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Covid-19: The Impact on State Budgets

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Covid-19: The Impact on State Budgets

March 25, 2020
Covid-19
Economy, finance, and budgets

Steven Malanga and Brian Anderson discuss how the economic shock resulting from the coronavirus—the closing of large sections of the American economy, the plunge of stock markets—is likely to undermine state and local budgets around the country.

Even as states are searching for extra funds to help battle Covid-19, the loss of tax revenue during the crisis will be devastating. “States that rely on meetings, conventions, and tourism, or that derive substantial economic growth from energy production, or that depend on big gains in the financial markets from wealthy individuals, will be among the biggest losers unless the economy turns around fast,” Malanga writes.

To follow City Journal’s continuous coverage of the pandemic, click here.

Audio Transcript

Brian Anderson: Welcome back to the 10 Blocks podcast. This is Brian Anderson, the editor of City Journal. I'm recording today under partial lockdown, from my home outside New York, and I'm joined today by my colleague Steve Malanga, remotely as well. Steve is our senior editor at City Journal and a senior fellow at the Manhattan Institute. He's joining us from his home in New Jersey, which has its own stay at home order in place as well. It's been a difficult couple of weeks here in the New York Metro area, as I imagine it's been for many of our listeners. But the City Journal team has been hard at work and if you visit our homepage, you can find our extensive coverage of the crisis.

Over the last week, City Journal has published a long series of articles on the situation, including: Seth Barron, on reforms to help New York City's hospitals fight the outbreak; Nicole Gelinas, on the prospect of a federal bailout for the region's transit system; Guy Sorman, on why he holds the Chinese communist party guilty of starting the pandemic; the virologist, Peter Kolchinsky, on vaccine development; the Italian professor, Flavio Felice, on his experience living under quarantine in his hard struck home country and much, much more. We've created a landing page, or vertical, on the website where you can find all of our coronavirus related articles, which we'll link to in the description. We're recording today on today's 10 Blocks to talk with Steve about his contribution to the Covid-19 coverage, “The Crisis's Impact on Budgets.”

Steve, thanks very much for joining us.

Steve Malanga: Yeah, I guess you could say it's my pleasure to be here. I'm not quite sure under these circumstances.

Brian Anderson: Now, as we're speaking, states across the country are spending, or they're preparing to spend, an enormous amount of money to fuel the resources to fight the Corona virus and, of course, there are shutdowns across the nation in many cities and many states to try to contain its spread, which is having a pretty big economic impact. All of this is understandable. When you combine the shutdowns and the spending, with the loss of tax revenues from tourism, sports arenas, conventions, along with what we've seen, at least until today, on the stock market, it's looking like this will be a real problem, a big disaster for state and local budgets everywhere.

Before we get into that though, how were the budgets looking before Covid-19? They'd been spending years kind of rebuilding from the great recession of 12 years ago now. What was it looking like, right before this a viral pandemic?

Steve Malanga: Well, the last two or three years have been crucial, because essentially, the recovery, almost for a decade after the great recession, was the slowest recovery of state and local tax revenues, really since world war II. And as a result, it took states on average until 2016 to get back on an inflation adjusted budget to where they had been in 2007, so that's a pretty big hit. But these last three years have been much better and including the gains in the stock market, which have really helped state pension funds, states were in much better shape.

The problem now, is that after this long expansion, which was mediocre for so long, you could say that their fiscal position is certainly better than it was, let's say three years ago, when people were worried that a new recession might be just around the corner, but it's nowhere in a position to compensate for the level of shutdown of economic activity that we're starting to see.

And so, literally every day, states are coming out with new projections about how much money they can lose. And in particular, what we're seeing is, it's fairly broad because if you're a state that relies on tourism, for instance, that's one thing that's taken a hit. If you're a state that relies on, let's say, financial markets, that's something else that's taken a big hit. If you're a state that relies on energy, that's a third thing that's taken a big hit. So, it's going to be pretty difficult for any state to escape this bloodbath that's occurring right now.

Brian Anderson: Certain states' tax environments will be a problem here too, those in particular that rely heavily on high earners, right?

Steve Malanga: Yeah, so basically what's happened, is over the years, some states have added a lot of progressivism to their tax structures. They tax people at higher rates, people who earn more money. Those kinds of tax structures are just inherently more volatile.

We saw this in 2008 for instance, when California lost during the financial meltdown of 2008, it basically saw it's income tax revenues alone shrink by $7 billion. That's a really big hit for a state to take because state governments aren't in a position to deal with that kind of volatility, because they have to keep providing services in a steep recession like that. So you have a bunch of states, in particular New York, Connecticut, and California, which are extremely susceptible to the kind of downturn that we're seeing now, particularly the really big slump in the stock market.

California, in particular, gets a substantial amount of its revenue from high income earners, from what's known as capital gains, and capital gains meaning basically, when you make a big gain in the stock market and then you sell your stock, that's tax. And so it's estimated, for instance, that for people in California, who earn over a million dollars a year, as much as 25% of their income comes from capital gains. Well, with the decline in the stock market, those capital gains have just vanished. They're just gone, you know? That income is just gone. And in fact, many of these people might actually be taking losses, and therefore will be looking for deductions on their income tax, rather than paying hefty capital gains tax. So that's a very big number and it's going to affect New York and California particularly hard.

Brian Anderson: You mentioned oil states. What's the picture look like there, and what's going on, apart from the COVID crisis, to drive down oil prices?

Steve Malanga: Well, it's related because essentially, what happened was, as soon as we saw economic activity starting to shut down around the world, particularly things like, again, airlines not flying and other kinds of transportation, tourism taking a hit, oil prices started declining. Then Saudi Arabia and Russia got into, essentially, a price war, which drove down the numbers much further. What we have is, we have states around the country where they produce a lot of energy now.

America's become the leading producer of oil and natural gas, over the last decade. But many states like New Mexico, Alaska, Texas, Oklahoma, oil is so important to them, that they essentially, in their budgets, project what they think oil will be over the next year. Most of the projections are in the $50, $55, to $60 a barrel range, but oil has been trading down below $25 a barrel. It's just sunk basically in the last couple of months. So that's going to mean tens of millions, in some cases, hundreds of millions of dollars in less in oil revenues.

Alaska projects that if prices don't recover substantially, next year they could lose half a billion dollars in oil revenue. One Texas taxpayer group says that every $1 drop in the price of a barrel of oil, costs them $85 million in tax revenues. And again, the prices dropped between $25 and $30, so that's a lot of $85 millions when you start doing the math.

Brian Anderson: Wow. Towards the end of your piece, you shift to the question of pension systems, and they really raise some of the biggest challenges that states are going to face from this downturn. Why don't we talk a little bit about that? What's that picture looking like?

Steve Malanga: Well, the problem was, again, this was a picture that was not looking very good, even before what's going on now. And essentially what happened is, in 2007 state pensions were on average about 87% funded. Then you had this deep decline in 2008 and 2009, and even though we subsequently had an 11 year economic expansion and an 11 year bull market, state pensions didn't recover. They were probably somewhere, we don't have exact numbers on day-to-day, they would always take six months or so for the numbers to come in, but even with the rise in the market that we had seen to new heights, they were probably about 75% funded, before this dramatic drop in the marketplace.

So, you already have a situation where you had a long recovery, and a long bull market, and yet the pension systems had not been able to make up a substantial chunk of what they lost during 2008 and 2009. When people ask me, why this is the case, because of course the market recovered and went well beyond where it had been even back in 2007, but what happens essentially, is a lot of these pension systems, they're designed in a way that two thirds of the money almost is supposed to come from assets that are in the system itself. Once you have a tremendous decline in assets, like we saw in 2008 and like we're seeing now, what happens is that cities and states are supposed to then put more money into the system. The way the system works is the new calculation says, okay, now you have to make up for some of this by putting more taxpayer money in.

Well, the problem is that a recession, like we're in the process of experiencing now, is pretty much the worst time for cities and states to put more money in to the system, because they simply don't have it. They're spending it on other things, or their tax revenues are declining. As a result of that, rather than increasing contributions, cities and states let them lag. And so, they have a harder and harder time catching up.

Now, we're in a situation where we've seen this tremendous decline in the market, and unless it really bounces back quickly, once we do the numbers, we're probably going to say that on average state pension funds are only maybe 65% funded, or so. That's really a very troubling number, because it means that probably a dozen or so pensions, the worst funded pensions, are down below 50%. Problem with this, again, is it's almost becomes, you're essentially spinning your wheels in place because the lower the funding goes, the larger the amount of money you're supposed to put into the system.

The amount of money that some states, like New Jersey, or Illinois, are supposed to be putting into a system, has increased so much that the states can't keep up with it. Even when their tax revenues recover, they don't recover enough to allow the states to increase their level of contributions to the point that would actually start cutting down on the debt.

And so you're just in this cycle, where it's a downward spiral, what I call, one step forward during a recovery and two steps backwards during the next recession. So there are a bunch of states, Kentucky, Illinois, Connecticut, New Jersey, in particular, that are in this position and they're really caught in a downward spiral. And if you look at the math, it's very, very hard to see how they actually can ultimately fix this, because they're just essentially, swimming upstream and they don't have enough power in their strokes at this point.

Brian Anderson: What happens in a case like that, if they muddle along for a while, but are we looking at federal bailouts? Are we...

Steve Malanga: I mean, we're really unimpressive and a territory right here. There have been mostly city pension systems that have failed and become insolvent. Very few of them have ever been bailed out. There's a lot of talk about what happens to a state pension [inaudible 00:13:40] system that becomes insolvent. We don't even really know how, let's say, a court were to rule on a case like this. We're really in uncharted territory. I really doubt that we're going to see federal bailouts of this sort, because the whole talk of bailing out the pension systems for states that have not adequately funded their systems does not play very well in Washington, among representatives of states that have put the money aside, and that don't have this problem. Many of the congressional representatives from these states, both Democrats and Republicans have said over the years, our constituents don't want us bailing out other states, when we've paid our bills. So, we'll have to see what happens. But we really are on unprecedented territory in that respect.

Brian Anderson: More broadly, and as you say, we are in uncharted territory, what going to need to happen to get this ship righted more broadly post-crisis?

Steve Malanga: Well, first of all, the states are going to definitely look to Washington for some aid. Washington has already determined they're going to help out the Medicaid program, which is the joint state and federal healthcare program and Washington is also putting money aside to help, broadly speaking, states ramp up their healthcare systems. We did of course, in the aftermath of the 2008 and 2009, we did have a federal stimulus bill for states and cities that was about $250 billion.

I'm expecting another stimulus bill, but that's going to be a battle in Washington. You know, in 2009, when we had the last stimulus bill, we had a Democratic Congress and a Democratic President. Now we have a split Congress, a divided Congress and the President is a Republican. I think that they'll offer aid that's very targeted, but the idea for instance, that they'll just give states unlimited amounts of money to do things like put into their pension system, I believe is off the table. So they may do things like saying specifically, this is money that you can use to keep your schools open, to make sure you have adequate levels of services in your schools or your basic municipal services, but I don't think that some of the other funding crises that states are going to face, would be something that Washington's going to designate money for.

Brian Anderson: Thanks, Steve. Don't forget to check out Steven Malanga's piece at City Journal, it's called “The Crisis's Impact on Budgets.” You can find it on our website, along with a lot of other coronavirus related material. We'll link to it in the description.

You can follow City Journal on Twitter @CityJournal and on Instagram @cityjournal_mi. And remember you can email us at podcast@city-journal.org if you've got any questions or suggestions. And always, if you like what you've heard on the podcast, please give us a rating on iTunes. Thanks for listening and thanks very much, Steve, for joining us.

Steve Malanga: Thank you.

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Photo by Michael Warren/iStock

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