“California is not only poised for recovery, but we’re seeing real signs of recovery in our state,” Governor Gavin Newsom announced in early January, as he unveiled a state budget with record spending fueled by a $15 billion budget surplus. Yet two weeks later, Newsom sent a letter to President Biden expressing support for his plan to give an additional $350 billion in aid to state and local governments.
Similar stories have played out in other states. “We’re going to need a robust federal support system to help our states and economies recover beyond the federal CARES funds that expire at the end of the year,” said Wisconsin governor Tony Evers in November. Yet within weeks, the state was projecting a budget surplus, and by January it had revised that estimate up to $1.8 billion. Rather than drawing on these reserves, Wisconsin added to its “rainy day” fund, the balance of which is expected to hit nearly $1 billion this year.
Undoubtedly some states and cities have faced challenges, but nationwide, state and local governments have seen tax revenue rebound to pre-pandemic levels, even as they have continued to receive a large influx of federal funds. When the pandemic began, states and local governments naturally feared that they would suffer a huge budget hit. Indeed, state and local tax revenue did decline by more than 17 percent from the first to the second quarter of 2020. In response, Congress allocated $280 billion to state and local governments under the CARES act, plus $120 billion in the December stimulus package. This aid, along with the recovery of state and local revenue, has more than filled the gaps in state and local budgets.
During 2020, a year in which real GDP fell by 3.5 percent, state and local government revenue grew by 8.9 percent in real terms, a rapid increase from its 2 percent growth rate in 2019 (based on data from the Bureau of Economic Analysis and my own projections). After plummeting in the second quarter, state and local current tax receipts recovered sharply in the second half of the year, ending 2020 essentially unchanged from 2019 in real terms, after growing by 1.9 percent in 2019. Income-tax revenue made the strongest recovery in the second half, as the revenue decline in the first half of the year was partly due to delayed tax filings. Real income-tax revenue ended the year up nearly 1.8 percent, showing a strong rebound (albeit a slowdown from 2019’s 3.1 percent real growth).
By far the biggest contributor to the growth in state and local budgets was federal aid, which totaled $265 billion in the BEA data, an increase of 42 percent in real terms. How is it that state and local tax revenue rebounded, even though employment and output remain below pre-pandemic levels? The states largely rely on income and sales taxes, while local governments largely rely on property taxes. Real personal consumption expenditures fell by 3.9 percent in 2020, and accordingly, sales tax revenue was down 3.4 percent in real terms. However, real incomes grew by 5.1 percent in 2020, thanks to transfers like the federal relief checks and enhanced unemployment benefits. In addition, the real-estate market stayed strong in the work-from-home environment. The Case-Shiller home price index was up 9.5 percent year-over-year in November 2020. Accordingly, property-tax revenue grew 2.6 percent in real terms in 2020, after increasing by only 1 percent the previous year.
States also entered the 2020 budget year, which started in June in most states, with a record $119 billion in balances, including $75 billion in rainy-day funds. At least ten states drew on these funds to close deficits in fiscal 2020, and at least eight have enacted legislation to do so in 2021. In most cases, these withdrawals did not deplete the funds. At least five states have added to their rainy-day fund balances during the pandemic.
The lack of interest in the Federal Reserve’s Municipal Lending Facility also suggests no emergency in state and local finances. The facility was authorized to lend up to $500 billion to states, counties, and cities. Before this facility closed for new loans at the end of 2020, only $6.6 billion in loans had been issued to only two borrowers: the State of Illinois and the New York Metropolitan Transit Authority. Both had planned to borrow from the private market but used the Fed Facility to lower their borrowing costs.
State and local revenues undoubtedly collapsed early in the pandemic, but they have now recovered even better than the overall economy. The $400 billion in federal transfers already allocated should drive growth in state and local revenues well into 2021. While state and local governments may need targeted federal funds for vaccinations and other expenses tied to the pandemic, the broad $350 billion in aid to state and local governments in Biden’s American Rescue Plan is unnecessary.