National newspapers, including The Wall Street Journal and The New York Times, continue to publish news articles and editorials outlining the arguments for more federal aid to help state and local governments get through the current crisis. Without additional federal revenue, many governments will indeed have to cut their spending or raise taxes, much as they did during the Great Recession.
As House Speaker Nancy Pelosi and Treasury Secretary Steven Mnuchin resume negotiations on a coronavirus relief package, we must remember that the federal government has already borrowed heavily during this crisis, and that state revenue shortfalls look less daunting than some experts anticipated a few months ago.
The “Heroes Act,” which was passed by the House of Representatives on May 15, would allocate more than $1 trillion of additional aid to state and local governments. A new $2.2 trillion proposal from House Democrats would provide $436 billion for state, local and tribal governments over one year. But neither of those plans has enough support to pass in the Republican-controlled Senate. The much smaller relief bill recently introduced by Senate Republicans does not include any additional federal aid to states.
Meanwhile, due to the rebounding stock market and retail sales, the tax revenue situation in most states isn’t quite as bad as some feared early in the pandemic.
According to the Tax Foundation, state tax revenue in Fiscal Year (FY) 2021 is expected to be lower than pre-Covid-19 projections by $117.8 billion. The sum of losses in both 2020 and 2021 projects to around $191 billion, and when combined with local tax revenue losses, grows to about $280 billion. If the economy recovers slowly, state and local tax revenues may continue to be low for an additional year or longer.
This is substantial, but consider that the federal government has already approved a total of $357 billion in aid to state and local governments, of which $150 billion is flexible enough to be used as each government decides. This does not count considerable federal spending on unemployment compensation.
It appears that federal aid is enough to make up for the revenue loss of the average state and locality in FY 2020 and FY 2021. It won’t, however, be enough to cover pension shortfalls in many states. Pension shortfalls are the result of many years of underfunding, though the problem is made worse by the recession. They can best be addressed by reform at the state level.
Not every state has same level of fiscal stress. Some are facing particularly steep revenue declines, especially energy producing states. But some of those same states also have large rainy day funds that will get them through. Overall, 18 states have large enough rainy day funds to pay for more than 10% of their annual spending. Other states have been more profligate, saving little or nothing during the recent economic boom.
If state leaders expect a federal bailout, it will be much easier not to save during an economic boom and to extend their shutdowns, further reducing their tax revenues.
When revenue declines, this gives state and local governments, like businesses, an opportunity to become more efficient. There is no need to cut essential services like police, fire and sanitation, which account for just 7% of state and local government budgets. Most state and local governments have lower-value or nonessential programs, and can also consider tough emergency measures such as temporarily freezing salaries, furloughing workers and delaying highway spending and new initiatives.
It would be better if states reduced their reliance on aid from the federal government, not only during crises, but also during normal times. States are required to balance their budgets, while the federal government has can accumulate unlimited debt. Even if it is financed by deficit spending, every dollar of federal aid to states comes from the same taxpayers who state and local governments serve.
If government borrowing is financed by Federal Reserve money creation, as has been the case recently, we may well pay for it with an inflation tax, as the money we have saved loses value and buys fewer goods and services in the future.
And if the federal government continues to expand its borrowing, we are likely to face a combination of higher inflation rates and higher tax rates in the future, depending on how much of the additional debt the Federal Reserve buys. More federal spending and debt will make it more difficult to pay all of the Social Security benefits that seniors have been told they can expect, since those benefits exceed payroll tax revenue by a growing amount each year.
A recession like we are now experiencing has reduced output and the incomes of many workers and business owners. To cover the cost of the trillions recently spent on programs to help them, we will eventually have a large bill to pay. We must make sure that any additional federal spending and borrowing is absolutely necessary, because it will only make these costs more onerous.
Tracy C. Miller is a senior policy research editor with the Mercatus Center at George Mason University