The Era of Flush State Budgets Is Over
What comes next? As part of the deal to extend the debt limit, President Joe Biden and Congress agreed to rescind about $30 billion that had originally been allocated in 2021s American Rescue Plan, some of which was going to be sent to state and local governments for a variety of projects. The amount isnt that large, at least by federal-budget standards, but it is indicative of a huge change in policy. The federal response to COVID-19 included enormous amounts of mostly unconditional fiscal aid to states, cities, and other local governments. But this era of huge federal aid, and the flush state and local budgets it helped create, is over. In its place will be a period of state fiscal retrenchment. Between the huge buckets of federal aid and the strong economy of the past few years, state budgets have never been healthier. Some states and cities have used this time to address long-standing fiscal problems and to sock away significant rainy day funds , which will ease the coming crunch. But others have not, instead using the money to build out new government programs or cut taxes, policies that will prove hard to reverse even when budgets get tighter. Read: Why Biden caved And they are getting tighter. Across the country , state and local tax and other revenues are declining, and the outcome will be particularly bad for transit agencies dependent on farebox revenue where many fewer people are riding transit and for cities reliant on downtown commercial property taxes where more people are working from home. When the flow of federal money to state and local budgets runs out, some jurisdictionsincluding California, Illinois, and New York Citywill face enormous budget gaps. People have become used to the state and local politics that were ushered in by the full budgets written amid the growing economy of the late 2010s, and the boom in state revenue around COVID. During these flush years, even some liberal politicians supported tax cuts and even some conservative ones supported increasing pay for teachers. The next few years will not look like that. Rather than new programs and tax reductions, we are going to see a number of states and localities forced to cut back. Police departments will be partially defunded not because of political preferences but because of fiscal necessity, despite worries about crime; class sizes in public schools will increase because fewer teachers will be hired. Federal efforts to encourage green infrastructure will be partially frustrated by declining state and local investment. Some places will raise taxes. And, in the medium term, we are likely to see severe fiscal crises in at least a few jurisdictions, like what we saw in Detroit in 2013. The central lesson of the past few years is that although federal aid to state and local governments can be extremely useful in heading off economic crises, it should be paired with conditions that encourage states and cities to budget responsibly. Congress could still encourage some changes in state and local fiscal policy. Achieving these reforms would have been much easier when federal money was flowing; now, however, well be able to see the need for them more clearly. Federal aid for states and cities came in several packages in 2020 and 2021 and was crucial in ensuring that the economic shock of COVID didnt turn into a giant recession. One reason the post-2007 Great Recession was so big was that it led to a huge downturn in state and local employment, substantially extending the economic decline. States and cities ended up hiding a lot of their lost revenue in underfunded public-pension systems, and the consequences persist to this day. During the Great Recession, interest rates were low and unemployment was high, which should have led to massive investment in new infrastructure, but states and cities used their borrowing capacity to accrue pension debt (ask yourself, where are the infrastructural wonders of the past 20 years?). Some jurisdictions, notably Detroit and Puerto Rico, were forced to default on their debts. In contrast, the state and local aid during the COVID recession was so substantial that it far exceeded the holes in state and local budgets created by the pandemic . It was so successful as an economic stimulus that it likely contributed substantially to inflation. Aid to states and cities during budget crisesa measure the federal government has taken intermittently since Alexander Hamiltons plan to assume state debts in 1790 has real benefits, as it helps avoid austerity or defaults. But such aid has obvious drawbacks as well. States and cities begin to expect aid going forward, leading to irresponsible budgeting decisions. Perhaps more important, lenders to states and cities grow less concerned about the condition of their budgets, encouraging reckless fiscal policies. In some periods, these drawbacks were seen as so severe that the federal government allowed states to default on their debts, rather than bailing them out. In the 1840s, the 1870s, and the 1930s, states defaulted, leading bond markets to shun those states and limiting their ability to invest in infrastructure. The best answer is to provide aid to states and cities in a crisis, but to add explicit requirements that states and cities reform their budget processes. Conditions on aid could encourage states to take steps that are politically harmful in the short run but that will improve their fiscal sustainability. Congress had leverage to encourage these reforms when providing massive amounts of aid during the COVID emergency. But it failed to do so. Congress still can pass legislation to encourage states to budget responsibly, even though it will be harder now. Conor Clarke: Theres no constitutional end run around the debt limit For instance, states and cities regularly budget using the cash accounting method , measuring dollars in and dollars out during a given year while failing to account for the accrual of liabilities that will hurt down the road (such as underfunding pensions or failing to maintain bridges). Congress could encourage states to adopt a more reasonable approach. Heres how: Congress gives states and cities a subsidy every time they borrow, because it has made the interest paid to lenders on state and local debt exempt from federal income taxes, meaning that lenders are willing to lend to states and cities at lower rates. Congress could say that this income-tax exemption is available only if states put a covenant in their bond contracts that they will budget in accord with generally accepted accounting principles, taking into consideration the accrual of liabilities. Even more dramatically, federal regulators could require jurisdictions to adopt volatility caps, or covenants not to spend money when state tax revenues suddenly spike. Congress could model these reforms on improvements made in the state of Connecticut, which until recently had been one of the nations most significant fiscal basket cases. Several years before the pandemic, though, Connecticut put spending limits and volatility-cap covenants into its bonds . This made the states fiscal rules enforceable by bondholders, and any effort to break them extremely risky. Connecticut saved an extraordinary amount of money during the pandemic, emerging as one of the true fiscal-policy success stories of recent years. Congress could also create tools to make defaults less costly if they do need to happen. After 2008, municipal bankruptcy proved a useful tool for places such as Detroit and Stockton, California, ensuring that neither one set of creditors (bondholders, public pensioners) nor todays taxpayers would be held entirely responsible for the bad fiscal decisions of the past, balancing losses for groups of creditors with court supervision of future spending plans for sustainability. Municipal bankruptcy law could be made more functional, however, by clarifying what it takes for a government to be insolvent, by authorizing multiple overlapping governments (a city, a county, and a school district that all govern and tax the same people) to file all at once and thereby reducing conflicts between them, or by authorizing state governments to file themselves . But the biggest policy questions are going to happen at the state and local levels. We will need to do more with less. There is huge demand for state and local governments to make historic investmentsin clean energy, in affordable housing, in transportation. Ideally, governments would have saved money during the boom so that they could continue to make investments even when revenues dry up. Where that is not the case, state and local governments simply wont be able to make these investments unless they figure out how to reduce costs. The cost of building highways has been growing for decades , and the cost of building tunneled mass transit in America is completely out of whack with the cost in our peer countries . To get new investment during a fiscal retrenchment, we will have to focus on the drivers of those costs bad planning practices , difficult permitting processes and environmental reviews , and refusals to negotiate with labor unions . Calls for state investment will have to lean into supply-side progressivism ideas that see Yes, in My Backyard regulatory reforms as both good in and of themselves and as tools for making state investment more efficient. Annie Lowrey: America has wasted its chance to move the economy forward The responsibility for these state budget problems rests on state government officials, and even more fundamentally, on us, the voters who select them. Over the past few decades, voters have used state and local elections as a way to comment on national politicsf or instance , voting for Democratic state legislators if they like President Joe Biden or for Republican ones if they like former President Donald Trump. What people in state and local office actually do has mattered less and less to general-election outcomes. We have ignored state and local politics, assuming that everything will work out fine. Once federal cash stops flowing and budgets worsen, the costs of having done so will be all too clear. Whether and how we respond are up to us.