Fiscal Policy

Getting State and Local Aid Right

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Congress should use historical data, not future projections, to determine state and local assistance.

President Biden’s American Rescue Plan contains $350 billion of state and local aid, well above the $160 billion proposed by the Problem Solvers Coalition in December but well below the $915 billion in the original HEROES Act proposed by House Democrats last year. There are real questions about the need for aid, but it has majority support in Congress and is thus likely to pass. Policy-makers now will be asking how big the package should be and how to allocate it across state and local governments.

Though popular in Congress right now, a large aid package to state and local governments is not without risks. It could mean that taxpayers in states that have been fiscally responsible will be effectively bailing out taxpayers in states that haven’t managed their money well. And states that have been making poor spending decisions are likely to do the same with new federal aid. There will be a lot of good money going after bad.

Previous House aid packages for state and local governments were influenced by studies from Moody’s Analytics and others that try to project revenue losses over multiple fiscal years. This is a tall order not only because it requires forecasting numerous variables, but because it also uses an essentially immeasurable baseline: the amount of revenue that state and local governments would have collected had the pandemic not reached U.S. shores.

In September, Moody’s Analytics predicted that state and local governments would lose between $450 billion and $650 billion of revenue through 2022. In December, the firm estimated a lower range of revenue losses: $331.5 billion to $468.2 billion.

State revenue forecasts have also been volatile. California’s pre-pandemic budget issued last January anticipated a total of $211.9 billion in state revenue (excluding federal grants) for its 2020–21 fiscal year, which ends June 30, 2021. When Governor Newsom issued his May budget revision, anticipated revenue for the year was slashed to $181.9 billion. But actual revenues consistently exceeded the lower forecast. In the new January budget issued last week, the state raised its 2020–21 revenue forecast to $214.2 billion — slightly exceeding the pre-pandemic forecast.

State and local governments use a variety of revenue-estimation methods, and there is no comprehensive repository of such estimates. Making aid decisions based on counterfactual revenue estimates also raises the question of whether the federal government should guarantee increased budgets for each state and local government. Should the fact that a state budget office or an independent forecaster expects a 5 percent revenue increase in a given year under normal circumstances mean that the state is entitled to this 5 percent revenue bump even under adverse circumstances?

An alternative is to base state and local relief payments on actual revenue losses. For example, calendar year 2019 could be used as a revenue baseline, and aid awards could be based on shortfalls in 2020 and subsequent years. An advantage of this approach is that it requires no forecasting at all. Governments seeking grants could simply report their 2019 and 2020 revenue collections to a federal agency, which would provide an award based on the difference. Another set of grants could be computed and issued once actual 2021 revenue receipts are known.

Basing grants on actual revenue losses rather than on population, unemployment rates, or COVID-19 cases (all of which have appeared as allocation bases in previous House bills) prevents aid money from going to governments that may not need it. For example, Idaho’s most recent revenue report shows receipts from July to November 2020 exceeding prior year collections by 16.6 percent and budget forecasts by 10.6 percent. Limiting assistance to those states that have seen tax revenue decline would better focus relief on those entities facing budgetary difficulties. But a less inclusive package could raise political challenges since representatives and senators from excluded entities would be less inclined to support it.

Allocating aid on the basis of historical revenue losses reduces the risk of state and local governments factoring in aid when making their own policy decisions. For example, a local government might offer new tax abatements for local businesses on the assumption that the federal government will cover resulting revenue losses. Or a state might pursue more stringent shelter-in-place policies with the expectation that lost sales-tax revenues will be picked up by federal taxpayers. When allocations are based on historical revenue data, the prospect of increased federal aid won’t factor into these decisions.

While an approach based on historical data would be simplest, it would not be without moral hazard. Such a measure could create the expectation that the federal government will make up state and local revenue shortfalls during future national or even localized crises. As a result, states and cities might be deterred from maintaining reserves — a prudent fiscal practice. Also, revenue shortfalls can occur for a variety of reasons, including tax-rate reductions, commodity-price fluctuations (in states that rely on severance taxes), and outmigration of taxpayers. Insulating state and local governments from these effects could raise policy concerns. If, for example, people are leaving a state to avoid its high-income taxes, should the federal government offset this effect, or should the state adjust its tax rates?

Rather than guarantee constant or rising revenues, Congress might instead consider providing aid only to those entities that suffer especially steep revenue declines arising from the unique vulnerabilities of their economies to a national emergency. In contrast to Idaho, both Nevada and Hawaii have seen significant revenue declines due to their dependence on tourism. A federal aid package might best be focused on cushioning the blow experienced by state and local governments that heavily depend on travel and tourism revenues. But federal aid to tourism-dependent areas might deter affected state and local governments from diversifying their revenue sources.

Although overall state and local government revenues held up much better than expected at the beginning of the COVID-19 recession, some governments have suffered severe impacts. Whether revenue shortfalls merit a further congressional response will undoubtedly be a matter of fierce debate in the coming weeks. But if Congress does decide to intervene, it should be cautious about basing aid allocations on unreliable forecasts or creating moral hazards at the state and local levels.


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