State budget woes: How much will they drag down US economy?

States and cities collectively face the most precipitous decline in revenues on record, and the economy, while improving, does not appear to be picking up fast enough to prevent new layoffs of public employees and deep cuts in public services this year.

The budgetary downsizing is expected to act as a drag on overall economic growth, as the housing market has for the past three years. Just how heavy will this particular anchor be?

Economist Mark Zandi of Moody's Analytics in West Chester, Pa., estimates that state and local governments will lay off 150,000 more workers, after giving pink slips to 250,000 in 2010. Belt-tightening by state and local governments will shave 0.4 percentage points off America's gross domestic product this year, he predicts.

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"It is a significant head wind, but it won't blow the recovery over," mainly because other head winds are subsiding, he says.

Like almost everyone else, states and cities have already endured two tough years. With the recession, their revenues fell, forcing pay cuts, layoffs, service reductions, and intense hunts for new revenue streams – sometimes all at the same time. What makes this year different is that states can't expect much help from Uncle Sam via a new stimulus package, meaning budget cuts are likely to be deeper than in the past couple of years.

Forty-five states are expected to need to cut their next budgets, some a little and some drastically. Many states have difficult but manageable shortfalls, but 10 face budget gaps of 20 percent or more over this fiscal year's budget. Among them are some of the most populous states.

•In California, new Gov. Jerry Brown (D) and state lawmakers must find a way to bridge a projected $25.4 billion budget gap – more than double what the state spends on higher education each year.

•Illinois, with a projected budget gap of $17 billion, is so late paying its bills that it owes some vendors money from last August.

•New Jersey's projected $10.5 billion in red ink is equal to almost 10 years of tolls collected on the Turnpike and Garden State Parkway combined.

One prominent danger to the economy is that some state and local governments may decide they won't be able to pay the interest on their debt.

"It is hard to get to a scenario where the defaults undermine the financial markets, but it is a risk," says Mr. Zandi.

Some financial analysts, however, do see defaults ahead. One is Meredith Whitney, who correctly forecast the problems leading to the banking crisis in 2008. In December, on CBS's "60 Minutes," she predicted hundreds of billions of dollars in defaults.

In a November report, though, credit analyst Gabriel Petek of Standard & Poor's said broad defaults are unlikely. State and local revenues would have to drop by "substantially more than the average decline witnessed during the Great Depression before this priority protection [for bonds issued by state and local governments] would be breached," he said.

In fact, states' revenues are starting to rise again, reflecting the improving economy. In the third quarter of 2010, 42 states took in more from personal income taxes and sales taxes than during same period in 2009, according to a recent report by the Rockefeller Institute of Government, part of the State University at Albany.

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