States and the Fiscal Experiment Flowing from Washington

Despite predictions that COVID-19 would crush state tax revenues, most of them didn’t need megabillions in pandemic aid to balance their budgets. But for the most part they seem to be spending the money wisely.

September 14, 2021 •

The U.S. Capitol building with $100 bills behind it.

It’s time for macroeconomists and public finance pundits to eat crow. Early last year, almost all of us — myself included — predicted that states would encounter major revenue shortfalls as the nation locked down to fight the coronavirus. In retrospect, that proved to be a false alarm, at least for all but a third of the states. So the megabillions of federal dollars allocated to them by the 2020 CARES Act and the 2021 American Rescue Plan are largely going someplace other than budget balancing. Has a half-century of empirical public finance wisdom gone out the window?

As for my own humble pie, hopefully I can pass up the largest slice: While I was among the pundits predicting significant tax revenue shortfalls, I did make the case in this space in April 2020 that the size of federal relief packages being proposed at the time by congressional liberals and advocates of state and local government were double or even quadruple the realistic magnitude of what the pandemic could inflict. Beginning with the data point that total state and local sales and income taxes garner about $1 trillion annually, my bar-napkin estimate of the likely revenue shortfall was a range of 10 to 25 percent of that number, so perhaps $100 billion to $250 billion. At the time, governors were pleading for $500 billion, and I explained how that was probably going to be far more than was actually needed.

Although the 2020 CARES Act focused mostly on direct aid to individuals and small businesses, it did include about $150 billion for states and localities. With Democrats relentlessly pushing for more, the bigger funding package came later in this year’s pandemic relief legislation: the American Rescue Plan, which earmarked another $350 billion for intergovernmental aid — a number that will be debated for many years to come.

As it turned out, the CARES Act alone would have been more on the mark from a purely macroeconomic point of view, if I now say so myself. Hindsight is 20/20. But even that level of aid turned out to exceed actual revenue shortfalls in the aggregate nationally. And the American Rescue Plan’s relief for the states turned out to be well over the top, at least in that narrow fiscal retrospect. Bloomberg CityLab has compiled a very thorough, insightful and informative summary of each state’s actual tax revenues for the period of April 2020 to March 2021, compared with the prior 12 months, showing only 16 states with an actual revenue reduction. Many of those were oil producers whose royalties declined. But ironically, several of the notable revenue shortfalls were in no-income-tax red states whose politicians complained the most loudly about giving away excessive federal aid. Political cynics could say it was a perverse form of justice from the fiscal gods.

This is not to assert that the money was not and is not being well spent overall. The states have proved to be quite creative and thoughtful about how to spend their shares. A report by the National Conference of State Legislatures provides a state-by-state summary of key actions taken at that level. In many cases, the money is not yet disbursed, as the Bloomberg report shows, but the variety of state actions to deploy the federal aid is impressive to students of public policymaking and fiscal federalism. As Dan White, the director of public-sector research at Moody’s Analytics, remarked, “it is a very interesting, natural experiment that Congress has set up, whether they know it or not.” So let’s learn from these unintended social science laboratories. Soon there will be abundant data for doctoral dissertations in public finance and political science, as well as point-counterpoint on the Sunday public affairs talk shows. Where state politicians made questionable decisions, those need to be called out as well.

Going back to those early overestimates of the states’ fiscal shortfalls, we must remember that back in March 2020 nobody could possibly have predicted that (1) the stock market would actually rally mid-pandemic, boosting income tax revenues; (2) millions of higher-income and middle-class knowledge workers would be able to work productively from home; (3) direct federal aid to unemployed individuals and struggling small businesses would keep much of the economy afloat; and (4) consumers would ramp up their spending on Amazon and other online retail platforms, bolstering sales tax collection.

In this light, the CARES Act in particular was the most genius federal fiscal intervention in U.S. history, arguably even more surgically powerful than Franklin D. Roosevelt’s New Deal as a swift operation. Coupled with massive monetary stimulus from the Federal Reserve that flooded the economy with lower interest rates and a huge increase in the money supply (which arguably fueled the stock market and capital gains taxes), the quick and broad magnitude of early 2020’s rapid-response federal action was unprecedented.

One Size Does Not Fit All

With the COVID-19 experience baked into the economic databanks, it’s the form of federal aid that will be the topic of future partisan debates: Increasingly, many macroeconomists may advocate direct aid to households — “helicopter money.” Republicans will instinctively favor forgivable “paycheck protection” and emergency loans to smaller businesses, whereas Democrats will continue to promote social programs, enhanced unemployment compensation and intergovernmental fiscal aid tilted to blue states.

The political takeaway from the COVID-19 era could turn out to be that massive federal aid to states and localities in similar scenarios hereafter will be a tough sell, that direct payments to households are far more swift, legislatively simpler and more effective at bolstering aggregate demand. This counters conventional public finance wisdom based on earlier historical experience when budget-balancing cutbacks by state and local governments — their “fiscal drag” — offset much of the Keynesian federal fiscal stimulus.

So it’s going to be very important for the state and local government community to be able to show politicians, pundits and voters that the federal money they have received is mostly being well and wisely spent, has clearly benefited their most needy residents, wasn’t hoarded and didn’t waste taxpayers’ dollars. We need serious studies of outcomes of these diverse “experiments” by recipient states. Without proof of efficacy, advocates for the states won’t be able to fall back on 20th-century conventional wisdom as an elixir in every future recession. They must now compete with the evident success of direct wire transfers to taxpayers’ bank accounts and supplemental unemployment payouts.

What if it’s not either/or? Despite the stock market euphoria that has taken over Wall Street and jacked up state income tax revenues, most public officials and everyday Americans are not yet convinced that we’ve turned the corner on the pandemic or that the fiscal support provided by the American Rescue Plan was unneeded. For example, public transit agencies massively lost revenue and warrant fiscal aid. Center cities and various municipalities, particularly those dependent on tourism and business travel, fared worse than others. Nor should this commentary suggest that money earmarked for the states in the pending infrastructure bill and proposed bipartisan budget package should now be cut out. Those bills address longer-term structural fiscal issues that many governors and mayors had identified long before COVID-19 hit the globe.

What the past year ultimately tells us is that one size does not fit all, that “needs-based” legislative formulas have merit despite ideological and partisan bickering, and that the states and localities overall are remarkably creative in putting “found money” to good use to meet specific local needs. As with COVID-19 vaccinations, an ailing economy ultimately needs two shots in the arm, perhaps with governors administering boosters where the need is proven. What remains unanswered is how potent the dosage should be.

Governing’s opinion columns reflect the views of their authors and not necessarily those of Governing’s editors or management.