On Friday my colleague Mark Muro showed us “four different styles of [fiscal] trainwreck” from Western states, which is the subject (along with a few suggestions for improving budgetary processes) of a report we released last week with the Morrison Institute in Arizona. 

Related, equally important, and in many ways more dire, though, is the local government fiscal crisis. And this crisis is about to escalate, for three main reasons:

  • Ongoing impacts of the state crisis
  • Shrinking property tax bases
  • Withdrawal of federal stimulus dollars

We first wrote about the local government fiscal crisis—then looming, now here—over one year ago in a paper with the National League of Cities and in a series of blog posts covering the impact of state and local budget cuts on public sector employment, which blogger Ezra Klein dubs the “anti-stimulus.” 

Local government finances initially plunged into the red as taxable economic activity declined with the recession but demand for services did not. These effects our new paper classifies as cyclical problems, and they’ll fade with the recovery. The three structural effects listed above, on the other hand, will ultimately define the era of the “new normal” as they impact local government finances for years to come.

Firstly, localities will have to deal with the ongoing and uncertain impacts of state actions to balance their own budgets. Since local governments derive about one-third of their revenues from states, their fortunes are directly linked to state budget decisions. Arizona counties, featured in our report, have already been forced to make unilateral transfers into the state general fund (to the tune of $34.6 million in FY 2010-11) and forgo their shares of certain monies, like those from the Highway User Revenue Fund ($13.2 million in FY 2010-11), for example. 

Next will likely come programmatic shifts and unfunded mandates. States can--and, in all likelihood, increasingly will--pass responsibility for certain programs onto localities. A range of constraints imposed by states will complicate adjustment. In 2000, Arizona, for example, capped permissible local property tax increases absent voter approval. Such inflexibilities plague localities across the country.

Property taxes--despite being the primary source of revenue at the local level--will in their own right become a second source of aggravation. Places hard hit by the housing market crash, like Phoenix and Tucson in Arizona, where house prices have tanked over 45 and 32 percent, respectively, may not see property tax receipts recover to their pre-bust levels for years. And because recessions hit collections with a two- to three-year lag anyway, many cities and counties will only now be reaching the trough in their property tax receipts—exactly where they’ll remain absent a robust housing market recovery.

Finally, stimulus dollars were a temporary reprieve that masked the severity of the downturn and shielded local governments--and residents--from sharper retrenchments during the worst of the recession, especially in education and healthcare. Only after these funds disappear will it become clear how harsh a reality the new normal actually represents. 

In all of this local governments face two wild cards: the pace of economic recovery, and the decisions made by state legislatures. As city and county leaders continue to try to balance dwindling local resources with needed local service delivery, they face the unsettling fact that the fate of their operations may largely be determined by how state lawmakers choose to deal with their own fiscal deficits--and the extent to which they off-load major expenses onto localities.  Amidst the uncertainty, however, one thing is certain: The impact of the recession on localities is about to intensify.