Economic Recovery? Where are the Tax Revenues?

I wrote about this on January 28. Bottom line is that if the economy is recovering, tax revenues should be increasing, but that is not what’s happening. This from the March “Moving Markets” newsletter: (Note: For a free subscription to this monthly newsletter providing economic and market commentary, click on the free newsletter offer on the right hand side of this site)

Gary Shilling, in the March issue of his “Insight” newsletter discusses the difficulty that state and local governments are having with their budgets. With unemployment up, tax revenues are down but expenses haven’t followed. Shilling cites these facts:

· Personal state taxes collected were down 11.8% in the 3^rd quarter of 2009 versus the same period one year earlier.

· Personal taxes account for a minimum of one third of total tax revenue in 28 states and exceed sales taxes in 25 states. Ouch!

· In spite of a slightly better business climate of late, corporate tax revenues were still down in the third quarter form one year prior by 22.6%. Ouch, again!

· Because consumers have hiked their rate of personal savings for the first time in 25 years, resulting in less spending, state sales tax revenues were down 8.9% in the third quarter of 2009 from one year earlier.

· Many states get about 55% of their revenue from these three sources – personal state taxes, corporate taxes and sales taxes. These statistics are nothing but bad news for them. Revenues from these three sources were the worst that they’ve been at any time since records began in 1963.

· While complete numbers for the 4^th quarter are not yet available, with 38 states reporting, the weakness appears to be continuing. With 38 states reporting 4^th quarter numbers, revenues fell 5.4% from one year earlier, with a median 6.5% drop in personal income taxes and a 5.5% decline in sales taxes.

With tax revenues at the state and local levels linked to economic activity those statistics may tell us that the economy is still ailing and weak. Economic recovery typically means that tax revenues increase and that’s not happening.

This trend of declining tax revenues is taking its toll. A survey of 379 municipalities found that in fiscal year 2009, which ended at the end of June 2009 for most cities, revenues fell .4% while expenditures rose 2.5%. (Source: March 2010 “Insight”) When considering that statistic, also consider that real estate tax revenues were still up by 1.7%, a fact that’s likely to change once real estate taxes are adjusted to reflect lower real estate values in most areas of the country.

In his newsletter, Shilling presents evidence that state and local governments have not yet come to grips with the reality of the recession. Since the recession began in 2007, private payrolls have declined by 7.4%, yet state and municipal employment rates haven’t changed. But, that trend may be changing according to Shilling.

The City of Los Angeles recently cut 4,000 jobs since they were facing a $200 million budget shortfall this year and $500 million next year. The job cuts will save the city $260 million annually.

State governments are also facing additional Medicaid spending – spending that the Federal Government mandates but does not fund. During fiscal year 2008, these Medicaid expenditures cost states 20.7% of all outlays on average according to Shilling. Shilling also comments that state rainy day funds, estimated to be $36.5 billion in fiscal year 2009, have likely been exhausted.

That leaves states in a precarious situation. Slush funds are largely gone, revenues are still declining, and expenses haven’t changed. You don’t have to be an accountant to figure out that won’t work for long.

As a result, State and Local Government debt outstanding increased by 3.3% in 2009 from 2008. (Source: Federal Reserve)

While State and Local Governments are carrying more debt, this debt on their balance sheets doesn’t fully reflect the complete financial liabilities of many of these entities. According to the Pew Center, as of June 30, 2008, state reports show that they are obligated for $3.35 trillion in pension benefits owed to current and future employees. The problem is that the states have only contributed $2.35 trillion to meet these liabilities. That leaves unfunded pension liabilities of $1 trillion. On top of that, The Pew Center reports that states, on average, have set aside only 7.1% of retiree healthcare and other non-pension benefits. The Pew Center also reports that 20 states have reserved nothing for these benefits.

The Pew Center estimates that its estimates are conservative since the Center didn’t take into account investment losses experienced by many of these governments in late 2008 and early 2009.

Until the excess debt in the system and the unfunded liabilities of government are dealt with, full and robust economic recovery, in my opinion, cannot occur. I’m looking for the financial markets to come to grips with this fact soon.

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