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Tax Increases Loom as Federal COVID Bill Scraps State Aid

Posted on Dec. 23, 2020

The COVID-19 relief bill passed by Congress did not include direct federal aid for state and local governments to address revenue losses resulting from the pandemic, which could have tax policy implications for states.

State and local aid had been a major sticking point in negotiations over the year-end legislative package and the final version of H.R. 133, approved December 21, did not include the aid sought by the National Governors Association, the National Conference of State Legislatures, and other groups.

States have faced budget shortfalls because of the economic downturn, although experts said they haven’t been as high as predicted at the start of the pandemic. Because most states have balanced budget requirements, they have responded to the shortfalls by cutting spending, using reserves, or adopting other one-time measures to address the shortfalls, such as borrowing.

Before the pandemic, states were projecting average general fund revenue growth of 3 percent for fiscal 2020. However, preliminary data show revenues instead decreased by 3 percent, leading to a 6 percent shortfall on average, said Shelby Kerns, executive director of the National Association of State Budget Officers, in a September 8 blog post.

Jared Walczak, vice president of state tax projects at the Tax Foundation, told Tax Notes that while the requested aid wasn’t included, the bill includes about $127 billion in grant money to supplement education and transportation spending. He said many states will treat those as fungible and reduce their own contribution to education and transportation, freeing up dollars that can be used elsewhere.

“We saw this earlier with the [Coronavirus Aid, Relief, and Economic Security] Act, and it’s actually the primary way state and local governments were assisted in the Great Recession as well,” Walczak said.

Emily Brock, chief lobbyist at the Government Finance Officers Association, told Tax Notes that funds in the bill won’t be flexible enough to address the needs of state and local governments.

State and local governments can draw from property taxes, income taxes, and sales taxes. Brock explained that collecting revenues has become more uncertain because of the pandemic, and she hopes there will be a conversation about how state and local governments assess and collect those revenue sources.

“At this point, they’ve proven to be awfully challenging during a time of economic hardship,” Brock said.

Morgan Scarboro of MultiState Associates wrote in a July 23 blog post that "without additional federal aid, we can expect groups that have historically championed tax increases will use this circumstance to argue that states must act to increase revenue."

Tracy Gordon, senior fellow with the Urban-Brookings Tax Policy Center, told Tax Notes that tax increases will have to be on the table if budget shortfalls are as bad as projections suggest, but said that when tax increases do come along in these types of circumstances, they tend to be temporary. 

Gordon said states typically cut spending first because it is easier to get spending cuts approved, whereas it takes time to craft a tax package and get it through the legislature.

Josh Goodman, senior officer at the Pew Charitable Trusts, told Tax Notes that the absence of direct federal aid for state and local governments in the package will add to the difficulties state and local governments face in trying to balance their budgets.

Goodman said one advantage states had going into this economic downturn is the size of their budget reserves, which are higher than at any time in at least 20 years. However, Goodman noted in an April 9 report that some states, including Kansas, Kentucky, Illinois, New Jersey, and Pennsylvania, have little saved up. 

If state and local governments need to increase taxes to address budget shortfalls, economic recovery will be hindered, Goodman added.

Meanwhile, income tax cuts have been proposed in southern states such as Mississippi, where Gov. Tate Reeves (R) has proposed gradually phasing out the tax by 2030. 

"There does seem to be this growing belief that if we survive this pandemic and still have revenues to spare, then we might have room for tax cuts," Walczak said. "Those deliberations are going to be tough; there is going to be a lot of controversy around them; and even though revenue losses haven't been nearly as significant as those states planned for, most states have seen revenue reductions."

But Walczak said discussions about tax increases and tax cuts seem to have less to do with the pandemic itself than with the existing policy goals of state lawmakers. 

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