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    State and Local Governments Peer Into the Pandemic Abyss
    Research & Ideas
    State and Local Governments Peer Into the Pandemic Abyss
    31 Aug 2020Research & Ideas

    State and Local Governments Peer Into the Pandemic Abyss

    by Kristen Senz
    31 Aug 2020| by Kristen Senz
    State and local governments that rely heavily on sales tax revenue face an increasing financial burden absent federal aid, says Daniel Green.
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    Cities and states are feeling the financial pain of this recession more quickly than in past downturns after pandemic-induced lockdowns swiftly decimated sales tax revenue that helps fund their operations.

    In fact, new research finds that the level of dependence on sales tax revenue for states and local governments can be used to predict the number of public workers that governments laid off during the early months of COVID-19’s spread, with higher sales tax dependence leading to more layoffs.

    “State and local governments deriving 10 percentage points more of their revenues from sales taxes saw 2.6 percentage points higher unemployment among their government workers,” researchers Daniel Green and Erik Loualiche write in a recent working paper, State and Local Government Employment in the COVID-19 Crisis. “A back-of-the-envelope aggregation exercise suggests that sales tax exposure alone can explain over 660,000 of the state and local government jobs lost in April, about two-thirds of the total observed declines.”

    In their research, Green, an assistant professor in the Finance Unit at Harvard Business School, and Loualiche, an assistant professor at the University of Minnesota’s Carlson School of Management, show how the link between sales tax dependence and layoffs sheds light on the growing fiscal crisis of state and local governments.

    The correlation between sales tax dependence and layoffs suggests that the budget crunch cities and states are feeling is more a function of revenue composition than budget mismanagement, as some observers have argued, says Green. “The fact that there were cuts along this dimension, I think, shows you that this is not just an issue of states being irresponsible,” he says. “It’s an issue of the implications of the balanced budget.”

    "For state and local governments, balanced budget requirements force them to save up in advance or beg Congress for federal support.”

    Most states are required by law to carry balanced budgets and can only borrow to fund capital projects, such as infrastructure improvements. That means sudden shocks to revenue sources force governments to make deep cuts in staff and services. In contrast, the federal government can borrow to fund its operations.

    “The federal government can double their spending overnight,” Green says. “It doesn't have to worry about how to pay for it in the short term, but state and local governments can do nothing like that, which is a big problem at a time when the services provided by local governments are more critical than ever. ”

    Many government workers have already lost their jobs since the pandemic began. According to the Bureau of Labor Statistics, more than 1.5 million state and local public workers were laid off this spring as governments scrambled to cut expenses amid widespread mandatory lockdowns that halted vast swaths of economic activity.

    But not all states, cities, counties, and other local governments were affected equally by the turbulence, the researchers noticed. Using data from the monthly Current Population Survey (CPS) by the US Bureau of Labor Statistics, they were able to tie a government's level of sales tax dependence directly to the number of layoffs it made in April, May, and June (see graphic).


    In past recessions, especially the 2008 financial crisis, it was lost income taxes that caused state and local governments to feel the pinch, but only after annual taxes became due in 2009. The result was a drawn-out recovery lasting nearly 10 years, as state and municipal employment slowly recovered to pre-recession levels.

    Now, despite an initial round of federal aid dispersed to cities and states in March, and a considerable bounce-back of consumer spending following the reopening of local economies, fiscal pressures continue to force deep cuts in state and local government budgets—even as demand for public services peaks.

    Many predict that losses in the next fiscal year will be even worse because persistent record-high unemployment will significantly impact income tax revenue, says Green.

    Cash on hand helps

    Through their research, Green and Loualiche found that the biggest mitigating factor for public sector job losses in the COVID-19 crisis has been the amount of cash governments had on hand and how much they received from federal government stimulus measures.

    Because of balanced budget requirements, states maintain so-called rainy-day funds to support operations when revenues dip. Following the 2008 recession, when states’ rainy-day funds were found to be insufficient, many states built up their reserves. These cash cushions are softening the pandemic’s blow in some cases, Green’s research shows, but not all. States with lower rainy-day fund balances laid off more workers, regardless of their levels of sales tax reliance, the researchers found, but in cases of high sales-tax dependence, having more cash on hand weakened the effect on job losses.

    Federal aid to states that came as part of the initial CARES Act in late March did help stop the hemorrhaging of jobs, according to the study. For each dollar of federal aid received, state and local governments used 31 cents toward payroll, the researchers estimate.

    One possible helping hand—another round of financial aid from the federal government—has so far been held up in Congress. Critics of such a measure, most on the Republican side of the aisle, argue that Democratic governors and municipal leaders have mismanaged state and local budgets. Green contends that his research offers evidence that a government’s level of dependence on sales tax, which was once considered a stable revenue source, is potentially a more salient factor in the crisis cities and states are experiencing.

    “For people and businesses alike, it’s clearly valuable to be able to borrow money to weather an unexpected shock that is no fault of their own,” says Green. “But for state and local governments, balanced budget requirements instead force them to save up in advance or beg Congress for federal support.”

    Is there a better solution?

    The results of Green's and Loualiche’s research point to the potential benefit of an automatic federal aid mechanism that would kick in to prevent cuts in state and local budgets when extreme circumstances all but eliminate a major revenue stream, Green says.

    The research also spotlights the speed with which the pandemic inflicted damage on state and local budgets, as compared to the slow decline felt in the wake of the Great Recession. More than 10 years later, most state and city government balance sheets had just barely recovered from that shock when the pandemic hit.

    Green says it remains unclear whether climbing back from this new recession will take as long. Government leaders must make critical decisions about whether and when to drain and replenish their rainy-day funds in a potentially protracted balancing act.

    “I think there’s going to be a lot of fiscal prudence here that’s going to affect the recovery time, just like in ’08, but I can't say for sure if it’s going to be 10 years or not,” he says. “It’s definitely a concern.”

    About the Author

    Kristen Senz is a social media editor and writer for Harvard Business School Working Knowledge.


    [Image: iStock Photo]

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    Should state and local governments receive a bailout from Congress? What can they do to generate more revenue?

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