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CBPP and Heritage Analysts Debate State Responses to COVID-19: Transcript

Posted on Aug. 5, 2020

The COVID-19 crisis has put a particular burden on state governments, with the combination of steep revenue shortfalls and balanced budget rules likely to force sharp cuts in services. Congress is currently at a stalemate over how to address the situation.

Michael Leachman of the Center on Budget and Policy Priorities and Adam Michel of the Heritage Foundation joined Tax Analysts President and CEO Cara Griffith in a July 29 "Taxing Issues" webinar to debate whether and how the federal government should step in to help, and what the long-term fiscal impacts of such aid might be.

Cara Griffith: Welcome, everyone. I'm Cara Griffith, the president and CEO of Tax Analysts. I'm so pleased you've joined us today for what I know will be a very stimulating discussion on the budget crisis that states are facing as a result of COVID-19 and the economic downturn. We're thrilled to have a large audience tuning in from all over the country. We're also pleased we have many listeners today from state governments. You are uniquely positioned to raise the tough issues and ask the tough questions, and we hope that you do. Today's event is the fourth in Tax Analysts’ new series of public discussions we call “Taxing Issues.” We launched this series as part of our 50th anniversary celebrations and through it we're bringing the tax community together for bipartisan discussions on the future of tax policy with leading policymakers and experts. As I mentioned at previous events, this series will not just address federal tax issues, but state and international tax issues, as well. We'll also explore budget issues like we're doing today because budgets and taxes are closely connected. For the foreseeable future, with COVID-19 still continuing to threaten the health of Americans from coast to coast, we will hold these discussions in a virtual format, but we welcome your feedback on how we can make them more interactive. And now on to the topic at hand.

State governments perform vital functions, and they provide vital services for millions of people and businesses every day. They finance education, they provide law enforcement, they protect public health, they build roads and bridges, and they do lots more. To finance all that activity, they collect revenue. In fact, state revenue totals nearly 6% of the economy, gross domestic product, and taxes represent the largest single source of that revenue. This includes income taxes, property taxes, sales and use taxes, and a variety of other excise taxes. When COVID-19 hit and the economy was effectively shut down, closing businesses and throwing millions of people out of work, state governments were hit especially hard. Because they rely so much on income and sales tax revenue, a huge drop in economic activity translated into huge drops in state tax revenue. Many states had to close budget shortfalls in fiscal 2020, which ended on June 30th for many states. And many of those states are now facing shortfalls for fiscal 2021, some of which are enormous. At the same time, states have been facing growing pension liabilities for many years, and some states continue to make matters worse by using money that should go to fund their pension plans instead to finance their day-to-day activities. States have been using creative budgeting for decades to deal with the strain of this liability. Unlike the federal government, though, most states are required to balance their budgets every year. That means when they can't collect enough revenue, they have to cut spending. Many states have already cut state government jobs or are considering whether to do so, and are beginning to make sizable cuts in basic services. If you recall, the Great Recession about a decade ago hit state budgets very hard. States had to cut so much, they questioned whether even the most basic services were truly vital. they also laid off workers, but even as state revenue fell and state workers lost their jobs, the need for public services grew as laid off workers applied for unemployment, for Medicaid, and for other services. The same is happening today.

So what can states do to avoid what seems inevitable? And, as the president and Congress begin to negotiate what will probably be the last economic relief bill of the year, what is the federal government's responsibility to provide financial support to states so they can continue to provide basic services to their residents? To help us sort all of this out, we have two outstanding speakers, and I will introduce them in the order in which they will speak. I've asked each of them to speak for five to seven minutes to set the stage. When they're done, we'll begin a discussion with questions. As I noted at the outset, we welcome your questions. For this webinar, we are using the Q&A function, which you'll find at the right-hand side of your screen, and I will try to get to as many of them as time permits. We'll hear first from Michael Leachman. He's vice president for state fiscal policy at the Center on Budget and Policy Priorities. He directs the center’s state policy research and has a wealth of experience examining how federal policy decisions affect states, as well as the effects of state policy choices. We'll hear next from Adam Michel, senior policy analyst at the Heritage Foundation. Adam focuses on tax policy and the federal government and how taxes affect the wellbeing and opportunity of Americans. And so with that, Mike, I turn it over to you.

Michael Leachman: Great, thanks, Cara. And good afternoon, everyone. The COVID-19 pandemic has created, as Cara said, just an extraordinary and unanticipated state fiscal crisis. States rely on sales and income taxes for 70% of their tax revenue, and with so many businesses closed and so many people laid off, these revenues have fallen off a table. Based on past recessions and economic projections from the Congressional Budget Office and the Federal Reserve, we project total state shortfalls of $555 billion over three fiscal years. We have a chart that shows that — if Cara, we could pull that up, please. Thank you. It's hard to exaggerate the magnitude of this crisis. The shortfalls states will face in the current fiscal 2021 fiscal year alone far exceed even the worst year of the Great Recession of a decade ago as you can see in the chart. Federal aid provided so far, while helpful, is much too small to allow states to avoid laying off teachers and healthcare workers and others and taking other economically harmful steps. States can use this aid to close roughly $70 to $120 billion of their budget gaps. Even with that aid and with all of the states’ rainy day funds, they would still fall roughly $400 billion short. These estimates do not include states’ added costs due to COVID-19. School districts, for example, face substantial unanticipated costs, including costs for regular cleanings, protective equipment for staff, distance learning, and expanded learning time to offset the learning loss caused by school closures this spring. Further, our shortfall estimates are for states only. Local governments also face significant shortfalls, as do tribal governments, whose revenues were hit especially hard, and U.S. territories like Puerto Rico. Unless these states and these other governments receive much more federal aid, they'll lay off more and more teachers and other workers and cut spending in other ways, and that will further harm an already weak economy. When states last faced a budget crisis and the Great Recession a decade ago, emergency federal aid closed only about a quarter of state budget shortfalls, and here, Cara, if you could pull up the second slide. Thank you. The states laid off — you can see that they relied primarily on spending cuts in the last recession. States laid off hundreds of thousands of workers and cut spending deeply in other ways. Those layoffs and spending cuts created a major drag on the economy's recovery. And that's why [Federal Reserve Chair Jerome] Powell and other prominent economists are urging that we not make the same mistake this time around. The legacy of the Great Recession's cuts [is] still with us today. School districts, for example, have never recovered from the layoffs that they imposed during the Great Recession. When COVID-19 hit earlier this year, schools employed 77,000 fewer teachers and other workers than they did before the Great Recession took hold, even though they were teaching one-and-a-half million more children. These funding cuts and layoffs hurt our kids, and that hurts our future. Recent research finds that the cuts in school funding drove down test scores and college attendance rates, and the impact was particularly damaging for low-income students and students of color, adding to the substantial structural barriers these children must overcome. States were already cutting this time around — in April and May alone, states and localities furloughed or laid off one and a half million workers, about twice as many as in the entire aftermath of the Great Recession. And just to offer a couple of state-specific examples, in Georgia policymakers approved a 10% cut for fiscal 2021, including a nearly $1 billion cut for K-12 public schools and cuts to programs for people with developmental disabilities among others. And in Maryland, Gov. Larry Hogan [R] has proposed nearly $1.5 billion in cuts. Some 413 million of those cuts are already taking effect, nearly half of which will fall on colleges and universities, likely driving faculty furloughs, pay reductions, and cuts to financial aid.

Many states are waiting to see how much federal aid they'll receive before imposing deep cuts and raising taxes and taking other steps. A significant share of states are operating under budgets adopted before the pandemic took hold. They're going to have to come back and rewrite those budgets. Others adopted short-term budgets to get them through the first part of the current fiscal year, or their fiscal year doesn't start until the fall. And that buys them a little bit of time, but not a lot. And in this environment, further cuts would not only slow the economy and hurt families, they could also weaken the ability of states and localities to fight the virus. If a state lays off healthcare workers and teachers and others, it'll be that much harder for the remaining staff to do their job safely. So in summary, federal aid to states and localities is an urgent priority right now. It's just the last thing that we need right now is more layoffs and cuts to services that people need for their health and wellbeing. Thank you, Cara, I'll hand it back to you.

Griffith: It paints quite a dismal picture for the states that at this point [inaudible] definitely got a lot to discuss. Adam, let's get your take on it. alice

Adam Michel: Well, thank you for having me, and I think I have a slightly more optimistic take than Mike does. I'll highlight three broad points to start. First, I think this idea that state budgets require large federal bailouts right now is a bit misleading. And that second, although states will undeniably have revenue shortfalls, they can and should look to expenditure reforms rather than federal taxpayers or tax increases to make up shortfalls. And lastly, I'll highlight how past bailouts have historically had unintended consequences over the long term for states.

So first, the good news is that state revenue shortfalls are smaller than initially projected. Over the last couple of months, as we've seen new revisions coming out, they seem to get smaller with each new revision. Right now, across a variety of estimates — [the] Tax Policy Center, [the] Tax Foundation, NCSL — it looks like state revenues by my estimation could be down by about $50 billion this year, $80 billion in 2021, and that's about 6% decline in 2021 revenues. More pessimistic projections put those declines at closer to 10 or 11%. But as a fraction of total state income, when we include federal transfers and not just own source state revenue, states are expecting about a 3% decline in revenues. So it's helpful, then, to remember that before the crisis, state rainy day funds, on average, were ready to cover more than 8% of yearly expenditures. On top of that, the federal government has already provided $150 billion in direct aid to states to cover COVID-related costs and more than $50 billion to schools, transportation, and some other items, much of which hasn't been spent yet. The Federal Reserve has also set up a $500 billion lending facility, and state and local governments are benefiting from the $1.3 trillion in indirect aid Congress has sent to individuals. These unemployment benefits [and] stimulus checks will ultimately support income and sales tax revenue at the state and local level. [JPMorgan Chase & Co.] recently projected that because the unemployment insurance is replacing more than 100% of many people's pre-pandemic wages, on top of additional federal transfers, disposable income could actually be higher this year than past years. And that'll translate to additional tax revenue once people feel comfortable leaving their homes and spending again. So while state budgets are certainly under a lot of pressure, I'm not sure that it's a crisis yet in most states.

So where states do face pressures, there are plenty of ways to cut unnecessary expenditures without relying on federal taxpayers or tax increases. By way of a high-level example, New York and California — their states’ spending, adjusted for population and inflation, has increased by 50% over the last two decades, driven largely by health and education spending. And without seeing much difference in measures of success in health or education outcomes, New York spends about twice as much per person in states like Florida, for example. And this isn't just a California and New York phenomenon. I average state and local spending has increased by more than 30% over the last two decades, and rolling back just a fraction of these increases could save states hundreds of billions of dollars. More specifically, state and local employees make 50% more than those in the private sector. Simply freezing compensation growth could save about $50 billion across the states in just one year. Similarly, state pension programs also need reform. In Illinois, for example, retiree benefits take up 25% of the state’s general funds budget, up from 4% in the mid-90s. So reforming these obligations will ultimately save states a lot of resources over the long run, but they can also provide tens of billions of dollars in short-run cost savings by doing things like eliminating pension spiking and reforming cost-of-living adjustments. So, and unfortunately dangling federal bailouts in front of state legislatures makes these types of reforms even more challenging, as it removes the incentives to bring all the necessary parties to the table to make these difficult decisions.

And last, just briefly I would like to touch on some of the unintended consequences of these types of federal bailouts. When we socialize state budgets through federal aid, it's sort of like splitting the tab among a large group of friends at an expensive restaurant. People tend to order that extra drink or ordering that dessert that they otherwise wouldn't have ordered, and then everyone ends up paying more because your personal expenses are split by the table as a whole. And this is exactly what we see happens at the state level when federal government picks up the tab. In 2009 state aid funds were used to expand programs beyond what was sustainable, education funds were used to create new nonteaching positions, and when the funds dried up, states called for additional federal funding to support these new positions. Similarly, following the expansion of Medicaid funding during the Great Recession, more than half of states built their 2011 budgets around the expectation that Congress was going to continue these elevated levels of funding when the program was slated to expire in 2010. These and other examples show that past bailouts . . . ultimately leave states in a worse fiscal position and less prepared to manage the next crisis.

So just a summary, I think that most of the state budget crisis is not as dire as we previously believed, and that the states that will ultimately have to make hard choices would be much better off addressing decades of expanding budgets and over-promised retiree benefits rather than taking federal money or delaying the necessary reforms that will still be a necessary component after this crisis is over.

Griffith: Thanks. That's very interesting. I have to admit I was a reporter and a writer back when the Great Recession hit, and I spent a lot of time thinking about, is this going to spur on tax reform? Is there going to be more fundamental movement that stems from what are otherwise very difficult times you [inaudible] the case today.

Mike, I’m going turn it back to you for a second. I think your position is relatively clear that the states do need federal fiscal aid. Do you have any caveat to that? Would you say that, you know, if you were the one that was doling out the money, would you give it to all states? Would you give it to states that do in fact have a budget deficit or that are facing a budget shortfall at this point? Or would you look to states that maybe have a budget shortfall and have been good stewards of their money in the past? Is there any level of responsibility that you'd put on the states in terms of how they managed their finances before?

Leachman: Yeah, I mean the immediate crisis is the pandemic and the economic fallout from the pandemic. I think the key reason why aid is needed is that we want to contain the damage. I mean, first we need to contain the virus, and then we also want to contain the economic impacts. So, you know, I would distribute aid based on the economic conditions in states and assure that the aid was appropriate to meet the shortfalls that are resulting from the pandemic’s impact on state budgets because of the economic effects. The virus is nonpartisan — it's affected every state. Every state depends on revenue sources that have been deeply affected by the virus. So I would base it on economic factors and assure that it was structured so that ideally it would trigger on and off, depending on what happens with the economy. We're not, you know, nobody has that crystal ball. So it would stay on as long as it's needed. And if the forecasters are more pessimistic than they need to be and it turns out that the economy recovers more quickly than most people think, then the aid would turn off as the economy improved.

Griffith: So Adam, your take on that and, you know, you sort of have to admit that COVID-19 was an unexpected event that has occurred that has put a lot of people, and the states as well, in a very difficult position. Would you support any sort of federal relief [inaudible] good stewards of their money to states that could say, well, what we're facing right now is simply a result of COVID and is not a result of structural issues that we have, or, you know, research that I had done years ago on, on pensions and things like that that are grossly underfunded, and that have been a huge liability to states in the past. Is there any amount of, you know, being a good fiscal steward that would sway your mind one way or the other?

Michel: A couple of thoughts: I certainly think that there's a federal role for increasing testing and increasing things that directly get to sort of safety health outcomes. But when we start talking about general fiscal rules that toggle on and off additional aid to the states based on economic conditions and backfilling reductions in revenue, that's where I start seeing problems. Many states had budget problems before the current crisis after a decade of historic economic growth. I think Illinois had something like [a] $3 billion deficit. Before the pandemic, New York had a $6 billion deficit. These types of underlying fiscal problems are not new, and the virus has simply brought them to the foreground, that where previous economic growth made those things harder to see. I think it's also — I have a different perspective that simply sending more money to the states is a way to prop up the economy. We have pretty compelling evidence, the way that various governments reacted after the Great Recession and following other recessions that those governments that are facing fiscal crises, like many states are, whether the pandemic was here or not, are much better off addressing the budget crises with expenditure reforms rather than taking on additional debt or tax increases, and taking on additional debt is simply just tax increases in the future. Those governments that cut expenditure growth and create a solid fiscal footing moving forward are actually those that bounce back most quickly and have the quickest economic recoveries. So that's where I would focus, both at the federal and the state level. Simply pushing state cost to the federal level doesn't really get rid of the problem, it simply just spreads the cost over more people. We still have a tremendous federal deficit and debt. It still means taxes have to go up in the future. It's just a matter of sort of where you're categorizing it and the incentives that follow those decisions.

Griffith: So I'm going to turn to a question that came in from listeners, and [inaudible] kind of interesting. I'll open this up to both of you. Is federal funding for states less efficient than bailouts for businesses? Both are an example of socializing risks, but it's important to consider which will act more effectively.

Michel: I'm not sure which is more efficient. I think any time you're asking another person or entity to spend someone else's money, you're going to get many inefficiencies. Maybe sending money through two levels of government is going to be more inefficient. But broadly speaking the estimates of government fiscal stimulus — for every dollar the government spends — it actually crowds out private sector investment in private sector job creation, contrary to how people normally think of stimulus. So whether it's going through governments or to the private sector, I think it's almost always ill-conceived and will ultimately cause problems down the road.

Leachman: Yeah, I would say that fiscal federal support for states is at least as efficient as aid for saving jobs in the private sector during a recession like we're in right now. You know, that the dollars are going directly to save the jobs of teachers and healthcare workers and others. If that’s because states have to balance their budgets, they don't have much choice except to lay those people off and cut spending in other ways or raise taxes, and those steps just add fuel to the recession's fire. So I don't see crowding out in the midst of a deep downturn like this. It's going directly into income, protecting salaries and income. [Inaudible] funnel that right back into the economy and keep the recession from getting worse and help the recovery to come as quickly as possible.

Griffith: Mike, what do you think about balanced budgets in a time of crisis like this? Is this a time to start revisiting balanced budgets, or is that something that should stick around regardless of how difficult these economic times are?

Leachman: I think it’s important for states to have balanced budget rules, and effectively every state, or every state except for maybe Vermont, has some form of balanced budget rule. And that grows out of going back into the 19th century with states when they were first forming, and the need for them to have some rules like that in place. It's also important for the federal government to be able to deficit spend during our recession for the reasons that we've been talking about. It's an important tool in their toolbox to be able to use fiscal power to keep the recession from getting worse and to get the recovery going as quickly as possible.

Griffith: Do you both expect to see tax increases? I mean, it seems likely to me that in particular, retail sales tax could certainly expand. There are in most states services that could be brought under the sales tax umbrella. What are your thoughts on, if we're going to see some level of federal aid, OK, but that's not going to make up the entire budget shortfall in many of these states. Do you expect to see a broadening of the base for sales tax? And if so, is that a good thing?

Leachman: I'll take that. I think it's definitely a good thing. You point to an important structural issue in state revenue systems that state sales taxes were built a long time ago, largely during the Great Depression and in years after, and at those times, in those days, the economy was different. We spent mostly on goods and a lot less on services than we do today, so there are a lot of services that are still exempt from state taxes, and in that way, the systems are antiquated and need to be updated for today's economy — similarly around internet purchases and such. So there are important modernizations that need to happen to improve state fiscal systems so that they're sort of up to date, and that's a good one. In terms of whether I expect it to happen, I think definitely states will be looking at that, as well as other ways to raise revenue. We'll see what happens with the federal aid debate, but I don't think there's any — it seems likely that the states are also gonna need to look to their revenue systems and also to the expenditure side to close their budgets and to build towards a better future.

Michel: If I could just add to that — it's not, I would expect taxes to go up regardless of whether or not there is a federal bailout. We saw this after the Great Recession. Taxes did end up coming up a little bit. Those taxes were usually not some sort of a broad-based tax reform, but instead smaller increases in excise taxes and other sorts of marginal pieces of revenue, however much I would have rather a broad-based tax reform to improve the efficiency of the system overall. But the historical evidence also shows that federal bailouts don't mean that state taxes won't go up. Instead, every dollar of federal money that's been sent to the states has been associated with a three- to four-cent increase in state taxes. And this is for two reasons. One, there's often federal strings attached to new money that raises the cost and requires states to use some of their own money. And two, states use money to expand programs that are ultimately unsustainable once the federal money dries up, and so states then backfill with tax increases — not necessarily right away, but once that money starts running out. So I think there's concerns on both sides, and sending money to the states doesn't protect us from tax increases.

Griffith: No, I think that's a very good point. And my next follow-up to you is going to be on localities — that I would expect that we are seeing localities that are struggling right now and do have large budget shortfalls. Either of you, have you heard word of, or would you expect to see, more local taxes implemented? [Inaudible] Portland, for example. Would you expect to see some more local-level or city-level taxes in the near future?

Leachman: I do expect that. Local governments’ revenue base tends to be more stable than at the state level because local governments depend more on property taxes, and that's particularly true at the moment and for the current recession, but generally true, as well. That said, localities do — and depending on the city and county, it's particularly true — do also depend on sales taxes and in some cases, income taxes, so they're facing significant fiscal pressures, as well. And so I expect a similar dynamic to play out there where local governments are looking to federal aid. They're also looking to tax increases, and on the expenditure side, to balance their budgets and to position themselves for the future.

Griffith: Going back to a broader point, I kind of wonder [inaudible], should states take responsibility for the position that they are in right now. They're facing shortfalls. There are some fundamental reasons for that. What level of responsibility should states be taking for the position that they're in today?

Michel: I think ultimately the sort of tax and spending decisions should reside together at whatever level of government we're doing, the spending and the taxes that fund that. So to the extent that the states are responsible for their own budgets, I think they should take full responsibility for that. The federal government also has a budget that it's responsible for, and I think states are doing much better at balancing their budgets and staying sort of within the rules of sanity than the federal government is right now. So this idea that it's not states’ fault, therefore federal taxpayers should pick up the bill — it's also not the federal government's fault. And when we drill down into governors’ decisions around shutdown orders and other regulations relating to the virus, those are all local- and state-level decisions that are at least in some part then tied to their economies and their revenue and how the crisis evolves. So I think moving sort of the budgetary side of that up to the federal level while leaving the rest of the governing decisions at the local level also can create some mismatches in incentives moving forward.

Griffith: Do you think if we were to get federal funding, should it be tied — and maybe Mike, I can turn this one to you — should it be tied to things that are directly related to the pandemic? So for example, should federal aid be tied to healthcare? Should it be tied to something that would benefit the situation that we're in?

Leachman: I think a portion of it should for sure. The states and localities face significant additional costs to just directly fight the virus for protective equipment and directly for healthcare and a whole variety of other things that need to happen to help contain the virus. But that's not all. The state revenues have fallen off the table because of the pandemic, and it's in the national interest to make sure that we minimize the economic effects and the human effects of that because, as we've been talking about, states without federal aid — because they have to balance their budgets — are very likely to lay people off and cut services and spending in ways that would do damage. We depend in this country so much on the states and localities to deliver our major national priorities — our education system, a big portion of our healthcare system, our infrastructure. Like 90% of our public infrastructure outside of defense is owned by states and localities. So given that, we need to do more than — although it's important — provide support for directly fighting the virus.

Griffith: Should states freeze things like contributions into pensions and other state employee benefits?

Leachman: Well, I think that states are responsible for their budgets generally, right? And we want states to be taking good fiscal care of their finances. So it's a separate question from what's needed right now because of the pandemic’s effect on our lives and on the economy. But for sure, separate from that, states need to be responsible in how they balance their revenues with their spending.

Michel: And I'm not sure if it's necessarily separate, but my colleague Rachel Greszler wrote a great paper I encourage everyone to check out on ways states can address their budget crises. And she estimates something like suspending pension contributions and accruals for just one year could save states up to $234 billion in a year. And that's similar to what private sector companies are doing to avoid layoffs, to avoid cuts to other benefits like healthcare. So I think states should most certainly look to these types of temporary freezes raises and contributions, and then also those longer-run reforms as a way to keep layoffs from happening, keep taxes from going up, and keep the dollars from ending up on the federal credit card.

Griffith: So I'm going to turn to a question from the listeners, and we've actually gotten in a lot of questions. This is fantastic. A listener writes in, “Should states borrow against future tax revenues to address the needs of this crisis?” I'll open it up to either one of you that wants to take a stab at it.

Michel: I think that states should first look to the expenditure side. As I was just saying, where can we freeze costs? Where can we make decisions like the private sector is making and change obligations we have to make this year? But then certainly rather than simply putting the money on the federal credit card, I'd much rather states take on that liability and have to pay it off going forward rather than moving all of those costs up to federal taxpayers.

Leachman: I'm concerned about states relying too heavily on borrowing to get through the crisis. For one thing, there are serious limitations on their ability to do that. And, of course, when we come out of the recession, states are still gonna have spending needs, and we don't want — I mean, if they also have to be paying back a large amount of borrowing that they did to get through the recession, then that's just sort of delaying cuts and will slow our recovery as opposed to getting through it. Now, you know, I do think that there are some things that states can do in a shorter-term way to kind of get through the immediate crisis into later into the fiscal year, and that can include, I think, borrowing on future tax increases, depending on what exactly what we're talking about. But again, I worry about exactly how that's structured and particularly if you're just borrowing against your future revenue, then you're getting through the immediate crisis while creating more problems for yourself down the road.

Griffith: It definitely does seem like a kicking-the-can-down-the-road idea that is not going to play out well in future years because we still have a balanced budget requirement, so unless we're going to lose at some point, then you're going to have to deal with the strain now, or then. Adam, a question for you. We are certainly in economic difficult times right now. Is a recession a good time to think about cutting budget and social services? You know, I would say I can certainly agree that tax reform is needed at the state level, and there are a lot of states that should take a look at their systems as a whole, and are they modernized? You know, if we're going to try to tax services, then we've got a lot of rewriting to do on some codes and things like that, but is a recession the right time to try to do any of that, or should we prop the states up for a bit until they are on more solid ground before trying to do any sort of a massive overhaul?

Michel: Without the — if we continue to kick the can down the road as we've seen in the last several recessions, that day when the reforms actually come to fruition never actually happens. The federal bailout money simply allows states to get back to normal. And then when the recovery is here, they sort of return to their previous paths of underfunding, pensions, and the rest of it. So in that context, it is never a good time to make big reforms to anything politically, but it's certainly preferable to kicking the can down the road or racking up debt and increasing taxes in the future. As I was pointing out before, the history from mostly European countries facing fiscal crises shows that those that even in a recession address the reforms through expenditure-based plans rather than tax-based plans see much brighter economic futures than those that kick the can down the road or try to tackle the problem with tax increases, which ultimately is just kicking the can down the road because almost always, fiscal crises are driven by expenditures growing at a faster rate than the economy or reasonable tax collections, and not tax revenue being too low or other things that are more easily fixed.

Leachman: Can I jump in there a second?

Griffith: Yeah, absolutely.

Leachman: Just to provide some context for what happened during the Great Recession and where things stand as we headed into the pandemic. As a share of the economy, state general fund spending was well below its levels heading into the Great Recession. I mentioned that heading into the pandemic, there were 77,000 fewer K-12 school workers, teachers, and other workers. . . . Even though there's a million and a half more children enrolled in K-12 schools, state funding for higher education per pupil is down 13% on average after adjusting for inflation relative to a decade ago. That's . . . made college less affordable. Spending on infrastructure by states stands at historic lows as a share of the economy. And states did a pretty good job of saving, heading into this downturn. They had about seven-and-a-half percent of their budgets held in rainy day funds. That's compared to 5% heading into the Great Recession . . . about 13% of their budgets held in total reserves. Most state unemployment insurance systems met the U.S. Department of Labor standard for a UI trust fund being prepared for a downturn. So, you know, states made a lot of cuts during the Great Recession. Those cuts are largely still with us, and it's hard to argue that failing to make investments in our education system and in our infrastructure and other areas is a path to a stronger future.

Griffith: Interesting. Um, so here's a question that came from listeners, and it stems from both of your collective openings. During that, each of you presented different shortfall figures. So the question is, do states face the crisis or don't they, and can you each speak to the other’s very different shortfall figures?

Michel: I'll start there. These projections are highly uncertain and coming from various different data sources, and everyone's simply making guesses. That's why we've seen, as the crisis evolves, that originally folks were calling for trillion dollar bailouts of the states in order to make up for revenue shortfalls, and ever since then, the need for state budgets seems to be becoming less severe as we move along through this crisis. Who knows what next shoe will drop? If states begin to shut down again and the virus continues to surge, we could see a change again, but the trend I think is what's important, and that's that the projections of state budget shortfalls are trending in the good direction rather than the bad direction.

Leachman: I don't really see that trend. You know, there was on the national level, the forecasts have gotten a little bit better than they were a month ago, although the spread of the virus recently I think pretends a worsening of forecasts from the federal reserve and increased Congressional Budget Office and private sector forecasters that we look at, and states themselves have issued very sizeable shortfall estimates. You know, we could tick through some of the specific states, but most of the states have issued numbers of their own, which we expect to get worse. In terms of the difference between some of the estimates, I mean, there's sort of a combination of factors. One factor is, are you looking just at the current fiscal year, or the 2020 and 2021 fiscal year? We do include fiscal 2022, which starts in most states on July 1st next year, so that's a difference with some of the forecasts. But the forecasts from [the] Congressional Budget Office and others suggest that unemployment is still going to be pretty high in the second half of next year, and that's the fiscal 2022 year, so that's why we're including it. Another factor is that some of the projections that I've seen use estimates of elasticity, or just so the underlying assumptions seem unrealistic or don't match with a historical pattern. And another thing is that sometimes they're just looking at revenue or just at general fund revenue. . . . Other forms of taxes, gas taxes for instance, have also been deeply affected. And states budgets are also affected by growth on the expenditure side. Medicaid is up because more people need help. Other forms of public assistance, those costs are up. And then there's the cost of fighting the virus, which, you know, some of the estimates out there include or not. And the final thing I'll mention is that some of them are states only like ours and don't include localities or tribal governments and such like that. That’s how you can, if you add all of those things up, you can get to a bigger number than where we've been at.

Griffith: You know, one thing that I haven't heard about in this round is rainy day funds. That was a thing of a previous recession . . . well, we'll just grab into our rainy day fund, and that will effectively get us through a time like this unpredicted economic event. Where are states on their rainy day funds?

Leachman: State rainy day funds heading into the pandemic were at seven and a half percent of general fund revenues. It’s around $70, $75 billion total nationally. As I said, that's pretty good compared to heading into the Great Recession, when states had about 5% of their budgets. Total reserves, including ending balances, were about 13% of state budgets. So, I mean, they did relatively well. And the magnitude of the downturn and the speed and severity of it have been so large that it sort of swamps state rainy day funds.

Michel: I think it's also important to point out the variation between states on how prepared they were coming into this crisis. Wyoming, for example, could cover 400 days’ worth of expenses, whereas on the other end of the spectrum, Kansas and Illinois had basically nothing in their rainy day funds. And so this is just another area of discrepancy and how states choose to conduct their fiscal preparedness. And one of many concerns with sort of federalizing those differences is it creates an incentive for states not to put money away in a rainy day fund going forward, or not to budget for emergency expenses. We've seen this in other areas like where the federal government steps in for disaster spending and fires or hurricane states. As the federal government increases their role in footing that bill, states step back and end up not budgeting for those emergencies at all, and I think that's generally not a good thing for federalism or for the federal budget.

Griffith: Yeah, and on the federal budget, how is federal aid to state local governments going to be financed? Is this going to be more federal deficit? And then what's the point which we're going to start looking at the federal deficit and saying it's gotten too big?

Michel: It's just additional federal debt. Like all of the coronavirus relief that it's been done, several trillion dollars’ worth of it thus far, continuing to pile up, depending on how big the next package will be. And while one-time expenditures are one thing, it's likely that the coronavirus relief spending — all the programs that we're putting into place — will not only increase the total size of the debt, but also accelerate the growth of the debt and expand the pre-crisis $1 trillion deficit to something closer to $2 trillion, which just makes it that much more untenable in the future requiring either tax increases, difficult decisions on the spending side, which are necessary, or some sort of fiscal crisis at an unknown date.

Leachman: Yeah, it's debt balanced against the economic damage that's done by ignoring the pandemic, and the spending is justified by its proven capacity to limit the economic and human harm of the recession and get us into recovery as quickly as possible. It's one time, and so its effect on the long-term debt is limited in that way and counterbalanced by the economic and human benefits of avoiding all those layoffs and all those other effects on families and communities.

Griffith: So I probably have time for one more question, and I'm going to ask one that I've kind of been thinking about and would love to get both of your takes on. We have everyone, or the vast majority of people right now, if they are able, are working from home. So that has shifted in what is now more months than we would like. People are working in different states. So I'm an employer in Virginia. I have a lot of folks that live in Maryland, and now they're working in Maryland. And so it seems as though we have until the end of the calendar year, where for payroll purposes, their nexus may still be in the state of Virginia. What's going to happen in January if that goes away? And now do I suddenly have a whole bunch of people who have nexus in Maryland, and what is this going to do for people in other states? And are we going to have a lot of States that start to grab that tax revenue and say, well, nexus is for me, I need that revenue. And what kind of infighting is that gonna produce amongst the states?

Michel: I think that's really a real risk, and we've already seen Gov. [Andrew] Cuomo [D] in New York flat out say that that's exactly what he's going to try to do. It's both on the income tax side, but also on the business tax side. Where you have employees in a state [when] you otherwise don't, business income taxes could potentially shift there, as well. So states should put out clear guidance and say we're going to treat pandemic remote work as work that was done as if pre-pandemic at your business location or at your residence. There's also a federal fix on the table that’s included in the HEALS [Health, Economic Assistance, Liability, and Schools] Act that was just released. And I think there's similar problems on the sales tax side, where small businesses are still dealing with the impacts of Wayfair, trying to comply with sales tax systems and 10,000 different sales tax jurisdictions, which is just an additional cost on them. And so some sort of physical presence requirement for sales tax collection, I think could be a really important part of protecting businesses as part of the economic recovery.

Griffith: Mike, you look like you have thoughts.

Leachman: Yeah, no, I'm just thinking about it as I have a colleague who's way in the weeds on this, and so I'm trying to channel him a little bit. I think I'm going to have to set that one aside [because] I'm just not [an] expert [on] it.

Griffith: It's a challenging issue. And, you know, Tax Analysts is an employer, and some of these issues I'm certainly facing right now and I'm struggling with, obviously on sales tax. These are challenging things for a business of our size to handle and to try to deal with stuff. Hopefully as we [inaudible] on the federal side as well, some very clear guidance is going to be key, you know, on the nexus for workers. It seems like we are moving in a direction where pre-COVID/ post-COVID, we're going to have more workers that are working remote at the end of this, and so I think it will change the landscape and with luck, we will get the type of guidance and clarity from the states that businesses [inaudible].

Well, that was a fantastic conversation, and I thoroughly enjoyed it. And I thank you both greatly for your time. I thank our listeners for putting in so many questions and for listening, and I hope everyone enjoyed this as much as I [did], and I look forward to our next conversation. Thanks, everyone. Have a good day.

Leachman: Thank you very much.

Michel: Thank you for having us.

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