Fiscal freefall for state and local governments: The crisis we are not (yet) addressing

The federal stimulus bill signed late last month is good news for individuals and small businesses who in the coming months will receive cash payments intended to cushion the immediate economic pain of the coronavirus pandemic. But the effects of the pandemic on local and regional economies will be far deeper and go on much longer than many acknowledge.

It may be hard to think about these longer-term impacts in light of today’s urgent problems. But, based on evidence from past crises, the best time to address these challenges is now.

The plunge in economic activity from the coronavirus crisis will soon bring about a free fall in state and local government revenues. As sales taxes dry up, incomes shrink and state income tax payments are postponed, state and local governments will face painful choices. The just-passed stimulus bill (the CARES Act) includes $150 billion in direct aid to state and local governments. But the legislation requires these funds be spent on new costs directly related to the pandemic, such as providing emergency treatment facilities. In other words, governors and mayors are not allowed to use the stimulus funds to pay for basic services already budgeted, such as education, police and firefighters, or road maintenance. Even if they were allowed to do so, lost state and local revenue would outstrip the $150 billion almost immediately. With state and local governments’ own-source general revenue coming in at $2.4 trillion annually, even a 10 percent drop would amount to more than $240 billion.

State and local governments are required to balance their budgets. Initial moves to do so will involve repurposing existing financial commitments and a dip into the “rainy day” reserves that many states have built up since the 2008 recession. But without additional federal aid, the likely outcome is large cuts in state and local public spending.

Recent news stories report anticipated state budget cuts of at least 6 percent in Arkansas, 8 percent in New York and 20 percent in Ohio. Not only will such cuts damage the quality of public services, they will also prolong the pandemic-induced recession. We saw the long-lasting effects of cutbacks after the last recession when almost all states reduced funding for higher education; in most states, education funding has yet to recover pre-recession levels. Any U.S. recovery over the next few years will be seriously harmed if state and local governments cut public spending by hundreds of billions of dollars and lay off teachers, social workers, sanitation workers and others. These spending cuts will further hurt many small businesses that sell goods and services to these workers.

The actual economic effects of the “corona-economy” will hit some areas harder than others. Our colleagues at the Brookings Institution recently documented how the effects could vary across regions, with the hardest-hit areas including states and localities dependent on hospitality and tourism, like Florida and Nevada, and manufacturing, like our home state of Michigan.

Regionally severe recessions have long-run effects. Residents of an area that experiences 5 percent more job loss during a recession will, in the long run, be less likely to find work: Out of every 100 residents, 2 fewer will be employed. These effects occur because regional recessions damage the skills of workers and the ability of state and local governments to provide public services. 

What is to be done? Over the long term, we need better economic development policies to deal with regional disparities. But in the short run – in April and May, when Congress reconvenes to consider another stimulus package – we need state and local fiscal aid that is generous, flexible and targeted at the hardest-hit areas.

Aid to states should amount to at least $250 billion over the next year and preferably more to account for the expected decline in state and local tax revenue. Because there is no way to foresee the magnitude of that decline, we urge Congress to approve a fiscal aid formula under which the amount of state and local fiscal aid is tied to the health of the national economy. If the recession is deeper than expected, aid would go up as needed. If the nation does achieve a rapid V-shaped recovery, aid levels would automatically fall.

Aid should be flexible so governors and mayors can make choices about which services are most needed. Any congressional temptation to tie strings to state and local aid should be resisted.

And aid should be targeted to the state and local areas that are hardest hit. Aid formulas should adjust for local unemployment rates, so the states and local areas that experience the largest revenue shortfalls get the resources they need to maintain public services.

It is hard in the midst of a crisis to think around the next corner. But only by doing so can the worst economic effects of the current crisis be understood and addressed.

Timothy Bartik is a senior economist and Michelle Miller-Adams is a senior researcher with the W.E. Upjohn Institute. John Austin directs the Michigan Economic Center and is a research fellow with the Upjohn Institute.