U.S. state and local governments, on the front lines of the response to the pandemic of a new coronavirus disease, COVID-19, are projected to face record budget shortfalls. A distressing combination of dwindling tax revenues, record unemployment, and rising health costs will push many to consider major cutbacks to infrastructure and education—of which states and cities are by far the primary funders. Many still bear the scars of the 2008 financial crisis, which forced painful spending cuts to public services.
Even before the pandemic, many subnational governments were grappling with ballooning costs, including health care and pensions for public employees. Some had already sought bankruptcy protection.
In response to COVID-19, many states and municipalities have already made cuts, frozen spending and hiring, laid off workers, and drawn down rainy day funds. The federal government has stepped in to provide aid, but some say more is needed.
How do state and local governments budget?
Most state and local governments keep two budgets. The operating budget, often simply referred to as “the budget,” funds ongoing outlays such as employee salaries, payments for services, and interest on long-term debt. The capital budget—which is used to fund major infrastructure projects such as bridges, roads, or waterworks—issues long-term debt, such as bonds.
Unlike the federal government, states cannot run operating budget deficits. Every state in the union, with the exception of Vermont, has some type of balanced budget requirement—though many states have in the past used gimmicks, such as selling assets and then leasing them back, to circumvent the law. Under state laws, most municipalities must also keep balanced books. The cost of borrowing is also greater for subnational governments, as their bonds typically carry higher interest rates than U.S. Treasuries.
Some federal lawmakers have expressed concerns about mounting municipal debt, but aggregate levels as a percentage of gross domestic product (GDP) have remained within historical parameters. According to the U.S. Census Bureau, state and local governments had a little more than $3 trillion in total outstanding debt in 2017, of which nearly 99 percent was long term. Interest payments on this debt were roughly 3.3 percent of total expenditures—no more than in the 1970s. In contrast, the U.S. national debt has risen dramatically over the same time period, and is projected to soon exceed GDP.
Why are state and local budgets relevant?
The U.S. national economy is composed of a vast collection of local and regional economies, where state and local policies play a significant role. Collectively, state and local governments outspend Washington on direct goods and services, employ more workers than the domestic manufacturing sector, and are responsible for about 11 percent of national GDP.
States and cities supply nearly 80 percent of the $441 billion spent nationally on transportation and water infrastructure, according to the Congressional Budget Office’s most recent data. These investments help fuel the economy directly by creating jobs in sectors such as construction, experts say, and are also essential for improving long-term economic efficiency and international competitiveness. (For example, less congestion lowers business costs.) The 2019 Global Competitiveness Report from the World Economic Forum (WEF) ranked the United States second overall in economic competitiveness, but thirteenth in quality of infrastructure. The American Society of Civil Engineers gave the United States a D+ in its 2017 Infrastructure Report Card—the same grade it gave in 2013.
State and local governments contribute more than 90 percent of the money spent nationally on K–12 education, as well as provide substantial financing for the public university system, which graduates the majority of U.S. college students. While education has typically been the largest budget category of total state spending, Medicaid’s share has been growing over the past decade.
At a more basic level, states and cities are where life is lived and economic decisions are made. While budget austerity at the federal level can seem removed to many families and businesses, the effects of cutbacks in their home states and localities are tangible. Cuts to police and fire departments, for instance, mean some neighborhoods are less safe. Fewer teachers and more students per classroom erode the quality of education, making U.S. workers less competitive in the long run. Crumbling roads and bridges discourage businesses from investing.
How did the Great Recession affect state and local budgets?
The deep economic recession of December 2007 to June 2009 and slow recovery put many subnational budgets in unusually dire straits. Depressed tax revenues, elevated spending on social welfare programs such as unemployment insurance and Medicaid, and, in many cases, rising personnel costs squeezed public purses. The situation was particularly bleak at the local level, where many balance sheets were battered by the collapse of home values and property tax revenues.
Despite federal aid, states were compelled to slash spending by $290 billion and hike taxes by $100 billion to try to close the budget gap, according to the Center on Budget and Policy Priorities (CBPP). States continued to lay off workers for years after the recession and cut back on infrastructure and education spending. State support for public higher education dropped by 13 percent, on average, in constant dollars between fiscal years 2006 and 2011. California, with the largest state budget in the country, cut its transportation spending by 31 percent from 2007 to 2009; Texas shrank its funding by 8 percent.
In some cases, spending levels have not recovered. By 2017, some states’ education funding was still more than 10 percent below prerecession levels. Total public infrastructure spending, meanwhile, fell in real terms by nearly $10 billion between 2007 and 2017, according to the Brookings Institution, and a larger share now goes toward maintenance than toward new projects.
Other headwinds that hit state budgets include: the disproportionate growth of Medicaid spending; a decline in aid due to federal deficit reduction; shrinking tax bases and unstable revenues; and the fiscal plight of local governments. The recession also widened the hole in state pension funding. In 2017, states collectively could cover only 69 percent of their pension liabilities, down from 86 percent before the recession, according to a 2019 Pew report, though levels varied widely by state.
Unlike states, municipalities—of which there are more than eighty-seven thousand, including cities, towns, counties, school districts, and other public entities—can file for federal bankruptcy protection, known as Chapter 9 under the U.S. bankruptcy code. Though they are historically rare, there have been some high-profile cases, such as Detroit’s in 2013.
Bankruptcies in the wake of the recession came about for various reasons. The experiences of Harrisburg, Pennsylvania, and Jefferson County, Alabama, both of which filed in late 2011, were largely the result of poor infrastructure investments and political dysfunction. The challenges faced by many cities in California, such as Stockton and San Bernardino, largely stemmed from a precipitous drop in home values. In other cities, such as Vallejo, California, and Central Falls, Rhode Island, the main problem was escalating personnel costs.
How will the COVID-19 pandemic shape state and local budgets?
The fiscal shock from the coronavirus is expected to be at least as great as that of the last recession. Tax revenues are falling sharply as states face record unemployment claims and rising public health costs. By mid-May 2020, more than thirty million Americans had filed for unemployment benefits. As people lose jobs, more will qualify for Medicaid, the costs for which are shared by states and the federal government. Moreover, by the end of the first quarter of 2020, state pension funding levels had fallen to their lowest point in three decades as the pandemic caused the value of pension fund assets to plummet. The CBPP projects that the budget gap in fiscal year 2021 will be larger than that during the worst year of the Great Recession, and that states could see a $650 billion shortfall over the next three years.
The pandemic is starving state governments of sales taxes, one of their largest sources of revenue. Consumer spending has fallen off as social-distancing measures have curtailed activities such as shopping and dining out. Municipalities are being hit just as hard, since states are the biggest source of revenue for local governments.
Already states are rolling out austerity measures. Maryland has frozen spending while Pennsylvania has laid off or stopped paying thousands of state employees. Ohio has announced $775 million in immediate cuts, mostly to education and Medicaid. If the state made equivalent cuts over the next fiscal year, it would amount to roughly 20 percent of the state’s contributions to its general revenue fund, according to the Columbus Dispatch.
Education and infrastructure are again in jeopardy. The credit rating agency Moody’s downgraded its outlook for U.S. public universities to “negative”, citing potential state funding cuts. The pandemic will likely also lead to a drop in enrollment by international students, who typically pay higher tuition than state residents at public schools such as the University of California. Meanwhile, the Illinois Economic Policy Institute says that the projected drop in gas tax and gambling revenues could jeopardize the state’s $45 billion Rebuild Illinois infrastructure project.
What are the policy options for dealing with budget crises?
On their own, state and local governments have few options for dealing with budget shortfalls of great magnitude. Unlike the federal government, states cannot easily borrow money to fund their day-to-day operations. Some states’ laws prohibit such borrowing while others require voter approval, which would be difficult to quickly obtain. Most states have to pay back any debt within the fiscal year. States can, however, borrow from the federal government to pay out unemployment benefits; in May 2020, California became the first state to do so.
State budgets had mostly recovered from the recession, and many had built up rainy day funds to draw from during downturns. But the cushion will be nowhere near sufficient to prevent the pandemic from wreaking considerable economic damage.
That effectively leaves two options: raise revenue or cut spending. States have historically chosen the latter during recessions. Education and Medicaid, the two biggest budget items, cannot usually escape cuts; nor can state payrolls, another big expense. Mental health services, courts, law enforcement, and other public services could also see trims. “States are going to be laying off teachers and health-care workers and first responders, and this is exactly the worst time for that to happen,” Michael Leachman, vice president for state fiscal policy at CBPP, said at a CFR event in May 2020. The Bureau of Labor Statistics reported that almost one million state and local workers had been laid off or furloughed in April.
After the last recession, state and local governments found ways to do more with less. Some undertook infrastructure initiatives that leveraged private investment. To stretch the K–12 education dollar, many experts support greater efficiencies through the use of technology and e-learning tools. In recent months, the pandemic has forced most schools to convert to virtual education rapidly, prompting debate about the future of higher education altogether.
The federal government has stepped in to help states manage the pandemic response. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, passed in March, set aside roughly $150 billion for state, local, and tribal governments. An earlier measure, the Families First Coronavirus Response Act, increased the federal government’s contributions to Medicaid. Further aid to states is being debated, including an additional $750 billion in another rescue package.
“The federal government needs to step up to the plate and make sure that we don’t make the recession much worse by laying off a bunch more people and cutting spending in other ways,” said Leachman.