The case for a massive federal aid package for states and cities

The most immediate economic cost of the the coronavirus pandemic is obvious: At least 22 million Americans are newly unemployed, putting them and the people in their households at financial risk.

But the downturn is having a secondary effect that could make the recession even worse. It’s forcing states and local governments to cut spending and raise taxes just at the moment when that would do the most damage.

As my colleague Emily Stewart has documented, state budget shortfalls could exceed $500 billion this year, an amount that easily swamps the $283 billion in lost revenue that states experienced in the aftermath of the Great Recession. New York State alone is expecting between $10 billion and $15 billion in lost tax revenue, and Ohio Gov. Mike DeWine has proposed slashing up to 20 percent of his state’s spending to make up for its shortfalls. The mayor of Los Angeles announced upcoming furloughs for city workers on Sunday.

And despite this mounting pressure, efforts to include more federal aid to states and local governments in the latest stimulus package failed in congressional negotiations Tuesday night. Senate Majority Leader Mitch McConnell has suggested states should be able to declare bankruptcy instead.

We know a lot about what effects this kind of state financial crises can have, both on the economy and essential services like higher or K-12 education. Much of what we know comes from the 2008-’09 downturn, when state tax revenues cratered. Because almost all states have balanced budget requirements, they were forced to make deep cuts. Research found that this weakened the recovery and did lasting damage to the nation’s schools.

The prospect of another crisis like that should alarm all of us and push Congress to pass another relief package — this one for states and cities.

Why states cut spending and raise taxes during downturns

The basic problem for states and local governments is that when the economy craters, spending increases and, more importantly, tax revenue falls. People’s incomes are down, so income taxes raise less money; people spend less, so sales taxes raise less money; property tax revenue is more stable, but if housing prices fall, property taxes eventually raise less money too. At the same time, state- and locally funded social services, like Medicaid or Temporary Assistance to Needy Families or general assistance programs, face increased demand and cost more.

The federal government faces these same dynamics, and sees tax revenue fall and the cost of programs like food stamps and Medicaid (a shared state/federal program) rise. But the federal government is able to borrow money at will and can currently borrow for cheaper than free — if it borrows $1 trillion today, it will have to pay back less than $1 trillion because interest rates are so low. It can run large deficits during downturns, with a lack of political will from Congress as the main impediment to doing so.

By contrast, 46 out of 50 states (plus DC) had laws or constitutional amendments requiring balanced budgets as of 2015, and even most of the four remaining states have strict rules: Virginia doesn’t require the legislature or governor to pass or sign a balanced budget, for example, but bans deficit carryover, which de facto requires a balanced budget. Arizona and Indiana ban taking out debt altogether, also de facto requiring a balanced budget.

Urban Institute/Kim Rueben and Megan Randall

Colorado and Nebraska also ban taking out debt, and at least 12 other states require voter approval of new debt, greatly limiting legislatures’ ability to borrow.

On a deeper level, state and local governments cannot print new dollars. The federal government can always, in principle, pay its debts because they’re denominated in dollars, of which the federal government is a monopoly issuer. If worst comes to worst, it can always print the money necessary to pay its debts.

State and local debt is thus riskier and comes with higher interest rates, further raising the costs of running deficits.

What happened to state budgets after 2008

During the Great Recession, as the federal government spent some $1.4 trillion total in stimulus measures from 2008 to 2012, states and local governments adopted austerity measures to obey their balanced budget rules. Tax revenues fell off a cliff in the aftermath of the recession, as the Urban-Brookings Tax Policy Center’s Tracy Gordon, an expert on state and local fiscal policy, tracked in this chart:

Urban-Brookings Tax Policy Center/Tracy Gordon

Unlike the 2001 recession, revenues did not rebound rapidly either:

Urban-Brookings Tax Policy Center/Tracy Gordon

This was partially offset by the $145 billion included in the 2009 stimulus package to buffer state and local budgets, but as Gordon noted, “Federal funds did not [fully] offset state and local revenue” and stimulus programs then expired.

States were thus forced to raise taxes and slash spending, in many cases dramatically.

International Monetary Fund economist Jiri Jonas, in a 2012 working paper on state austerity during the Great Recession, noted that states raised their income taxes by $11 billion, sales taxes by over $7 billion, and various other taxes by $6 trillion in fiscal year 2010 alone. Twenty-nine out of 50 states enacted tax increases. Overall spending also fell as tax rates increased. “General fund” spending (the largest category of spending for states, excluding that from funds set aside for specific purposes) fell by nearly 4 percent in fiscal year 2009 and 6 percent in fiscal year 2010, which was, as Jonas noted, “an unprecedented decline in state history and the first nominal decrease since 1983.”

International Monetary Fund/Jiri Jonas

One budget area that experienced particularly dramatic cuts was higher education, where states made deep slashes to spending and pushed more costs onto students in the form of tuition, which rose an average of $2,484 a year at public colleges and universities, per the Center on Budget and Policy Priorities. That average masks a lot of heterogeneity. In some states, like Louisiana and Arizona, per-student spending on higher education fell by about half.

Only in natural-resource heavy states like North Dakota, Wyoming, and Montana did per-student spending grow from 2008 to 2017; in most states, including relatively blue states like Illinois and New Jersey, it fell substantially.

Center on Budget and Policy Priorities/Michael Mitchell, Michael Leachman, and Kathleen Masterson

Among other consequences, this shifting of costs to tuition helped fuel the rise of student loan debt for graduates and attendees of public colleges and universities.

These figures go until 2017, by which point the economy had recovered substantially and some states had started to boost funding again. The numbers looked much worse in 2012 or 2013, when economic conditions were still dire.

K-12 education also saw deep cuts. In 2018, economists C. Kirabo Jackson, Heyu Xiong, and Cora Wigger estimated that per-pupil spending on K-12 public schools fell by about 7 percent in the aftermath of the Great Recession. Jackson, Xiong, and Wigger found that this large reduction in spending caused a significant decline in test scores and college enrollment rates — and the effects were worst for students in poor neighborhoods.

State austerity substantially worsened the Great Recession

Despite federal stimulus measures, the austerity practices at the state level worsened the Great Recession and likely lengthened it as well. This is true partly as a matter of arithmetic: State spending is a component of gross domestic product (GDP), and as such, lower spending at the state and local levels reduces GDP.

Here’s how the Hutchins Center on Fiscal and Monetary Policy estimates the contribution of federal and state governments to the economic recovery. The blue bar is federal purchases, the purple bar states, and the green bar tax and safety-net programs (mostly federal). Note that from 2008-2010, the federal government is quickening the recovery, while states and local governments are dragging it down:

Hutchins Center on Fiscal and Monetary Policy/Manuel Alcalá, Kadija Yilla, and Louise Sheiner

You have to adjust those figures, however, by what economists call the “fiscal multiplier”: the fact that $1 in government spending doesn’t necessarily increase economic activity by $1. It can increase economic activity by less than $1, perhaps because the spending is financed (or expected to be financed) by a future tax increase. it can also increase economic activity by more than $1 by spurring further private-sector economic activity.

One review of the research from Harvard economist Gabriel Chodorow-Reich estimated the multiplier of about 1.7 or above. Another review by University of California San Diego Valerie Ramey put the estimate lower, at 0.6 to 1 for government purchases, but even higher for changes in taxes.

But whatever multiplier estimate you take, state and local governments took hundreds of billions of dollars out of the economy during the Great Recession. Per the Center on Budget and Policy Priorities, state budget shortfalls totaled $690 billion from 2009 to 2013. If the multiplier on the set of tax increases and spending cuts they used to fill those shortfalls was 0.5, then this cost the economy $345 billion. If the multiplier is 2, it cost the economy nearly $1.4 trillion in lost output.

Center on Budget and Policy Priorities

The CBPP anticipates an even deeper shortfall in 2021 than in 2010, the worst of the Great Recession. This means that unless the federal government makes up for states’ lost revenue, the coronavirus recession will worsen and the recovery will weaken dramatically.

Another way to look at state and local austerity is through its effects on jobs. Direct employment by these governments fell dramatically during the crisis:

Lincoln Institute of Land Policy/Donald Boyd

Lincoln Institute of Land Policy/Donald Boyd

But the effects weren’t limited to government jobs. Chodorow-Reich estimated that each $100,000 in additional Medicaid spending created 3.8 jobs for a year (or “job-years”), including 3.2 outside government, health, and education, implying that the spending spiraled out to the rest of the economy. Harvard economist Daniel Shoag estimated that every $35,000 in additional state spending during the Great Recession generated one job.

The Chodorow-Reich estimates suggest that the $690 billion shortfall added up to about 6.9 million in lost job-years due to state austerity. Shoag’s estimates suggest that filling the shortfall in 2010 entirely would’ve lead to about 6.5 million additional jobs.

How to prevent a repeat of the Great Recession’s fiscal calamity

The CBPP estimates that states face shortfalls of as much as $360 billion going forward due to coronavirus. That’s after taking into account the $110 billion in state aid included in the CARES act, $35 billion in additional Medicaid funding, and a $30 billion Education Stabilization Fund. (It also doesn’t account for the “substantial new costs they face to combat” the coronavirus pandemic.)

The situation is worsened if the Treasury interprets CARES’ language as barring the usage of the $110 billion to close revenue gaps, as seems plausible given the department’s admonitions that states not use the money for costs incurred pre-coronavirus.

To prevent this will require massive action by Congress and the Federal Reserve, the latter of which has already committed to buying hundreds of billions of dollars’ worth of state and municipal bonds — a program it’s reportedly weighing expanding to include more smaller cities, which would remedy an equity problem wherein cities with large populations of African Americans have not benefited from the program. But four states are outlawed from taking out debt to begin with, and a dozen more have strict limitations on the debt they can incur. That means you need direct federal grants to states, not just commitments by the Fed to keep interest rates on debt low.

There are several forms that this aid could take. Perhaps the easiest method of fiscal relief is through increasing the Federal Medical Assistance Percentage (FMAP), or the share of state Medicaid budgets covered by the federal government. Increasing that to 100 percent so that states don’t have to worry about their Medicaid budgets during this downturn would open up a lot of fiscal space and prevent damaging cuts to Medicaid and education.

Another option is bailing out state and local mass-transit systems, which are suffering from a loss of ridership that’s putting them in deep fiscal jeopardy.

The Urban-Brookings Tax Policy Center’s Gordon has argued for permanently tying Medicaid funding to economic indicators (such as state unemployment rates or the employment-population ratio) and increasing federal Medicaid funding when those indicators of economic distress increase. Sociologist Joshua McCabe has proposed emulating Canada’s “fiscal equalization” transfer system, which offers lightly restricted cash to provinces — with more going to poorer provinces — to cover much of their budgets. That approach could be especially valuable in a recession by letting the federal government take over more of states’ fiscal burdens.

But whatever approach you take, the takeaway is clear. The federal government needs to be directing much, much more money to state governments. Sens. Bill Cassidy (R-LA) and Bob Menendez (D-NJ) have a bipartisan plan to add $500 billion to state and local coffers. That’s a good start — but in case we need more, adding in automatic triggers as Gordon has proposed would be worthwhile.

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