Can State and Local Governments in the US Run Fiscal Deficits?

In the U.S., managing finances at the state and local government levels is an ongoing challenge, especially when it comes to balancing budgets. While the federal government can run fiscal deficits without legal limits, state and local governments face strict rules. This article explores whether state and local governments can run fiscal deficits, outlining the key features, restrictions, and implications of fiscal management at these levels of government.

Functions of State and Local Government Budgets

State and local governments play an essential role in providing public services such as education, healthcare, transportation, and law enforcement. To support these services, they must balance their budgets—planning revenues against expenditures. Unlike the federal government, which can run deficits and borrow freely, state and local governments are generally required to operate under a balanced budget.

• Balanced Budget Requirement: Many states have constitutional or statutory requirements to balance their budgets each year. This means that any deficit spending is usually prohibited. States cannot spend more than their revenues without facing legal and political consequences.

• Revenue Generation and Allocation: States rely on taxes (income, sales, property) and federal transfers as their main sources of income. Proper allocation ensures essential services continue functioning even in times of economic stress. However, an inability to raise sufficient revenue often forces local governments into fiscal deficits, prompting them to adjust spending or seek alternative funding.

Key Restrictions on Fiscal Deficits

States and local governments are typically not allowed to run budget deficits due to legal restrictions. However, certain provisions can help manage temporary shortfalls in the budget. Let’s break these down:

• Constitutional Provisions: Several states have provisions in their constitutions requiring them to maintain a balanced budget. For example, California has a "spending limit" that ties government spending to personal income growth, limiting how much can be spent in a given year.

• Debt Limits: Many states and local governments are limited in how much debt they can issue. For example, bonds issued by cities or counties may require voter approval, and those bonds are typically reserved for capital projects rather than daily operational expenses. Borrowing to cover operational deficits is often not allowed.

• Economic Constraints: During periods of economic downturn, states may face budget shortfalls. While they can draw from reserves or rely on federal aid, deficit spending over the long term is not an option for most states. They are often forced to reduce services or raise taxes to avoid deficits.

Characteristics of Fiscal Deficits in Local Governments

Although running a deficit is rare, some local governments may temporarily face fiscal imbalances. Heres how they navigate these situations:

• Temporary Deficits: Some local governments may use "deficit financing" in the short term to cover unexpected shortfalls, often through borrowing or reserve fund access. While this is allowed, it’s not a sustainable strategy in the long run.

• Debt Issuance: Local governments can issue bonds to raise money for capital projects or other needs. However, this borrowing is typically restricted to capital expenditure and does not cover daily operational costs.

• Federal Assistance: In times of economic crisis, such as during the 2008 recession or the COVID-19 pandemic, federal aid may help state and local governments fill budget gaps, but these funds are often temporary and come with restrictions.

Implications of Fiscal Deficits for Local and State Governments

Running a fiscal deficit can have significant consequences, especially if it becomes a long-term practice. Here’s what can happen:

• Credit Rating Impact: State and local governments that consistently run deficits may see their credit ratings downgraded, which increases the cost of borrowing. This is a significant consideration because higher borrowing costs can make funding future projects more expensive.

• Service Cuts: If deficits are not addressed, local governments may be forced to cut essential services like police, fire protection, or public health, leading to a reduced quality of life for citizens.

• Tax Increases: To combat fiscal imbalances, states may raise taxes to close budget gaps. While this may help balance the budget, it could also lead to political and economic challenges, especially if the tax increases are unpopular.

Conclusion: Can States and Local Governments Run Fiscal Deficits?

While state and local governments in the U.S. are generally prohibited from running fiscal deficits, they do have ways of managing temporary shortfalls. However, long-term deficits are not allowed due to constitutional restrictions, legal provisions, and economic constraints. By maintaining balanced budgets, these governments ensure fiscal stability and provide essential services. In times of crisis, temporary measures like borrowing or receiving federal aid may help fill gaps, but these should not be relied upon as long-term solutions.

Reliable Advice for Fiscal Health: It is crucial for state and local governments to prioritize fiscal discipline and long-term planning. Strategies such as diversifying revenue streams, controlling spending, and building reserve funds can help prevent the need for deficit spending. When crises arise, collaboration with federal authorities and timely action are key to avoiding severe financial imbalances.

Remember: Balanced Budgets Equal Stable Futures.