The US economic recovery from the pandemic been surprisingly swift, with output increasing, consumer spending recovering, and unemployment falling faster than expected. State and local governments’ tax revenues recovered rapidly as well, despite the dire predictions of many governors.
But what matters from the perspective of the overall national recovery is state and local government employment, not tax revenue. That hasn’t recovered. And that’s one of several reasons those governments need additional federal assistance.
When Covid-19 struck and states began locking down their economies, many economists, including me, were worried about the possibility of a “second Great Depression” that would have crippled state and local government finances.
Fortunately, efforts by the Federal Reserve, the extraordinary and effective response by Congress and the Donald Trump administration, and the resilience of US businesses and households created a robust overall recovery, beginning last spring.
The pace of the recovery has surprised forecasters. In May 2020, the Survey of Professional Forecasters’ median prediction was that the economy would shrink by 5.6% in 2020. By November, forecasters expected a 3.5% reduction for the year. That turned out to be an accurate prediction.
Like the overall economy, state and local governments’ tax revenues also looked better and better as 2020 unfolded. The economists Jeffrey Clemens and Stan Veuger (my colleague at the American Enterprise Institute) have been studying the likely effect of the pandemic on state and local tax revenue over the five-quarter period beginning in the second quarter of 2020 and ending in the second quarter of 2021, when the fiscal year ends for most states.
In June, they estimated that states would lose $72 billion in sales tax receipts and $76 billion in income tax revenue during this period. They updated their estimates in September, and things looked better. In their most recent update this month, they project state sales tax receipts to be down by $52 billion and state income tax revenue to be above pre-virus forecasts by $5 billion over the April 2020-June 2021 period.
When Clemens and Veuger add in other state and local revenue losses, they project the overall shortfall from the pandemic to be $130 billion.
How could the virus and lockdowns have increased income tax revenue? In part, it is because the federal government replaced so much lost income that people paid more in income taxes at the state and local levels than previously expected. The same holds for the improved outlook for state sales taxes: The replaced income boosted consumption spending, which boosted sales tax revenue.
Not only has the federal government helped states and communities raise revenue from taxes; it has also helped cover their budget shortfalls. Since the pandemic began, Congress has included funding for state and local governments in its various response measures, including $190 billion in the $1.8 trillion Cares Act, passed in March. All told, states and localities have received $360 billion from the federal government, according to the Committee for a Responsible Federal Budget.
Given that, why do states and localities need additional funding? Four reasons.
First, some states are doing much worse than the average. A recent J.P. Morgan report looked at total tax receipts for 47 states and found that, relative to 2019, revenue was down just 0.12% last year. But Hawaii, Nevada and Florida — all heavily dependent on tourism — are down 13.6%, 13% and 7.9%, respectively.
In addition, much of the funding already provided to the states can only be spent on specific programs — Medicaid, for example. States and localities could use funds with more flexibility to meet their specific needs.
Third, the pandemic has created the need for additional spending, so simple comparisons with pre-virus forecasts or with 2019 do not adequately capture the amount of revenue states and localities need.
Finally, public-sector employment hasn’t recovered. There are 1.3 million fewer state and local government employees than when the pandemic began. Education-sector employment by local governments is down by around 650,000. What matters for the overall national recovery is employment, not tax revenue, and state and local governments are major employers who haven’t come close to recovering.
President Joe Biden wants to send $350 billion to states and localities. That is clearly more than is needed. But about $100 billion would be appropriate and advisable.
Congress should make sure that this funding is not used to bail out state pension funds. It should not reward states for misusing rainy-day funds. And states and localities that don’t need federal resources should not get them.
To accomplish these goals, Congress needs to create a formula that ties the amount of federal grants directly to pandemic-related revenue losses. If the formula is written correctly, some states won’t get much.
If Congress does not provide states and localities the assistance they need, their employment growth will be weak, slowing down the national recovery. State governments were hit out of the blue last spring, just like households and small businesses.
Congress admirably helped households and small businesses to weather the storm. It should do the same for states and localities, while making sure not to send them more than they need. But they do need more than nothing.
Bloomberg
