American Enterprise Institute: ‘US Fiscal Federalism During COVID-19 Pandemic’

WASHINGTON, Dec. 4 -- The American Enterprise Institute issued the following working paper (No. 2020-16) entitled "US Fiscal Federalism During the COVID-19 Pandemic":

Here are the excerpts:

Abstract

The likely impact of the COVID-19 pandemic on state and local government revenues is increasingly well understood. The condition of state and local government finances depends further, however, on the pandemic's effects on expenditure needs, which have received less attention. Confusion also remains regarding both the quantity and purpose of federal support that has been and ought to be directed to state and local governments. In this paper, we attempt to have a unified discussion of these issues, with an emphasis on health spending needs and the role of the Medicaid program.

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Federal Fiscal Stabilization in the United States

Our aim in this paper is to describe the fiscal challenges that confront state and local governments as a result of the COVID-19 pandemic, and the federal government's role in addressing them. As we have discussed elsewhere (Clemens and Veuger, 2020a), challenges arise due to three factors. First, to varying degrees, state and local governments are constrained by balanced budget requirements. Second, the pandemic has adversely affected revenues. Third, the pandemic has increased certain expenditure needs.

The likely impact of the COVID-19 pandemic on state and local government revenues is increasingly well understood (e.g. Auerbach et al., 2020). Less well understood are the pandemic's effects on expenditure needs. Additionally, there is confusion regarding both the quantity and purpose of federal support that has been directed to state and local governments. In this paper, we attempt to have a unified discussion of these issues, with an emphasis on health spending needs and the role of the Medicaid program.

It is worth dwelling briefly on the scale of state and local governments. Taken together, state and local governments serve a broad set of functions. They administer and at least partially finance many public services, as well as major income-support programs. The services provided by state and local governments range from education to public safety and public utilities. In recent years, the delivery of these services had led state and local governments to employ just under 20 million workers (Shoag and Veuger, 2020). This accounts for roughly 13 percent of all non-farm employment.

The motivation for federal fiscal stabilization arises from state and local balanced-budget constraints. When state governments face downturns, their balanced budget rules prevent them from contributing to countercyclical policy. As revenues decline and spending needs rise, compliance with balanced-budget rules dictates increases in tax rates and a search for budgetary savings. Savings may come from wage freezes and layoffs for members of the public-sector work force. Figure 1 illustrates the reductions in state and local government employment that took place between February and October of this year. This can, in turn, imply reductions in service delivery just as needs run high.

Given the existence of states' balanced-budget requirements, it is not surprising that the federal government has a history intervening to reduce states' fiscal stress. The 2009 American Recovery and Reinvestment Act, which included $232 billion in support for state governments, is a prominent example (US Bureau of Economic Analysis (BEA), 2020b). In the current crisis, federal support for state and local governments has come piecemeal through existing and new legislation discussed below. This support is of central importance to the US system of fiscal federalism, which is characterized by heavy reliance on the central fiscal authority for countercyclical policy./1

Content omitted: Figure 1: State and Local Government Employment in 2020

There are a number of inputs for the estimation of optimal, reasonable, or likely federal transfers. Political considerations aside, perhaps the most salient factor is the downturn's effect on state and local government revenues, to which we turn next. After that we turn to the second factor, namely the extent to which federal transfers have already been authorized. Third, we highlight that in the short run and in the aggregate, at least, new spending needs are of particular importance. We discuss these first in the context of the Medicaid and CHIP programs, which highlight the complex relationships between new spending needs, intergovernmental transfers, and the conditions on which the federal government makes its aid contingent. We then provide a high-level overview of other new spending needs, after which we conclude.

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Conclusion

The COVID-19 pandemic has strained state and local governments in several ways. The first is its effect on tax revenues; the second is its effects on the safety net, in particular through the Medicaid program; the third is its effects on operating expenditures, including the costs of running schools. This paper adds to past work on the pandemic's effects on state and local governments' budgets by coupling a detailed look at the Medicaid program with broader discussions of other expenditure needs, revenue impacts, and existing federal aid.

Perhaps the most salient finding from this work is that, in the aggregate, existing federal aid to state and local governments appears sufficient, or at least nearly sufficient, to offset expected revenue shortfalls and increases in Medicaid expenditures for the 2021 fiscal year. Both the aid and the blend of Medicaid expenditures and revenue losses are in the ballpark of $200-300 billion. While aid appears comparable to budgetary strain in the aggregate, of course, this will not be true of all states and localities individually.

We emphasize that assessments of further federal transfers should take a number of additional factors into account. On the needs side of the ledger, it is important to keep in mind that state and local governments suffered revenue losses in the second quarter of 2020. These losses pre-date, and thus are not included in estimates for, the 2021 fiscal year. Applying the approach followed by Clemens and Veuger (2020b), we estimate this earlier revenue shortfall to amount to $67 billion across state and local governments combined. In addition, state and local governments have been exposed to new demands for spending on their regular activities outside the Medicaid program. As discussed in the previous section, these additional expenditure needs may be on the order of $50 billion for the 2021 fiscal year. Operating costs for public schools account for a substantial share of this estimate.

On the funding side of the ledger, state and local governments entered the recession with about $119 billion in balances, between rainy-day funds and budget surpluses (Auerbach et al., 2020). These surpluses and reserves are a source of fiscal space. Interestingly, this $119 billion is similar in magnitude to the costs discussed in the previous paragraph. That is, states' existing fiscal space may, on average across the country, be sufficient to address states' revenue shortfalls from the previous fiscal year (i.e., the shortfalls from the second quarter of 2020), as well as increases in the current year's costs of operating schools and financing cash welfare assistance. Again, the caveat applies that this comparison masks significant heterogeneity across state and local governments.

Our discussion so far paints a picture that, albeit under difficult circumstances, is in some respects optimistic. That is, between substantial federal assistance and previously accumulated reserves, state and local governments should, in the aggregate, be on stable footing for the remainder of the 2021 fiscal year. At the same time, this assessment comes with several caveats.

First, as mentioned, there is significant heterogeneity across states and localities. Not all states, for example, had accumulated substantial reserves in their rainy-day funds. Further, states that rely heavily on sales tax revenue, or where leisure, hospitality, and tourism are important industries, have experienced worse than average losses to revenue. States and localities that have been hardest hit, or that were least prepared, may thus remain in quite difficult straits.

Second, federal aid and accumulated reserves notwithstanding, state and local government employment has declined substantially. As shown previously in Figure 1, state and local government employment was down by 7 percent from February through October. The decline from September to October leaves uncertainty as to whether state and local government employment has stabilized. This tempers the cautious optimism we would otherwise maintain based on our overall assessment of aid, reserves, and sources of budgetary strain.

Finally, there are longer-term considerations that should be taken into account. Revenues are sure to remain below pre-pandemic projections beyond the current fiscal year. While the aggregate numbers may look fine for now, the picture may look worse moving forward. This is particularly likely if the public-health crisis and the concomitant economic downturn extend late into the 2021 calendar year. Long-term forecasts, as from the CBO, suggest that nominal GDP will remain below its pre-pandemic trend through the end of the current decade. While this may support short-run arguments for additional federal aid, it also suggests that state and local government budgets may need to adjust to a new normal of lower revenues and reduced spending.

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About the Authors

Jeffrey Clemens is an associate professor of economics at the University of California, San Diego, a faculty research fellow at the National Bureau of Economic Research, and a CESifo Research Network Fellow.

Benedic Ippolito is a resident scholar at the American Enterprise Institute.

Stan Veuger is a resident scholar at the American Enterprise Institute, a visiting lecturer of economics at Harvard University, and a fellow at the IE School of Global and Public Affairs and at Tilburg University

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REPORT and FOOTNOTES: https://www.aei.org/wp-content/uploads/2020/12/Clemens-Ippolito-Veuger-fiscal-federalism-WP.pdf

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