State, Local Tax Receipts Drop Again in 3Q

State and local government tax receipts plunged again in the third quarter as municipalities continued to feel the squeeze from shrinking incomes and tepid sales.

States and localities collected $266.54 billion in taxes in the third quarter, the Census Bureau reported yesterday, a decline of 6.7% from the third quarter of 2008.

This was the fourth consecutive quarter of shrinking tax collections.

The biggest culprit was income taxes. Personal income tax receipts tumbled 11.7% to $58.2 billion, while corporate taxes contracted 18% to $9.5 billion.

A quick glance at the Bureau of Economic Analysis’ report on gross domestic product for the third quarter partly explains the decline.

Employee compensation in the third quarter fell 2.8% from the third quarter of 2008, based on an annualized rate that adjusts for seasonality and other factors. Corporate profits sank 6.6%.

States derive about a third of their tax revenue from income taxes. Sales taxes contribute most of the remainder.

The third quarter was not pretty for sales either. According to the Commerce Department, retail sales shrank 2% in the third quarter.

State and local government receipts from sales taxes withered 9% to $69.7 billion.

Because of how municipalities finance their budgets, the recessionary vise has clamped state revenues far tighter than local government revenues.

With their heavy exposure to sales and income taxes, states’ tax revenue slipped 10.9% in the third quarter.

The weakened revenue streams from income and sales taxes have had a more muted effect on local governments, which derive nearly three-quarters of their tax revenue from property taxes.

Property taxes have so far proved a more stable revenue source.

Although real estate values have been tanking for a couple of years, localities typically assess tax rates on properties based on values from the most recent appraisal. Sometimes updating appraised values can take years, so many property owners continue to pay taxes on  real estate values assessed earlier this decade, when prices were ascending rapidly.

Even in the worst economic decline since the Great Depression, property tax receipts have yet to decline.

As a result, local governments’ tax revenues increased slightly during the third quarter.

In a preliminary estimate last month, the Nelson A. Rockefeller Institute of Government noted “widespread and sharp declines” in state tax revenues in the third quarter.

The New York-based think tank noted that even North Dakota, which had been the lone state reporting growth in tax revenues, posted a 17.3% decline in the third quarter.

The institute said it expects further declines for the fourth quarter.

“Despite indications that the national recession may be over, the revenue situation remained gloomy in virtually every state in the third quarter,” the group wrote in a report. “Further revenue shortfalls and more spending cuts are most likely on the way for many states, particularly those that did not take significant actions to balance revenues and expenditures in their fiscal year 2010 budgets.”

According to the Center on Budget and Policy Priorities, states face or have already closed $193 billion in budget gaps for fiscal 2010. At 28% of state expenditures, that represents the biggest annual shortfall on record.

The group estimated that states will have to close $350 billion in shortfalls in fiscal 2010 and 2011.

More than 30 states have raised tax rates to cope with these deficits, the CBPP said. At least 43 states have cut services.

The third-quarter GDP report showed state and local government spending was essentially flat in the third quarter and has barely increased since the recession began at the end of 2007.

The CBPP pointed out that state finances have in the past suffered for several years after recessions have ended.

“The same will undoubtedly be the case this time,” wrote the authors of a CBPP report, “since the current recession is more severe — deeper and longer — than the last one, and state fiscal problems have proven to be worse and are likely to remain so.”

An unemployment rate at 10%, depressed property values, and economic uncertainty, coupled with increased need for spending on services like Medicaid, mean “state budget gaps will continue to be significantly larger than in the last recession, and last longer,” the CBPP said.

All these terrifying numbers, and yet state and local government bonds are trading as if things could not be any better.

Top-quality 10-year municipal debt offers a historically low yield of 3%, according to the Municipal Market Data scale.

In its annual “State of the States and Local Governments” report, the municipal bond team at BlackRock Inc. explained that municipalities are in an operating crisis — not a debt crisis.

Despite their fiscal difficulties, states are “extremely unlikely to renege on full and timely debt-service payments,” BlackRock wrote in the report this month.

States have numerous resources at their disposal to ensure bondholders are repaid, BlackRock said, and anyway, states are not eligible to file for Chapter 9 bankruptcy protection.

Local governments, which are eligible to declare bankruptcy and may not have the economic resources that states have, may be more inclined toward default. BlackRock still considers this outcome “very unlikely.”

The cost of repaying debt remains both modest and predictable for most issuers, BlackRock said. According to the BEA, interest payments were 5.3% of total expenditures in the third quarter.

Municipalities are likely to attack their costliest line items before raiding the money used to service debt, BlackRock said.

This is especially true because municipalities need to mollify investors. States and localities exist in perpetuity and know they need access to the bond market to finance basic spending needs.

Municipalities know that defaulting on their debt would saddle them with higher borrowing costs and make things more difficult, BlackRock said.

BlackRock expect bankruptcies, if any, “to be minimal and isolated to mismanaged or weak credits.”

As examples, the team listed “overbuilt sunbelt exurbs and aging municipalities with narrow economies and high legacy costs.”

For anyone looking for a silver lining, the GDP report lists quarterly tax receipts on a seasonally adjusted annual basis.

According to this estimate, tax receipts improved in the third quarter from the second quarter, the first quarterly uptick since the second quarter of 2008.

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