Local governments still face stiff budget challenges, but their overall condition appears less dire.
City government spending will largely be unchanged in 2013 after four straight years of declines, says Michael Pagano, dean of the College of Urban Planning and Public Affairs at the University of Illinois-Chicago. Municipal revenue continued to fall during the 3-year-old economic recovery because cities and counties depend heavily on property taxes, which were hammered by sharp declines in home values after the real estate bust.
But home values have stabilized and started rising in most places. Local sales tax and income tax revenue is increasing as job growth and consumer spending pick up.
The city of Las Vegas' fiscal 2013 budget was the first in three years that didn't trim spending. The city, which was pummeled by the housing bust and saw its unemployment rate hit 15.6%, beefed up after-school programs and restored weekend cleanup for city parks. The city credits a rebound in tourism and fiscal austerity in the downturn.
States, which rely mostly on growing income tax and sales tax revenue, boosted spending modestly for the third straight year in fiscal 2013, which began in July. General-fund spending is up 2.2% after rising 3.4% in fiscal 2012, says Brian Sigritz of the National Association of State Budget Officers.
(Read More: States With the Most Federal Funding)
After eliminating 653,000 jobs from 2008 through 2011, state and local governments kept payrolls roughly stable in 2012, and Moody's expects them to add 220,000 jobs in 2013.
Boyd and Pagano caution that states and localities still face challenges that will limit growth, such as rising worker pension costs and falling federal funding.
But in effect, states and localities are switching roles with the federal government, whose spending insulated the economy from a worse fate in the recession.
In 2012, for example, public-sector spending cuts pared economic growth by 1 percentage point, says Mark Zandi, chief economist of Moody's Analytics. Most of that — 0.7 percentage points — came from federal reductions agreed to last year, Zandi says. The other 0.3 point was from state and local governments, with cities and counties accounting for two-thirds.
In 2013, public-sector cuts won't be much bigger. They'll slice economic growth by 1.2 percentage point — all from the federal government — according to Moody's. States and localities will have a neutral effect on growth, with states adding a bit and cities and counties subtracting far less than they did in previous years.
"The fiscal headwinds will be blowing hard in 2013," Zandi says. "But it isn't too much different" than 2012.