States Face Daunting Budget Gaps. What Can Be Done?

The Issue:

States across the nation are estimated to face budget shortfalls for the upcoming fiscal year 2021, ranging from as low as 4% in Arkansas to as high as 30% in New Mexico. In fact, these shortfalls have likely grown since first estimated as recent reports indicate that GDP has slowed more than expected, and more than one-fifth of the labor force is currently unemployed, working reduced hours, or had given up looking for work. Worse, revenues are falling exactly when more public spending is desperately needed to cover escalating public health costs and greater demands on social safety-net programs due to the coronavirus pandemic and its economic aftermath. Unlike the federal government, states face balanced budget mandates that mean either cutting spending or raising revenue or both. Although aid from the federal government or drawing on rainy day funds can help states relieve some of the burden, it is far from certain whether either source will be sufficient to fill expected budget gaps over the next several years. These deficits leave state policymakers with difficult choices to make this budget season as well as in the months and years ahead.

Unlike the federal government, states face balanced budget mandates that mean either cutting spending or raising revenue or both.

The Facts:

• State revenues continue to decline precipitously in the wake of economic disruption caused by the pandemic and rainy day funds fall far short of meeting the estimated need. Moody’s Investor Service projects that, compared to the prior fiscal year, state revenues will be 14.3 percent lower in fiscal year 2021 (FY2021), which runs from July 1, 2020 to June 30, 2021 for most state governments. However, the experience of individual states can vary significantly with recent estimates showing budget declines exceeding 25 percent in the coming fiscal year. Similarly, the National Conference of State Legislators (NCSL) projected state revenue losses of 15-20 percent for FY2021 in a recent letter to Congress. These gaps have important implications for local governments as well which typically rely on state governments for nearly a third (29 percent) of their revenues. And while most states have reserves or “rainy day funds, their balances at the end of fiscal year 2019 accounted for only 7.7% of spending, well below expected budget shortfalls over the next two years.
• At the same time, the demand for state services related to the pandemic and its economic consequences is spiking. The Kaiser Family Foundation estimates that state spending on Medicaid will rise by 6.2 percent due to expected increases in eligibility as a result of the income disruption and joblessness associated with the COVID-19 pandemic. (Medicaid, which provides health coverage to low-income individuals and families, is funded jointly by states and the federal government. States have wide latitude in designing and implementing their programs, and benefits vary markedly across states.) In addition, a growing share of state spending is on mandatory programs, like healthcare and human services, which tend to consume more resources during recessions. This leaves other legally discretionary budget items to bear the brunt of any cuts. These include aid to cities and towns, education, transportation, public safety, and other state funded programs and services.  
• Unlike the federal government, states must run balanced operating budgets. During the Great Recession, between FY08 and FY12, state tax revenues fell by more than 10 percent between 2008 and 2010 (see chart). Spending cuts were the biggest contributor to closing state budget gaps by a large margin. For example, state budgets shrank by $31.3 billion in fiscal year 2009 and states enacted $55.7 billion in budget cuts for fiscal year 2010. In this recession, revenues are expected to fall more sharply than the Great Recession and budget cuts may far exceed those made in the last downturn. The impact is being felt already; the most recent jobs report shows that the only sector that continued to shed jobs in May was government.
• Help may come from the federal government but when and how much remains uncertain. To limit the need for cuts in state and local public spending, the federal government can provide aid directly to states. For example, during the Great Recession, the American Recovery and Reinvestment Act of 2009 (ARRA) provided states with $145 billion in funds. Similarly, the federal funds in the CARES Act may be targeted for limited use  such as to cover the public health costs associated with the pandemic. However, during previous severe downturns, Congress has also provided unrestricted funds that can be used by states to replace lost revenue wherever it is most needed within their budgets. Along these lines, last month House Democrats approved the HEROES Act, a $3.5 trillion bill that includes additional safety-net spending and economic impacts payments, and roughly $1 trillion in aid to state and local governments. Republicans and White House officials have argued instead for a pause in further spending to assess the impact of existing measures and have raised concerns about the ballooning federal budget deficit, with some suggesting considering bankruptcy as an alternative for addressing the fiscal woes of states and municipalities.
• Raising taxes to fund state and local budgets could help support vital programs and those most in need and may not adversely affect economic recovery. There is a common view that asking taxpayers to pay more during a recession slows the recovery. This is not always the case, especially during a severe recession, because tax revenues directed to government spending can raise total spending in the economy since consumers would not have spent all the money that they paid in taxes (some of it would have gone to savings), but state governments will spend the full amount. States have raised taxes during previous recessions with the goal of limiting spending cuts. During the Great Recession, 29 states enacted a total of $23.9 billion in tax increases, primarily by means of the income tax ($10.7 billion) and the sales tax ($6.1 billion). Of course, federal support would provide an even bigger stimulus since the federal government, unlike states, can run budget deficits.