What Happened to State and Local Governments?
real state and local government output, as measured by the BEA, has been effectively flat since 2001. To put it a different way, the stagnation at the state and local government level started way before the 2007 recession.
Pointer from Mark Thoma.
I suspect that there are two reasons for this. One is Medicaid. The other is pensions for retired workers. As these grow, the state and local governments have to spend more without generating any more of what would be counted as GDP. On Medicaid, I am not sure whether that spending is counted as a transfer payment (not GDP) or spending on health care (GDP).