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State of the States

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State of the States

10 Blocks podcast August 18, 2021
Economy, finance, and budgets
Politics and law
Covid-19

Steven Malanga joins Brian Anderson to discuss state budgets before and after the pandemic, tax-policy competition among states flush with cash, and conflicts between cities and states over policy.

Audio Transcript

Brian Anderson: Welcome back to the 10 Blocks Podcast. This is Brian Anderson, the editor of City Journal. Joining me on today's show is my colleague, Steve Malanga. He's the senior editor of City Journal and the George M. Yeager Fellow at the Manhattan Institute. And he's the author of a brand new story in our summer issue of our quarterly magazine. It's called "An Epidemic of Bad Budgeting," and that's mostly what we're going to talk about today. So, Steve, thanks very much for joining us.

Steven Malanga: My pleasure.

Brian Anderson: This piece, and it's in our print issue, walks through the crisis that cities were facing when hit with the pandemic, the budget crisis. Your argument was that their situation actually was based on some pre-existing financial problems that have subsequently been masked over by all of the federal aid that's been coming from both the Trump administration and now the Biden administration after the pandemic struck that they've basically bailed these cities out so that the underlying financial problems have been hidden. Could you just describe the main themes of this print feature story and just how acute was the financial problem becoming before the pandemic struck?

Steven Malanga: Yeah. So when the pandemic did hit, cities as well as states made a lot of appeals first to the Trump administration and later to the Biden administration for direct budgetary aid. Much of the aid that came during the Trump administration was actually in the form of direct aid to support the effort against the pandemic itself, aid to hospitals, expanding Medicaid. But the cities complained that the shutdown in the economy that they said was necessary had also destroyed their budgets. And although Trump would not provide any direct aid of the sort—Republicans refused to do so, when the Biden administration came in, they put together an unprecedented $350 billion package for states and cities that amounts to about $130 billion in direct aid to cities for use for their budgets.

The problem is that many cities were in dire financial condition before the pandemic, because we had been in a 10-year economic expansion. And yet despite that, crucial cities had continued to use debt rather than balancing their budgets with revenues. They hadn't cut their budgets sufficiently back during the 2008/2009 recession and the aftermath of that when revenues slumped. And as the economy rebuilt itself, states didn't really do anything to correct their budgets and to get them in shape for the next recession, which was inevitable. No one understood that it would be a pandemic recession.

But to give you an example of this, an organization called the Institute for Truth in Accounting did a study based on 2019 numbers, so this is pre pandemic, of the largest 75 cities in America. And they found that 62 of them had consistently not balanced their budget with revenues. In other words, they'd used techniques like the debt to pay for ongoing programs, many times in violation of state rules and laws in many places. So even before the pandemic struck, the largest 75 cities in America had built up about $350 billion in debt and were consistently not balancing their budget by doing things like using debt to pay for everyday operations or not paying the full load on their pension requirements and racking up a healthcare retiree debt that they weren't funding.

So the problem was there well before the pandemic. And then when the pandemic struck, what happened is many of these cities reverted to using questionable financial techniques, again, to add new debt to their roles. And they used essentially the pandemic as an excuse. So we've got this pattern where every time there's a recession, cities do questionable things that they probably shouldn't be doing, that they stretch essentially the limits of the law in many states to do these things. And once the good times reoccur, they never essentially catch up. And that's why they're spinning their wheels in place, cities. And that's why they were in such poor condition to deal with a pandemic when it hit.

Brian Anderson: In a sense they've been kicking the can down the road when it comes to paying their debts without any responsibility here. Without these local governments being held accountable for their profligacy, how long is it going to be before some of these problems become really significant?

Steven Malanga: Well, of course, after the last recession, we saw quite a number of big cities—Detroit, Stockton, Harrisburg—become insolvent because of some of these debt problems. What we saw in the aftermath of the pandemic is real cities on the edge, including growing cities. I'll give you an example: Nashville, is one of the fastest growing Metro economies in the country. If there's any city that shouldn't be having financial problems at this time, it's Nashville. But immediately after the pandemic hit, they projected an incredible deficit on a $2.5 billion budget of several hundred million dollars.

Now, the back story to this is that even before the pandemic hit, the controller of the State of Tennessee had threatened the state takeover of Nashville, because they'd spent the last 10 years building up debt. They'd started using debt to fund their budget back in 2010 after the last recession. And despite all this economic growth, they never caught up. So we're talking about bad budgeting practices here. We're talking about the first sign of an economic slowdown rather than cutting inessential programs or paring back wages and salaries and benefits, the city started using debt-financing and other kinds of financing, sometimes in very, I guess, we would call tricky ways. Essentially they exploit loopholes, which stretch the limits of the law.

So in the pandemic what happened is a lot of cities were facing this precipice. Chicago was another one, New York City was another one. And then the Biden administration comes up with this incredible package of help for both state budgets and city budgets and the state money filters down to the cities, and then there's direct aid to the cities. So all of that goes away. What doesn't go away, however, are all the bad budgeting practices and all the new debt they've accumulated, including using several techniques to raise debt and extend pension costs in the billions of dollars during 2020. So that's a legacy of this recession, if you will, in the same way that there's still a legacy of the 2008 recession that's hanging over some cities.

Brian Anderson: One possible outcome here, and this anticipates a story you're working on now that will appear in our autumn issue is that there are going to be reforms on the state level to preempt urban irresponsibility, whether it's bad fiscal practices, as you're describing here, or decisions that are being made to defund police departments or other really unsound policies. These kinds of conflicts between states and cities have a long history. Is this just another chapter in a long-running tug-of-war between states and cities, or are we seeing a shift with some of the political divergences emerging on different government levels here, having an impact on how some of these conflicts are handled?

Steven Malanga: Well, to tell you the truth for some of these, what they call state preemptions that we're seeing lately are on areas like everything from minimum wage law to environmental legislation that states are moving to block cities from enacting on their own. The irony is that when it comes to city finances, many states have had these preemptions, if you want to call them that, for decades. In other words, the one area where states have been pretty clear is about the way cities are supposed to act financially. They're not allowed technically to run deficits.

Virtually every state constitution has some type of prohibition against municipalities doing deficit financing. Many of them have limits on debt that cities can undertake. But what happens is that cities find loopholes or they try to exploit loopholes. Unfortunately, state courts let them do that. And so, if you look at some of the biggest bankruptcies, a notable one would be the bankruptcy of Detroit after the 2008/2009 recession. They were using debt. They essentially violated the Michigan state constitution, but they used a very sophisticated technique, which they claimed got them around the debt limits.

When the city filed for bankruptcy, and it went into US bankruptcy court, essentially, a judge said that this debt had violated Michigan law and the people who purchased this debt received just cents on the dollar for what they had invested, because essentially both the judge and the bankruptcy trustee of Detroit said that this was just illegal, that you shouldn't have used this technique. There's too much of this going on all around America. And in the story that I talk about from the summer issue, I talk about places like Tucson and Flagstaff in Arizona essentially selling their city streets and their publicly owned golf courses and city hall, selling them to themselves to these shell corporations, and then paying rent to themselves, if you will, as a way of raising new money through debt. And it's a very sophisticated concept, which essentially uses debt that isn't called debt.

So the very idea of a city selling its golf courses to itself, and then renting them back, essentially, just as a way of raising more debt to do deficit financing, the court should step in and should have stepped in a long time ago to stop that stuff, and some states have not. It should be up to the states themselves to clamp down with new laws that outlaw some of these techniques or at the very least require that when cities want to use them, that they have to be approved by voters.

Brian Anderson: You can really see on the horizon a number of bankruptcies of big municipalities should there be another significant downturn in the economy soon. So it's very alarming and it's a very important piece to call attention to these practices. Let's shift gears a little bit and discuss tax policy. You've written a number of recent web pieces for City Journal's website about the various approaches that states are taking to tax policy in the post-COVID era. Many red states, which are now flushed with cash, have decided to return some of their surpluses to the taxpayer by cutting taxes. But other states, including Massachusetts and Washington, have sought to raise taxes despite having significant surpluses in some cases, and certainly receiving massive aid from the federal government.

So what's been the reaction to these measures in places like Massachusetts and Washington among taxpayers, which are basically making a punitive justification for tax hikes? Are we approaching a new era of tax policy competition among states?

Steven Malanga: Well, that's definitely starting to emerge. And frankly, it's reminiscent of what happened again after the last recession. In 2009, states—mostly led by democratic governance states—raised taxes by an aggregate total of $29 billion. It was the largest single-year state-tax increase up to that point. A few years after that, especially after the 2010 gubernatorial elections in which a whole bunch of new governors were elected, especially Republican governors, they reacted by cutting taxes. And so we saw this real dichotomy that places like Texas, governors were going around and advertising their tax cuts to companies, businesses in places like Illinois and California saying, "Come here instead."

What we've seen so far in this particular year, first of all, state tax collections bounced back faster than virtually anybody projected they would. And on top of that, states themselves received several hundred billion dollars from the Biden administration to spend as they see fit. So states are everywhere awash with tax. I've seen that headline in newspapers around the country about this state or that state being awash in cash. And we see big increases in spending as a result.

Washington State, to take one example, just finished their two-year budget. They had a 12% increase in spending. That's an enormous number for a state in any year, but particularly, in this situation where its economy isn't even completely open yet. But that's the money that's available. There have been 11 states in the wake of this money becoming available that decided to cut taxes despite the fact that the Biden administration tried to prevent this by saying that states would not be receiving their stimulus money if they used it to cut taxes. And there were a bunch of attorney generals from states that were cutting taxes sued, and this became a very big issue.

Virtually, all of the states that have cut taxes are Republican leaning or governed essentially by Republicans. In some cases, there's a Republican legislature and a democratic governor, but they're essentially heavily Republican leaning. We've seen a couple of places raise taxes. The one that's already done it is New York State. They had something like $12 billion in stimulus money from the Biden administration and yet they raised taxes by $4.3 billion. Massachusetts and Washington State are both attempting to raise taxes, but they have constitutional issues. And so they have to go to the voters. Massachusetts's Democratic-led legislature has already placed something on the ballot that would allow them to raise taxes by $2 billion. And the reason they have to go to the ballot is that you can't have a progressive income tax in Massachusetts, according to state constitution. They want to raise taxes on the rich, which is also, by the way, what New York did.

Washington State is in a similar situation. Their constitution doesn't even allow a state income tax. So they've tried to get around this. There have been 10 referenda over the decades in which they asked the people of Washington whether they could amend the constitution to start an income tax and all 10 have been defeated. So they recently tried to get around this, the Democratic legislature, by passing a capital-gains tax, which they say is not an income tax. Now, again, this is going to the courts. Typically, capital-gains taxes and dividends taxes are taxes that are enacted through an income-tax system. So this is a matter of controversy.

But in Washington State, as a result, a number of localities, cities and municipalities, around the state are now passing resolutions saying they don't want a state income tax or they think it's going to hurt their competitive advantage. The Economic Development Authority of Washington State advertises to people and companies that want to come there, that we don't have an income tax, but the state is trying to raise an income tax. Now, again, this is a place that had so much money. They were able to increase spending by 12%. But the proponents of the tax said, essentially, again, a capital-gains tax would mostly hit wealthier people. They said that wealthy people have a moral imperative, essentially, to contribute more.

So in all three cases, these tax increases during times of significant government resources, all three of these are being pitched as a moral crusade to tax the rich because they should be paying more, not because the money is necessarily needed. That is definitely a new model. Even in 2009, Democrats were talking about raising taxes because government revenues were declining or stagnating and government programs, they said needed to be funded. This is really a new model here. And we'll see how far this goes, but it's a very interesting model. Illinois is another state that would have raised taxes. Its current administration would have raised taxes except, again, their constitution prohibits the tax increase they wanted and citizens voted it down last November.

Brian Anderson: Let's close by talking a little bit more about New York, which you've just mentioned. Andrew Cuomo has now had to resign after allegations of sexual harassment. His most recent budget, as E.J. McMahon has written for us, was a blowout budget and massive increase in spending. What might the future of New York's fiscal policy look like, both on the city and the state levels? Because we also have a mayoral race coming up and Eric Adams is likely to become the new mayor of New York City. And the governor's office is going to be wide open heading into next year. So what do things look like here? Are we going to see more of this punitive taxation or return to sanity?

Steven Malanga: Well, even before Andrew Cuomo resigned, the City Journal was writing and observing that elections in New York State were turning the state legislature increasingly progressive. Cuomo used to be a figure of moderation in New York State, but he's been backpedaling, even before the sexual harassment allegations. He was backpedaling because of the deaths in nursing homes in New York and his administration's hand in ordering those nursing homes to take back from hospitals elderly people who were infected with COVID.

So he's been, if you will, losing power. And so the progressive legislature just steamrolled him, essentially, earlier this year when they passed the budget in the spring time. His deputy lieutenant governor, she doesn't have much of a power base on her own. And if we go back to when Eliot Spitzer had to resign as New York State governor because of similar sexual improprieties, and his lieutenant governor, David Paterson, took over and the legislature just steamrolled him and raised all kinds of taxes.

So it's difficult for me to see New York State heading in any direction except higher and higher taxes. They actually wanted this year, the legislature, about $7 billion in taxes. So they got a little bit more than half of that, but they have all kinds of ideas for new taxes. And I don't see any reason that they won't come back asking for more, especially now, because the administration is incredibly weakened and the state itself is heading—Albany, if you will, the state capital—is increasingly in the arms of progressive legislators.

Brian Anderson: Right. And this is true as well of New York City Council, which is increasingly dominated by the left. So it is a disturbing picture on the state and city level when it comes to the fiscal responsibility that the state clearly needs and the city clearly needs as we come out of this pandemic.

Thanks very much, Steve. Don't forget to check out Steve Malanga's work on the City Journal website, that's www.city-journal.org. We'll link to his author page in the description. His essay in the Summer issue, again, is terrific. It's called "An Epidemic of Bad Budgeting." Very, very illuminating discussion of all of these issues. And you can also find City Journal on Twitter @CityJournal and on Instagram @cityjournal_mi. And as always, as I always say, if you like what you've heard on the podcast, please give us a nice ratings on iTunes. So thanks again, Steve Malanga, as always.

Steven Malanga: Thank you.

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Photo: pictore/iStock

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