In previous U.S. recessions, a familiar fiscal pattern has almost always played out. Deprived of revenue, the state and local governments closest to the American people lay off employees and cut essential services. If and when Congress comes to the rescue, it’s often too late. The economic damage has been done.
In some ways, the coronavirus crisis has disrupted this sequence. Federal support has been substantial and, by earlier standards at least, prompt. Congress was quick to recognize the economic danger posed by the pandemic and didn’t stint on outlays. The third big stimulus package currently before Congress actually risks overshooting. Providing another $1.9 trillion in total, it promises state and local governments an additional $350 billion of aid, all told — a good deal more than the remaining revenue shortfall.
Even so, the same underlying flaw in the U.S. approach to fiscal federalism has again been apparent: Instead of being ready for the next recession, the fiscal machinery was taken by surprise. What’s needed is a system that doesn’t require so much frantic improvisation when economic conditions shift – one that delivers help quickly and predictably when it’s needed, but without undermining accountability, or treating states unfairly by rewarding those that fail to exercise strong fiscal control in ordinary times.
State and local governments play a huge role in the U.S. economy. They employ about one in eight workers, and their expenditures account for about a fifth of gross domestic product (according to Census data). They’re responsible for schools, police, hospitals, public transportation and more. They administer most of the country’s social safety net, including housing assistance, unemployment insurance and Medicaid.
Yet their finances are quite different from those of the federal government: They don’t issue their own currencies, so they don’t have the money-printing power of a central bank like the Federal Reserve standing behind their debts. A long history of fiscal crises — including a wave of defaults in the mid-19th century and New York City’s near-bankruptcy in the 1970s — has made the distinction clear to investors. The result is strict self-imposed limits on borrowing, reflected in the balanced-budget rules that almost all states have adopted.
Justified as these may be, such constraints inhibit the kind of deficit spending required to counteract economic slumps. When revenues decline, so must expenditures — a procyclical dynamic that makes recessions deeper and more destructive.
Despite the strong fiscal response, the COVID-19 pandemic created similar headwinds. Granted, state and local governments are doing much better than once feared: Sales and income taxes have in some cases proven surprisingly resilient. Still, taxes and fees for the use of infrastructure and institutions such as airports, subways, universities and hotels have declined sharply. The total revenue shortfall — current and prospective — will amount to as much as $300 billion through 2022, according to a recent estimate from the Brookings Institution. That’s not counting the significant added costs of procuring essential medical supplies, reopening schools and distributing vaccines.
Congress moved to fill the breach, and relief packages enacted last year have provided more than $300 billion to state and local governments. The additional support in the Biden administration’s new stimulus package is more than will actually be needed — but the point is, the aid already delivered arrived too late to prevent cuts that made the slowdown worse. From March through December, state and local governments shed about 1.4 million jobs, with the biggest layoffs falling on schools. Cities including San Francisco, Denver and Atlanta have shut down large parts of their public transit networks.
Officials can’t wait while Washington debates: When they make their budgets, they must work with the revenues they have.
Instead of cobbling together aid packages whenever a crisis hits, Congress should make federal support more systematic. The aid should start promptly, when a state’s economy enters a downturn, as defined by an objective measure such as employment. To ensure predictable funding, Congress could create a special rainy-day account for the purpose.
For the sake of good fiscal discipline, and as a matter of basic fairness, it’s vital to avoid rewarding states that spend carelessly in good times and then find it necessary to cut more severely when the economy turns down. A higher baseline of state spending per capita shouldn’t automatically attract extra support.
This means tying the amount of emergency help to indicators that can’t be gamed, such as the local unemployment data produced by the Bureau of Labor Statistics. To further encourage fiscal control in good times, aid could be linked to states’ own prior contributions to the federal rainy-day fund. When it comes to disbursement, the funds might be unrestricted, allowing local officials the flexibility to spend as required, or delivered through existing state-run programs such as Medicaid, which prioritize the neediest citizens.
If the system were properly designed, incentives to maintain good fiscal discipline in normal times would be preserved, and there’d be no net cost to the federal government. The aim is to deliver fiscal support faster and more predictably, not to increase it over the course of the whole business cycle. If necessary, adjustments could be made to offset any unforeseen federal burden.
A system of this kind would do away with recurrent bickering over emergency aid, allowing Congress to focus on other issues in times of crisis. It would give states the certainty required to avoid cutting back at the worst possible moment. And it would allocate responsibilities more efficiently — because the federal government has greater revenue-raising and borrowing capacity, while states and cities have the local knowledge required to deliver services most effectively.
Over the past year, America’s system of fiscal federalism has performed well enough, especially by its own past standards. But it can and should be improved. This emergency won’t be the last, and recessions can’t always be avoided. Before the next one happens, policy makers should get to work on fiscal resilience.