In ways never seen before in the annals of public finance, a good number of states actually made money on the pandemic — for a year, anyway. Flush with this unanticipated windfall, 48 states and the District of Columbia cut taxes or issued one-time rebates. Even though Congress had enacted rules to discourage use of the federal money for state-level tax cuts, governors and legislators quickly found ways around that by pointing to their good fortune from locally collected revenues.
Now that the economy has normalized and their federal money has largely been spent, a number of states are struggling to make ends meet. Three dozen of them experienced a revenue drop in the past year, and at least five now have serious budget shortfalls. Nonetheless, most states reportedly met their fiscal 2024 budget projections, which had anticipated lower revenues. For most, the problem now is what to do to balance their budgets after all those high-tide tax cuts.
That’s the central finding of a magnificently meticulous and thoughtful research report from the Pew Charitable Trusts. Without pointing fingers, the writers have documented the scope and contours of this historical moment with data that will serve the public finance and policy community well for decades to come. They also chronicled a new phenomenon I call “trickle-up economics” — a concept with serious intergovernmental policy implications.
Also to their credit, earlier this year the Pew research teams published a thoughtful report with recommendations for state-level rainy-day funds, or budget stabilization reserves as they’re more formally known. A politicians’ digest of that document should become required reading for governors, treasurers and state legislators: It’s a worthwhile place to start a broader discussion of how federal, state and local governments ought best to prepare for recurring private-sector business cycles, recessions and their ensuing slumps in tax revenues.
History is quite clear, going all the way back to the Great Depression, that when the U.S. economy goes into a downturn, state and local tax revenue shortfalls and ensuing layoffs amplify private-sector pain. Budget cutbacks, layoffs and tax increases by states and localities during the Depression offset most if not all of the macroeconomic stimulus of New Deal deficit spending from Franklin D. Roosevelt’s social programs. Learning from history, Congress has often attempted to provide countercyclical financial aid to the states. A widely accepted strategy is federal aid to extend state unemployment benefits; another has been to provide federal grants for local public works projects that are expected to reduce unemployment.
After the pandemic set in, Congress established the Coronavirus Relief Fund and the State and Local Fiscal Recovery Fund, which together provided more than $800 billion in financial aid to states and municipalities. In addition, more than $3 trillion in direct federal stimulus payments to households and employers was distributed under the Trump and Biden administrations, providing the personal spending money that helped boost sales tax and income tax revenues.
Elephant Memories in Congress
When federal money and consumer spending began to dry up, some states tapped into their rainy-day funds. Those facing major revenue shortfalls are siphoning hard from these rain barrels. Others are making do with some combination of newfound revenues and short-term budgetary gymnastics. As a result, it is very difficult to draw a single conclusion about any one best way to manage through such fiscal tidal waves. Nonetheless, there are several common themes worth noting — and now there are two skeptical elephants roaming in congressional budget hearing rooms that will have long memories when the next big recession comes along and governors return with hats in hand.
The first elephant in those rooms is that the COVID-19 era taught politicians and economists a lot about various aspects of countercyclical spending. A clear lesson was that direct payments to households and “payroll protection” for employers were quicker ways to pump money into the economy than going through all the rigamarole of funding multilayered, multiyear public-sector construction projects.
Much of the relief money flowing directly into people’s pockets was soon spent, which generated unforeseen sales tax revenues. It was history’s first recorded incident of trickle-up economics, whereby federal cash handed down to households then percolated $150 billion of unbudgeted, transient tax revenue upward to the states, with a multiyear total windfall of $500 billion above trend, according to the Pew report. With this surplus cash in hand, politicians in red and blue states alike could not resist the temptation to cut taxes, getting around federal restrictions by tapping their sales tax surpluses and other sources. Congressional staffers will not forget that COVID-19 aid was never intended to enable recipient politicians to cut their taxes. Expect more attention to be paid to the issue the next time states are pleading for countercyclical aid from Washington.
To add insult to injury, at least half of the State and Local Fiscal Recovery Fund money was not actually spent until the economy had already clearly resumed its growth path. This belated fiscal stimulus unwittingly bloated aggregate demand in the economy. Massive deficit spending coupled with “accommodative” expansion of the money supply by the Federal Reserve, along with private-sector product shortages, ultimately led to nasty price inflation. From a purely macroeconomic viewpoint, the sluggish timing was inopportune if not inept. That bodes against overdoing it on the federal stimulus next time, and cutting it off faster.
The second elephant in the room is that the federal deficit ballooned and keeps swelling, despite shallow rhetoric and magical thinking from Washington politicians. If that growth remains unchecked, and in light of the first elephant, it’s increasingly likely that in future recessions Washington will be more reluctant to send massive and arguably overgenerous financial aid directly to the states. That’s why states and localities need to plan ahead for more cyclical self-sufficiency and expect more-stringent strings on future federal bailout funds.
What Congress Should Do
Given the COVID-era experience, it’s foreseeable that future Congresses will impose tighter restrictions on intergovernmental countercyclical aid. For starters, it would be prudent to outright prohibit tax cuts and rebates by recipients of federal aid no matter what the ostensible revenue sources are — with clawbacks for violators — until the national economy has begun to recover. At that point, the spigot of federal funds should be shut off quickly as a statutory provision. These rules will suppress the wave effect.
Uncle Sam should only help those who help themselves: Recipients of countercyclical aid should be required to demonstrate that they have prudently maintained a federally qualifying rainy-day fund as a condition of receiving that aid. Calibrating the proper level of such reserves is a complex problem, but a good rule of thumb would be to target as a fund’s minimum reserve level the average of the governmental unit’s historic recessionary local-source revenue shortfalls. This process will enhance the countercyclical Keynesian benefits of rainy-day funds.
With this approach, recessionary aid to states need not exceed their rainy-day fund drawdowns except in the worst recessions, depending on their length and magnitude. Obviously, this formula won’t work with sudden double-dip recessions like the two in the early 1980s, when there wasn’t enough time to rebuild reserves. That said, it’s a reasonable requirement, and it’s a superior remedial formula for longer and deeper recessions like the big one in 2008. Bluntly, states and municipalities must learn to be rainy-day savers because modern Congresses clearly won’t.
What States Should Do
To qualify, the states should also be helping low-income communities fund their cyclical reserves with matching funds when times are good, to distinguish fairly between chronic and cyclical distress. And when states are awarded federal funds by formula as replacement offsets of recession-shrunk income and sales taxes, Congress should require them to correspondingly pass along to localities the same percentage of state revenues that they historically or statutorily allocate downstream, instead of using the federal funds to offset only state taxes or pad their own payrolls.
I have outlined previously how Congress can enact some of these ground rules and mandate anticipatory regulations for future cycles and aid packages when it adopts a new budget and tax plan in 2025. That would provide fair notice and incentives for all levels of government to get their acts together.
The academic community can play an important role here by wading in to conduct deeper research on the evolving problem of how to optimize intergovernmental countercyclical aid. For those interested, the publishers of the Public Finance Journal expect to encourage research and invite articles on this topic in the near future. The National Association of State Budget Officers and the National Conference of State Legislatures can also help craft some reasonable, principles-based guidelines that could actually be implemented by Congress and the states before the fiscal seas are roiling again.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.
