and must invest in technology, outsourcing, and productivity improvements. Medicaid is a persistent pressure on state budgets and is crowding out spending on education, employees, and other core services. Long-term obligations such as pensions, OPEB, and deferred maintenance remain significant even if near-term liquidity is strong. The expiration of federal aid in 2026 will create a fiscal cliff unless states use the money for durable, one-time investments rather than recurring programs. Infrastructure aid will help, but its impact will be uneven and may be partially offset by inflation and by state governments shifting their own capital spending plans.

Data Points: State and local government share of GDP: 17% - Estimated by the speakers as the approximate share of the economy accounted for by state and local government spending. State and local government annual expenditures: About $3 trillion - Rough estimate of total yearly state and local government spending discussed in the episode. Federal support to states/localities: About $900 billion to $1 trillion per year - Combined grants, tax credits, and tax exemptions flowing from the federal government to state and local entities. ARPA state/local aid: $350 billion - Direct budget support to state and local governments under the American Rescue Plan. ARPA school aid: About $150 billion - K-12-related funding included in the broader American Rescue Plan package. ARPA deployment deadline: 2026 - Deadline by which states and localities must spend or deploy federal relief funds. States able to handle recession without tax/spending changes: About 39 states - Dan White said the annual stress tests indicate roughly 39 states could weather a recession without major tax hikes or spending cuts. State budgets for fiscal 2023 growth: About 1% nominally - NASBO data cited by the discussion, implying flat to negative real spending after inflation. State government non-education employment: Lowest level since 1993 - Dan White noted that state government employment excluding schools and universities is at a multi-decade low. Municipal market size: $4 trillion - Bill Glasgow described the municipal market as the principal infrastructure funding facility for the country. Infrastructure bill spending: About $500 billion over 10 years - Half of the roughly $1 trillion federal infrastructure package was characterized as new spending beyond existing highway commitments. Tax reductions: 32-33 states - Bill Glasgow said roughly that many states had adopted some form of tax reduction, rebate, or credit. New York City rainy day fund coverage: About half of projected deficits - Bill said NYC’s rainy day fund could cover roughly half of the Adams administration’s expected deficits over the next three years. State UI loans at peak: $52-$53 billion - Amount states owed during COVID-related unemployment insurance borrowing. California UI loans: About $17 billion - Example of a large state unemployment insurance loan balance still needing resolution. New York UI loans: About $8 billion - Another large outstanding unemployment insurance balance discussed as a future fiscal pressure. State/local fiscal recovery fund share: $195 billion - Bill referenced the state and local portion of federal fiscal recovery funds. COVID-era Medicaid redetermination issue: Millions of enrollees - States must now re-evaluate eligibility for people kept on Medicaid during the pandemic.

Pivotal Quotes: "They've never been in better shape financially than they are right now." — Dan White: Summary judgment on the fiscal condition of state governments heading into a potential recession. "State and local governments are not adding to economic growth. And sounds like maybe even a drag." — Mark Sandy: Reflection on nominal vs. real spending growth and the limited macro impact of current state/local budgets. "The reason states are being so conservative is because this is one-time monies." — Dan White: Explaining why federal relief funds are being used for one-off investments rather than recurring obligations.

Implications: State and local finances are strong enough to support growth, but only modestly. The big risk is what happens when federal aid expires and structural costs—especially Medicaid, pensions, and labor shortages—keep rising without matching revenue.