The Impact of COVID-19 on State Budgets Will Ripple to the Broader Economy
What type of economic recovery will the U.S. see in the coming months? U, V, or W—or will it be more like a swoosh? Or, maybe, none of the above? While Americans were busy marking Memorial Day from their backyards, on Monday Wall Street Journal reporter David Harrison published this assessment: “The hit to U.S. state and local finances from the coronavirus pandemic could be a drag on the nation’s economic recovery for years to come, if the past is any guide.”
According to Harrison, some state and local officials were dealing with the fallout from the Great Recession of 2008 until just last fall. Others are still digging out of the downturn that ended more than a decade ago. Harrison noted that, in Colorado’s Jefferson County, for example, “funding for the school system is still about six percent below what it was before the last recession.”
We touched on the state of state and local finances a few weeks ago when we discussed whether these entities could declare bankruptcy. Today we examine the issue more closely and try to determine how holes in state and local budgets will impact the U.S. economic recovery from the COVID-19 pandemic.
The National Council of State Legislatures regularly updates its list of state budget projections and, not surprisingly, its assessment from early May is dire. Alaska, for example, faces a $527 million shortfall because the price of oil has dropped significantly. Nearly 88 percent, $461 million, of that state’s deficit is due to the downturn in the energy sector, which accounts for about half of the state’s revenue. (Oil prices are recovering somewhat now, but OilPrice.com wonders if prices ever will see their highs again, which means the budget outlook for energy-rich states like North Dakota, Pennsylvania, and Texas could be dark for many years.)
Washington, D.C. had issued revenue projections in February, before the coronavirus epidemic hit the United States in force. The District released an update two months later, in late April. Officials now say revenues are down $722 million. The state of South Carolina, meanwhile, has said if U.S. economic growth falls by 20 percent and economic and social activity resumes by June, its tax revenue collections will be down by half a billion dollars. Given the uncertainty of those assumptions—or any projections—things could be much worse.
States have no choice but to deal with the fallout. As the National Association of State Budget Officers (NASBO) explained, “Unlike the federal government, states are required by law to balance their budgets.” (Vermont is the only state that does not have this requirement.) What these Balanced Budget Requirements (BBRs) mean, generally, is that within their operating budgets, states cannot spend more than they take in.
As the Urban Institute has explained, BBRs do not prevent states from borrowing, nor do they actually mean that states to balance all aspects of their spending. According to the Institute, “BBRs vary by state. Some states have lenient BBRs that only require governors to propose a balanced budget; stricter BBRs require that the enacted budget be balanced. BBRs typically only apply to states’ operating budgets. Capital and pension funds are usually exempt from BBR limitations. “ Generally speaking, however, 49 of the 50 states must put forward an annual budget under which spending does not exceed revenue.
During the Great Recession, states dealt with declining revenues largely by cutting spending. According to NASBO, state revenue declined 10 percent over the two years of the Great Recession (fiscal years 2009 and 2010), and “even with federal aid to states and use of their reserve funds,” 26 states made across-the-board budget cuts to all programs and 33 states made targeted cuts.
The budget situation is more dire today. Current revenue shortfalls are running about five times higher than they were in 2009-2010. In most states, April tax collections were down about 50 percent year-over-year. Some of that decline is attributable to the fact that many states delayed the annual April 15 tax filing deadline until July. Certainly not all of the downturn in revenues is due to the delay, however. In fact, according to Harrison’s Journal story, analysts believe states “will need to make $500 billion in cuts over the next two years due to the economic effects of the coronavirus.”
All of this will impact U.S. job and economic growth.
Nearly one in eight Americans works for a state or local government agency. Philadelphia Mayor Jim Kenney has said he wants to eliminate entire departments in the aftermath of the pandemic, which will contribute to a higher jobless rate in the City of Brotherly Love. Mayors in other cities are contemplating similar options. According to The Journal report, it took four years for states to collectively start hiring again after the Great Recession. Fewer state and local workers earning income will add to the decline in income tax revenues.
Additionally, according to NASBO, “[S]tate spending represents roughly 10 percent of the nation’s annual gross domestic product” so “substantial cuts to services and the state/local workforce can harm citizens and dampen a national economic recovery.” Federal Reserve Chair Jerome Powell agrees. In a recent U.S. Senate Banking Committee hearing he said, “We have the evidence of the global financial crisis and the years afterward where state and local government layoffs and lack of hiring did weigh on economic growth.”
Just how much will local and state government spending and job cuts hurt the recovery? Gabriel Chodorow-Reich, an economist at Harvard University, told The Journal’s Harrison that, based on evidence from the last recession, “every dollar in cuts costs the overall economy $1.50 to $2.” If states do indeed need to cut $500 billion, the economic impact would be between $750 billion and $1 trillion.
What about turning to bonds to raise some cash? After all, as CNBC has noted, the municipal bond market is often “the lifeblood for state and local finances.” Indeed, Connecticut Treasurer Shawn T. Wooden announced last week that he would seek an $850 million bond sale to provide money for state transportation infrastructure. This week, he reportedly will seek another $500 million for “other capital projects and state initiatives.” Colorado is doing the same.
According to the CT Monitor, Wall Street generally reacted favorably to Connecticut’s move, but investors are “worried about” the state’s long-term pension and retiree healthcare obligations. Those worries could have long-reaching implications for investors.
Historically, investments in municipal bonds have been low-risk. As the Center for Budget and Policy Priorities (CBPP) noted in January 2018, “States and localities rarely fail to repay bondholders …” But then the CBPP gave a big exception to that statement, noting “there is some risk that they might borrow so heavily that their debt obligations begin to crowd out other parts of the budget.” Those worries are likely to be greater today than they were two years ago, especially considering the recent volatility in the bond market.
The economic news site Technical.ly warns, “In March, investors withdrew from the muni market … more in one week than ever before, $12 billion, as they feared a wave of pandemic-prompted defaults.” The fallout was significant: Local and state borrowing costs “shot up.” Certain variable-rate bonds supporting hospitals, for example, “surged from an interest rate of one percent to more than seven percent in one week in March, prompting some states to buy back the debt on behalf of their coronavirus-smacked health providers.”
Money magazine has cautioned investors about the bond market. In an article posted yesterday, reporter Mallika Mitra said, “[T]he coronavirus has shaken confidence in the safety of these bonds, as investors wonder if cash-strapped governments can continue to pay the interest on their debt.” Mitra notes that, while states have to balance their budgets, “they rely on income like tax revenues, which they won’t see for a couple more months because the tax filing deadlines have been pushed back in most states.” Mitra also said, “The pandemic also raised the cost of governing, and state and local governments have had to tap their rainy day funds.”
As bad as things were in March, the fallout likely is not over. Curtis Erickson, head of capital markets at Preston Hollow Capital, told CNBC late last month that “we’ve seen the liquidity impact to financial markets, and now you’re going to see the economic impact. In munis, it takes a while to play out, … Stuff we see now is going to start to hit municipal budgets three months from now ... It’s going to be a difficult process to get states and locals back to square on their finances.” Erickson worries a downturn in the real estate market, which has not happened yet, could be another blow to local governments, and the bond market.
Bottom line: it won’t be only policymakers in Washington who will determine the shape of the economic recovery.