State Fiscal Policy and the Economic Crises: Does the Obama Stimulus Make Sense?

Abstract

The American Recovery and Reinvestment Act of 2009 (ARRA) is an important policy response to the current deep recession. State and local governments have suffered significant declines in their revenues and, for states in particular, a significant increase in the demand for services, particularly Medicaid funding, unemployment compensation, and welfare spending. ARRA will provide over $200 billion in fiscal relief to state and local governments over three years. The hope is that this relief will encourage state spending and discourage state tax increases, thereby adding to national aggregate demand. This paper uses the U.S. experience of prior changes in federal aid to examine the likely consequences of this stimulus package for state unemployment rates, state net migration, state employment, and aggregate GDP. In an SVAR analysis we explicitly incorporate federal transfers to the state and local sector as part of federal fiscal policies. We find the response of GDP to federal aid shocks to be very small over the first two years after the receipt of aid. From a panel analysis of state budgetary behavior, we find that a potential reason for the weak response of GDP to aid is the propensity of state governments to save most of their new assistance. They do so by replenishing their rainy day funds and by paying down their long-term debt positions. Such behaviors are potentially rational responses to debt-financed temporary assistance.

JEL Classification: E3