Here’s a bit of good news: states have been able to collect roughly +2.5% more in taxes in the first half of 2010 compared with a year earlier. Then again, most states are staring down the barrel of massive budget deficits for 2011 and 2012, and a few percentage points here or there does little to change the frightening math.

Dire as their situations may be, most states had been assuming that Washington would again plug the gaps with federal aid. And as long as Washington was there to help, states would likely avoid the need to further eliminate jobs among teachers, firefighters, police officers and other local and state employees. This week’s election now makes any further stimulus very unlikely.

As I’ve recently noted, states are dealing with high unemployment rates [See: “12 States in Financial Distress”], along with large unfunded pension deficits [See: “5 U.S. States With Pension Time Bombs”].

With Governors and state legislators getting the message that new taxes are a non-starter, many state and local governments will have no choice but to trim payrolls even further. Thus far, they’ve only taken baby steps. Since December 2007, the private sector has shed about 6.6% of its workforce, according to a recent study by the Rockefeller Institute. In that time, state payrolls have stayed flat, while local government payrolls have shrunk by -1.6%. (The cuts would have been equivalent at about -0.8% each were it not for the fact that a large number of teachers were transferred from local government payrolls to state payrolls during the recent fiscal stimulus aid plan.)



Closing the gap
States collected -15% less taxes in fiscal (June) 2010 compared to two years ago, due in large part to lower levels of sales tax revenue and fewer real estate transactions that yield one-time mortgage and real-estate title transfer fees. States have raised a number of taxes and excise fees, resulting in an additional $4.9 billion in revenue in the second quarter of 2010 compared with a year earlier, according to the Rockefeller Institute. But it’s unclear if any further tax hikes will pass muster in these tough times.

#-ad_banner-#Even in the absence of further state and local tax hikes, we can assume that revenue will continue to rebound, albeit at a slow pace, perhaps closing cutting that -15% drop in revenue in half by 2013. That means that if states took no action, they would run large deficits again in 2011 and 2012 and steadily smaller deficits after that. More robust economic growth in 2011 and 2012, with GDP growing in excess of +3%, could quickly turn things around, as the impact on state and local taxes is doubly sensitive to any directional GDP moves — but few expect to see this kind of growth any time soon.

But states must balance their budgets each year, so waiting for a revenue turnaround is not an option. The only option is to sharply cut costs by further paring services and state and local jobs. Voters have just tacitly voted in favor of such a move, and it will be interesting to see how they react once such cuts take place.

What kind of numbers are we talking about? States employ about 5.2 million people, while local governments employ roughly 14.3 million. Assuming states need to cut their staffs by an additional -5% and local governments by about -3%, then we’re talking about 680,000 jobs. In normal economic times, the private sector would create about that many jobs in about four months. But in the current economic environment, it may take 12-18 months of private sector job creation to simply offset those losses, so there’s a real chance that the national unemployment rate moves up above 10% once public sector layoffs take place. (Forecasts for this Friday’s employment report call for 60,000 jobs to have been created in October and the unemployment rate to stay unchanged at 9.6%.)

Action to Take –> If you were banking on a jobs rebound helping your portfolio, don’t hold your breath. Private sector layoffs may have eased, but the public sector cuts have already begun. State and local governments shed a collective 83,000 jobs in September and will likely need to keep doing so at a similar clip during the winter months. The October jobs report may show a temporary slowdown in this trend as budget planners awaited the outcome of national elections.

Republican Governors have replaced Democratic Governors in Wyoming, New Mexico, Oklahoma, Kansas, Iowa, Wisconsin, Tennessee, Michigan, Ohio, Pennsylvania, Florida and Maine. These newly-elected officials likely campaigned on a platform of belt-tightening, and we’re likely to hear of specific budget-cutting plans in the weeks to come. How investors react to the likelihood of rising public sector unemployment will largely be a function of any gains made in private sector employment. This Friday’s jobs report could set the tone for that coming debate.