Goldman Fears "Persistent Headwind To Growth" As State/Tax Revenues Tumble

The latest confirmation that the US economy continues to deteriorate comes not from the Federal Government but from state-level data, where year-over-year growth in state tax revenues slowed dramatically in the last two quarters. As Goldman notes, this has subtracted an average of 0.25 percentage points from GDP growth, raising the question of whether municipal finances could again be a persistent headwind to growth.

Via Goldman Sachs,

For several years following the 2008-9 recession, spending cuts by state and local governments were a meaningful drag on US growth. Faced with declining revenues and constrained by balanced budget rules, most states were forced to retrench, even as the rest of the economy began to recover. State and local government spending declined almost continuously from Q4 2009 through Q1 2014, subtracting an average of about 0.25 percentage points (pp) from annualized GDP growth over this period (Exhibit 1). As budgets eventually recovered, spending began to pick up, and state and local government outlays added about 0.25pp to GDP growth from Q2 2014 through Q1 2016. However, over the last two quarters, spending by states and localities stumbled again, raising the question of whether municipal finances could again be a persistent headwind to growth.

Exhibit 1: State and Local Government Spending Has Been a Drag on Growth in the Last Two Quarters 

Source: Department of Commerce, Goldman Sachs Global Investment Research

The weakness in local and state government spending relates to both capital investment and current consumption. The more cyclical investment category—of which 80% is structures-related—subtracted 0.4pp from GDP growth in Q2 2016 and 0.2pp in Q3 2016. Investment spending decelerated from an average of +7% in 2014Q3-2016Q1 to -17% over the last two quarters. The less cyclical consumption component decelerated over the same period from 2% to 1% in real terms and now looks broadly in line with the currently still soft paces of hiring (0.5% year-on-year) and nominal ECI wage growth (2%) at the state and local level.

While the GDP data can be subject to revisions and other problems, other indicators support the idea that municipalities have indeed pulled back on spending. For example, the value of public construction contracts has declined by $25 billion (or more than 10%) since mid-2015 according to Dodge Data & Analytics, roughly in line with the Census Bureau’s estimate of the value of public construction put-in-place (left panel of Exhibit 2).[1] In addition, no single construction category appears to be driving the weakness: over the last year, construction spending has dropped in 11 out of the 12 subcategories in Census data (education-related construction is the only exception). The right panel of Exhibit 2 shows that a mix of infrastructure-related categories—including sewage and waste disposal, power, transportation and highway and street—account for most of the $22 billion decline in the value of state and local construction put in place over the last year.

Exhibit 2: The Decline in State and Local Construction Spending Runs Across Infrastructure Categories 

Source: Department of Commerce, Dodge Data Analytics , Goldman Sachs Global Investment Research

Weakness in revenue growth likely explains part of the slowdown. State tax revenues rose by an average of $40 billion per year in 2010-2015 but declined $23 billion (annualized) in Q2 2016 vs. Q2 2015. Most of the deceleration in state tax revenues reflects softer individual income tax receipts, but declines in corporate income taxes and natural resource “severance taxes”—incurred when natural resources are extracted in a given state—also played a role. While state tax revenue has been weaker, local tax revenue has been holding up quite steadily, plausibly reflecting their relatively large reliance on property taxes, which lag home prices.

Exhibit 3: State Tax Revenue Has Declined 

Source: Department of Commerce, Goldman Sachs Global Investment Research

State-level details suggest that the revenue weakness may relate to exposure to natural resource sectors and, to a lesser extent, the financial services sector. Exhibit 4 breaks down the growth of state tax revenues for three groups of states: the 9 energy states[2] (whose job growth is closely tied to changes in energy prices), the 3 finance states (New York, Connecticut and Delaware with a financial services employment share higher than 8%) and the 38 remaining other states. Exhibit 4 shows that the decline in state tax revenues has been significantly more pronounced since mid-2014 in the energy states than in the two other groups. Tax collection has also decelerated more sharply in the finance states—especially Connecticut—since mid-2015. Tax revenue growth has held up better in the other states, but has also slowed over the last year. Simple regression analysis supports the conclusion from the chart: the exposure to the energy job cycle[3] and the employment share in the financial sector are both statistically significant in explaining year-on-year growth rates of state-level tax revenues in 2016 Q2 and account for roughly 40% of the cross-state variation. In a nutshell, the weakness in state and local government spending—particularly on capital investments—looks real and appears to be driven by fundamentals.

Exhibit 4: Tax Revenues Have Declined More in States Exposed to Energy and Financial Services

Source: Department of Commerce, Goldman Sachs Global Investment Research

However dire the current situation is, Goldman however finds a silver lining...

That being said, we do not see a return to the municipal budget stress of the immediate post-crisis years (at least until unfunded pension obligations become a more immediate issue). Instead, state and local government spending looks more likely to rebound moderately over the coming year.

First, we expect overall GDP growth to accelerate, which should support tax revenues. Encouragingly, federal data available through Q3 suggests that individual income tax receipts have not slid further. Sales tax revenue has also underperformed retail sales over the last few quarters, and may have scope to rebound.

Second, our equity strategy colleagues still expect growing public construction spending over the next two years based on their analysis of state budget plans—and federal support for infrastructure spending could give an added boost.

Third, pension issues aside, most states have run their budgets more conservatively in recent years—aggregate “rainy day” funds, for example, bottomed at $21bn in FY 2010 but have since recovered to $49bn (according to NASBO). Unless the economy slows meaningfully, a lengthy period of municipal retrenchment looks unlikely.

So hope springs eternal for Goldman once again.