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The Crisis's Impact on Budgets

The Crisis's Impact on Budgets

Already strained by unfunded pension obligations, states now face a collapse in tax revenue.

By Steven Malanga

City Journal, March 23, 2020

When Major League Baseball postponed the opening of its season, teams also closed their spring training camps. That's a $25 million hit to the Arizona economy, where many clubs train, local experts say. Meantime, every NBA game that the Chicago Bulls don't play because the league has suspended its season will cost the Windy City and Cook County $228,000 in local amusement taxes alone. These are just a few of the many ways that the closing down of large sections of the American economy, along with the plunge of stock markets, is likely to undermine state and local budgets and force governments around the country to cut spending, even as they scramble to find extra funds to help battle the coronavirus. States that rely on meetings, conventions, and tourism, or that derive substantial economic growth from energy production, or that depend on big gains in the financial markets from wealthy individuals, will be among the biggest losers unless the economy turns around fast. The problem: most are in the middle of budget season, trying to plan for the fiscal year beginning July 1 amid enormous uncertainty.

The coronavirus economic shock came just as states were finally making up for the damage done by the Great Recession. Coming out of that downturn, state and local tax collections declined for two consecutive years—for the first time in the post-World War II era. A subsequent slow economic recovery made state revenue growth sluggish for nearly a decade. It took states, on an inflation-adjusted basis, until 2016 to get back to the levels of tax collections seen before the recession. But the economic expansion of the last three years, accompanied by a soaring stock market, had finally enabled states to stabilize their budgets, put money into areas (such as education) that some had neglected for years, and build up modest rainy-day funds.

Now much of that stability seems gone. Even before any recession actually hits, states are tapping their reserves to pay for resources in the fight against Covid-19, meaning that they'll have even less of a budget cushion should an economic downturn become severe. Washington State legislators, for instance, authorized drawing $200 million from their surplus fund for added health-care spending and to help pay for looming unemployment claims. Georgia has taken $100 million from its surplus fund to finance the coronavirus battle, and Maryland legislators have authorized Governor Larry Hogan to use $50 million for the same battle. The problem is that prior to the crisis, states collectively had only about $70 billion in these funds—enough to run state government for just eight days, on average. A few find themselves in even worse shape. A report by the Volcker Alliance, a budget watchdog group, estimated that Illinois has just a few million dollars in its fund, "enough to barely cover a few minutes of budget spending." Pennsylvania had just the equivalent of 1 percent of its budget in reserves.

Some states have designed their tax structures to collect a disproportionate share of revenue from upper-income residents. That makes their receipts volatile, especially during turbulent times, when so much of the income of high earners comes from capital gains, which have vanished suddenly. Income tax accounts for 70 percent of California's general-fund revenue, and the state's top 1 percent of earners pay almost half of all taxes. Among those earning $500,000 or more a year, capital gains account for 25 percent of their income. The state bases its current budget projections on the S&P 500 stock index trading around 3,120—but the index is currently at about 2,304, and instead of reporting fat gains, many of those tax filers may claim large capital losses, which will reduce their tax payments.

In addition to California, the states with the most financial-market sensitivity in their tax structures are New York, Connecticut, Massachusetts, and Oregon, according to a recent S&P Global Ratings report. New York generates 40 percent of its income-tax collections from high earners; on average, about 28 percent of its income comes from market gains, according to the Empire Center's E. J. McMahon. State Comptroller Thomas DiNapoli has already estimated that tax revenues could come in anywhere from $4 billion to $7 billion below projections, and New York faces other shortfalls from sources like the state lottery.

The sharp downturn has prompted an oil-price war, which has cut the price of a barrel in half. States that rely on the energy economy will take a big revenue hit. New Mexico gets one-third of its general-fund spending from taxes on oil production, and before the market slump, it was expecting to increase spending by 8 percent next year; it planned the extra money for schools and economic development. Now, the state is pulling back on some new spending. Oklahoma's budget is based on oil selling at $55 a barrel, far above its current price. The state is looking at a $100 million revenue hit if prices don't bounce back soon. The stakes are even bigger in Texas. The Texas Taxpayer and Research Association estimates that the state will lose $85 million for every $1 drop in a barrel of oil. So far, the price has plunged about $25 a barrel. And Alaska projects that it could lose up to half a billion dollars in tax revenue next year if oil prices don't recover.

The dramatic decline in travel, especially business-related trips and conferences, will also undermine budgets unless the slowdown is reversed quickly. Chicago is one of the nation's premiere settings for conventions and meetings, but it's already lost the giant International Housewares Show. That's 60,000 visitors and 47,000 hotel-room nights that the city and state won't get. The Civic Federation of Chicago estimates the financial hit from such cancellations and other consequences of the slowdown at potentially tens of millions of dollars for the city and hundreds of millions for the state. Both are deeply indebted and have struggled from budget to budget even in flush times. The state has been banking on raising taxes to cover its bills, including introducing a graduated income tax that will hit higher-income Illinois residents hardest. The problem now, however, is that the proposed tax hike, estimated at $3.4 billion, would only worsen the economic slowdown.

The biggest challenge some states may face from this downturn is maintaining their pension systems. Many are already deeply underfunded and have yet to recover fully from the 2008 downturn, despite an 11-year bull market. Though state pension systems were about 87 percent funded in 2007, they ended fiscal 2018 with just 72 percent of the money needed to pay future obligations, according to Wilshire Associates. Unfunded pension debt, just $138 billion in 2007, stood at $1.2 trillion in 2018, using the states' own estimates. The sharp run in the market since then had many state officials optimistically projecting that, when pension systems closed their books on the current fiscal year at the end of June, they would have made substantial progress toward paring that enormous debt—but all those market gains have vaporized for now, even as pension-system liabilities have swollen.

This is especially troubling for states that were already well below the average funding level before the market's precipitous drop. As many as 20 states were less than 70 percent funded. In the worst shape are Illinois, New Jersey, and Kentucky, all with less than 40 percent of the money needed to meet future obligations, while Connecticut is well below 50 percent funded. These states face two big obstacles in digging themselves out. The first is that up to 60 percent of the money governments are promising to workers in retirement is supposed to come from investment gains on dollars that employers and employees have contributed. When a state has less than 50 percent of the assets required to pay obligations, however, the amount of earning it can do is limited, because there isn't enough money to invest. That's why so many pension systems have struggled to recover.

Further, as funding levels have dropped, the amount that states should be contributing to pensions increases. States consistently failed to make their full yearly pension contributions for much of the recovery, preferring instead to put growing tax revenues into areas cut during the recession, like education. From 2015 through 2017, for instance, more than half the states did not contribute enough to their pension systems to reduce debt, even when the system met its investment targets. The amount that some states with enormous shortfalls must devote to pensions is simply out of reach. New Jersey, for instance, must contribute more than $5 billion a year to meet its obligations, an enormous sum for retirement costs in a $40 billion budget. Now, with tax revenues likely to plunge and important public initiatives that need financing, pension contributions are likely to fall short again, worsening an already-difficult situation.

These costs have led to calls for huge tax increases in states already heavily taxed. Much of the billions of dollars that Illinois governor Jay Pritzker wants to raise in taxes on high earners would be devoted to the state's pension system, while New Jersey governor Phil Murphy is lobbying for a new millionaire's tax—in a state with already one of the nation's highest tax rates for those earning more than $500,000.

The federal government is stepping in with some assistance, offering states money to help bolster local public-health dollars. The Trump administration has approved an increase in federal aid to states to help them pay their rising Medicaid bills. But Washington is unlikely to help in controversial areas where the states have created their own problems, like pension debt or revenue shortfalls from wealthy taxpayers.

In 2017, a senior official at S&P Global warned states that they had entered a new era characterized by sharp economic downturns and modest recoveries. The result would be "chronic budget stress," wrote S&P managing director Gabriel Petek. He urged states to fix their pension systems, build up their reserves, and bring spending and revenues into better alignment while there was time. The potentially severe coronavirus-generated economic downturn will test just how much progress states have made adjusting to a new fiscal reality. It's not like officials weren't warned.

Steven Malanga is the senior editor of City Journal, the George M. Yeager Fellow at the Manhattan Institute, and the author of Shakedown: The Continuing Conspiracy Against the American Taxpayer.