COVID’s Fiscal Footprint

When Covid-19 hit earlier this year, governments acted quickly and spent a lot of money to deal with an unfamiliar health and economic foe.   Speed was of utmost importance requiring state and federal governments to take a lot of action based on incomplete information on the virus itself and the economic consequences of its presence.   

To foster a better understanding of what we are facing, the venerable National Tax Association invited a number of scholars to assemble a “first look” at the fiscal impacts of the COVID-19 crisis and a snapshot-in-time assessment of what the policies accomplished.   The fall quarter issue of its National Tax Journal is devoted entirely to the topic.   We take a look at a couple of papers of particular interest and their potential relevance to future state budget discussions.

Implications for State Government Tax Revenues

One of the major limitations of the federal government’s COVID response is that the avalanche of cash delivered to states was only for COVID-related expenses.   The federal government’s guidance on what types of spending would qualify for COVID-related reimbursement was quite accommodating.   However, no money could be used to make up for lost tax revenue from a decline in economic activity stemming from the pandemic.

How much money do states need to make up for this revenue loss?  To answer that question researchers examined the pandemic’s effects on state government sales and individual income tax revenue collections.[1]  Together these two critical revenue streams comprise 85.5% of states’ total own source general tax revenues.[2] 

The revenue impact is a function of two components: 1) the change in the tax base due to the decline in economic activity; and 2) how sensitive individual state tax revenue collections are to the changes in tax base.  Using the Congressional Budget Office’s revised macroeconomic forecast to identify tax base effects, researchers translated the size and composition of the economic shock into changes in state government revenues.  This was accomplished by gathering information on individual state government tax bases and mining the considerable research history that exists on the sensitivity of tax revenues to economic shocks.

For the current fiscal year researchers projected the mean state revenue shortfall would be $303 per capita, split almost equally between individual income and sales taxes.   Unsurprisingly, there is considerable variation among states due to differences in tax bases and tax reliance.  Minnesota’s exposure was determined to be about 15% above the national average.  That translates into a projected FY21 revenue shortfall in the neighborhood of $1.9 billion compared to what we would otherwise collect if the pandemic did not exist.   For comparison purposes, MMB’s forecasted individual income and sales tax collections for FY21 prior to COVID was $19.7 billion last November and $17.1 billion this May, meaning a COVID-induced revenue shortfall of around $2.6 billion. 

These figures offer perspective on the amount of aid the federal government would need to provide states to offset pandemic-created income and sales tax shortfalls.  The $303 average per capita figure translates into $106 billion in federal aid to make up for lost state income and sales tax revenues in FY 21.  That’s substantially less than the $500 billion the National Governors Association requested earlier this year for revenue replacement purposes and less than half of what the last iteration of the House of Representative’s HEROES ACT would have provided to states for this purpose ($238 billion).  

However, a lot of general state revenues are derived from miscellaneous charges, fees, and other taxes also likely to be impacted by COVID-19.  These declines are not factored into the NTA author calculations.  A separate analysis conducted by the Cleveland Federal Reserve Bank estimates what Minnesota’s “all in” FY 21 revenue loss / replacement income need would be.[3]   As might be expected it all depends on the nature of the economic recovery.   The estimate of lost revenue in a V-shaped recovery is a “relatively” modest $800 million.    The “slow recovery” estimate is $2.5 billion – a figure that appears to largely track with the estimates generated by the NTA researchers if an additional $500-$600 million on top of individual income and sales tax shortfalls seems reasonable.   A major “second wave” scenario is projected to result in a $4.6 billion revenue shortfall this fiscal year.     Regardless of how accurate the estimates are, the message is clear: the evolution of the virus in the state in the next 2-3 months is going to have a huge say about our budget destiny. 

The Impact on Cities

A similar investigation was done to estimate the impact of the pandemic on city finances.[4]  Like the previous state-focused study, researchers assembled a counterfactual of what city revenues would look like absent the pandemic, then generated estimates of own-source revenue declines and state aid reductions to estimate city revenue shortfalls.  Researchers generated estimates under both a “less severe” and a “more severe” pandemic scenario. 

A challenge in investigating city finances is that the structure and organization of the services city residents receive from government varies widely across the country.   For example, the revenue needed for a service obligation in one city may be a county function in another.  To address this problem, researchers used a specialized database (created and managed by our 50-State Property Tax Comparsion Study partner, the Lincoln Institute of Land Policy).  It combines fiscal data from city governments with a prorated share of both expenditures and revenues from all overlying governments.  The result is detailed revenue and expenditure data that reflect total revenues raised on behalf of city residents and businesses and public spending carried out on their behalf.  The 150 “fiscally standardized cities” (or “FiSCs”) included in this study account for almost 75% of the residents of the principal cities comprising U.S metropolitan areas and include at least two cities from each state.[5] 

Table 2 presents the estimated average growth (decline) by revenue type in FY 21.  As might be expected, researchers found big differences in the sizes of shortfalls among cities – a function of, among other things, tax dependency, employment base, and how the fiscal condition of states affects the ability to provide/maintain local aid.  For the 150 FiSCs included in this investigation these declines translate into total revenue shortfalls of $34.2 billion in the less-severe scenario and $55.3 billion in the more severe scenario.

Cities’ relative reliance on property taxation is the major reason why aggregate shortfalls differ so much among cities.  The revenue stability that property tax reliance provides is an underappreciated quality of the tax.  The ability of local governments to offset declines or increases in property values by changing nominal rates (but collect the same amount of levy) is the key to this stability, and a feature of the tax that is commonly misunderstood by taxpayers.  Political messages to voters suggesting greater reliance on property taxation is something akin to contracting shingles has undoubtedly left some challenging municipal finance situations to deal with around the country.

Nevertheless, the pandemic’s influence on property values, the resulting shifts of tax burden, and the implications for raising property tax revenue in the future is something to watch.   Researchers flagged the uncertain future of urban commercial office space, noting a Stanford economist who was recently quoted as saying he could “easily see downtown skyscrapers in the center of some big cities falling in value by 60, 70 percent.”[6]  Meanwhile, unlike in the Great Recession, housing values remain robust and continue to grow.  Any distributional shift from commercial value onto residential value will be compounded by the leverage that exists in Minnesota’s classification system.   Assessment/taxation lag times may dampen this effect for a while, but some very interesting Truth-in-Taxation hearings may lie in the state’s future.

Regarding state aids, researchers observe states are in much better shape to address budget shortfalls compared to entering the Great Recession.  But they also observe most state governments close budget gaps by relying heavily on spending reductions in responding to a recession.  (An interesting fact: from the start to the end of the Great Recession, the sum total of state government-enacted revenue increases was less than 1% of all state general fund revenues.)  The state aid reduction estimates reflect this history.  

How state aids fair in state budget-cutting circumstances is another critical factor.  The historical answer is “not well.”  Minnesota local governments are certainly not alone in struggling with how state government treats them in difficult economic times.   State aids to the average FiSC continued to decline for four years after the official end of the Great Recession and by 2017 was still 7% below its 2007 value.  In Minnesota, general purpose aids to local governments have often been one of the first targets for reduction for the simple reason in stressed economic times the state has its own service delivery obligations to protect.  It will be interesting to see if the nature of the pandemic and its impact on local government alters policymaker perceptions about state budget cutting priorities.  

Expanding the estimates to all types of local governments in the U.S. yielded an estimated aggregate revenue shortfall of between $102.9 and $165.2 billion.  The latest iteration of the HEROES act would commit $178 billion to local governments.

Impact on Family Financial Security

Congress targeted about $560 billion of the $2 trillion CARES Act to individuals to improve household financial security.  Enhanced unemployment insurance (UI) benefits and direct cash (stimulus) payments comprised nearly all of this total.   Another group of researchers examined to what extent and for how long these CARES benefits would help families cover their normal monthly expenses during unemployment.[7]   Using federal Survey of Consumer Finance data, researchers examined this issue on several different dimensions including family type, income levels, ethnicity, and employment exposure.   Researchers calculated a “baseline” coverage of monthly expenses consisting only of existing household savings plus normal unemployment insurance.  The additional impact of CARES benefits on financial security was evaluated relative to this baseline.

Researchers concluded the bonus unemployment and stimulus payments have a major impact on improving the fragile financial security many working households face.   Thanks to the magnitude and progressive nature of federal CARES benefits nearly all working families are able to cover normal, recurring monthly expenses for six months -- with an important caveat.  For many working families the CARES Act actually improves household financial security compared to normal times. 

A few of the noteworthy findings:

• Among all working families, only 54% are able to cover normal monthly expenses for 6 months of job loss (through September, 2020) from household savings and regular unemployment insurance.  The addition of CARES Act cash assistance enables 94% of working families to cover these expenses.

• The ability to cover normal monthly expenses begins to taper off and accelerate downward beyond the six-month period of CARES assistance.   By December, only 85% of working families can cover these monthly expenses and less than 70% by March.  Without the CARES Act less than half of working families are able to cover expenses through the end of this year.

• Within the lowest income quartile of working households, only 29% are able to cover monthly expenses for 6 months with savings and regular unemployment benefits.  The inclusion of CARES Act benefits enable 97% of these families to cover monthly expenses.  Within the highest income quartile (whose regular monthly expenses are almost 3 times that of the lowest income quartile) 73% of families would be able to cover 6 months of expenses with savings and regular unemployment benefits.   Interestingly, with CARES Act benefits, 93% of these families can cover monthly expenses for 6 months.  That’s a notable improvement but a lower percentage than lower income households.   Researchers observed “the progressivity of CARES benefits not only removes disparities by income in financial security, but actually leads to relatively higher levels of financial security in the bottom two income quartiles.”

• Ten percent of working single parent families have savings to cover six months of household expenses.  With the CARES act 91% of these families are able to do so.

The caveat to all this is the assumption that households are able and willing to save any benefits in excess of monthly expenses to cover future monthly expenses.   Events like an unexpected health care expense, a needed durable good purchase, or some other unforeseen expense would affect these findings.  

What Comes Next?

This is hardly the extent of COVID’s fiscal footprint.  Another investigation concluded “coronavirus has created an enormous and expensive challenge for elementary and secondary schools while simultaneously depleting the revenue sources on which public schools depend.”  Still another found that each percentage point increase in the annual unemployment rate generates an additional $31 in per capita spending as demand for social insurance programs increases.

For all these reasons it should not be surprising that Federal Reserve Chair Jerome Powell has recently said failure to provide more federal support could have “tragic” economic consequences.  “At this early stage,” he said, “I would argue that the risks of policy intervention are still asymmetric. Too little support would lead to a weak recovery, creating unnecessary hardship.”[8] 

The prospects for further federal action are on hold at least until after the election and likely into 2021.   In the meantime, it’s important to learn the lessons from the experiences now playing out in our neighboring states.  An ounce of prevention is now worth $2.6 trillion…and counting.