As 2020 winds down, it's the time to look back on lessons learned from the unique experience we've all had in the COVID-19 era, which has challenged and stressed our systems of public finance in ways not experienced since the Great Depression. For state and local governments, there are some important takeaways that should be remembered for years to come:
Progressive taxation has its drawbacks when the economy tanks. Modern public finance theory typically favors progressive taxation, in which wealthier citizens pay a larger share of their incomes, as the most equitable way to raise revenues. This is a conventional credo among Democrats and moderate Republicans, and some states have reacted by shifting their income tax structures from a flat rate to a graduated schedule. California taxes its millionaires at a 13.3 percent marginal rate that takes in capital gains on investments. With movie and sports stars, corporate execs, beachfront billionaires and Silicon Valley fat cats contributing a big chunk of revenues, the state's progressive income tax produces huge budget surpluses whenever the stock market hits new highs.
It's no surprise that each time that happens, advocacy groups and unions line up with laundry lists of spending proposals to share the budget surplus by trickling that money down to needy residents and public employees. But the downside of this tax structure, with its over-reliance on taxing income as opposed to stabler revenue sources such as property, is that revenues collapse every time there is a recession or market crash, and the state quickly plunges into a budget deficit. That shortfall in turn ignites campaigns to raise income taxes yet further to avoid layoffs and cutbacks in an endless cycle of ratcheting and spending.
California is not alone in this syndrome, which is a constant complaint of conservatives and a headache for finance officials at all levels. Too often, local governments in such states have to tighten their belts disproportionately each time state-shared revenues collapse.
Rainy day funds are an essential component of fiscal policy at all levels. States should mandate them for every jurisdiction within their borders, with realistic budgetary guidelines. Turning again to California, one of former Gov. Jerry Brown's most important legacies was his insistence on building a strong and solid tradition of contributing to the state's rainy day fund during years of economic growth. Brown constantly had to swat back the free-spenders, but his tight fiscal fists paid off: Despite its severe loss of revenues in mid-2020, the Golden State avoided a complete fiscal meltdown. (Of course, it didn't hurt that the stock market bounced back.) As we scan local governments across the country, those with rainy day funds holding at least two months' of revenues, as the Government Finance Officers Association suggests, have dodged COVID layoffs more readily than those with razor-thin or no reserves.
A deficit-burdened Uncle Sam cannot forever come to the rescue. Putting aside this year's partisan bickering about the worthiness of states and localities for federal COVID relief funds, it's now obvious that old-school self-reliance and fiscal sobriety about business cycles and unforeseen emergencies must become the foundation of the entire intergovernmental fiscal scheme. While we remember the 1970s as a bygone era of federal revenue sharing, we now face a new normal in which counter-cyclical fiscal aid to states and municipalities might be called "federal deficit sharing." This does not mean that Congress should never provide intergovernmental aid in times of genuine fiscal emergency, but recipients of federal help should demonstrate — by contract — their commitment to accumulate their own reserves in sunnier economic days. I call it federal fiscal flood insurance. Federal aid should be a last resort, not a knee-jerk response, despite the unique ability of Congress to run budget deficits in recessions.
States and localities shouldn't overplay their hand in Congress. There is a reason that, on Capitol Hill, the state and local lobbying associations that style themselves as "public interest groups" are called PIGs. Looking back on 2020, it was obvious to me by May that the state policy associations in particular had tallied up numbers for fiscal "needs" in their COVID relief requests that would never fly in a bitterly, politically divided Congress. They projected a worst-case two-year budget deficit scenario and pleaded for the biggest package possible as if there were no tomorrow. House Democrats took the bait with their HEROES Act trillion-dollar intergovernmental aid package, when actual 2020 revenue shortfalls were likely to be far closer to the quarter-trillion-annual estimate I'd posted last April. In the lame-duck session, numbers were cut dramatically by bipartisan senators, and states got the short straw. Never forget what they say about half a loaf, especially if another slice or two are within reach.
America needs a real-time national fiscal databank. The Federal Reserve system and the Census Bureau collect data on state and local finances, but their annual and quarterly data are typically too stale to be actionable in a recession. This year, the public finance professional associations made a good effort to collect more timely numbers on the pandemic's fiscal impact, but that process was piecemeal, incomplete and insufficient. In an era of real-time "big data" analytics now blossoming in private-sector networks, it is a shame that the intergovernmental finance community is years behind when it comes to these tools.
We need the Federal Reserve system, or a nonpartisan arm of the federal government such as the Congressional Budget Office, to establish and maintain an ongoing live-data reporting system so that incoming revenues are tallied immediately. Every major municipal property and sales tax collector and every state revenue department should be providing weekly updates on cash receipts to a centralized clearinghouse. Such a federalized revenue databank could ensure that intergovernmental aid is based on reliable and nonpartisan real-time information, and would have made it obvious by early summer that the HEROES Act aid was oversized for this calendar year.
The Fed's Municipal Liquidity Facility needs a tune-up. The new Federal Reserve window for states and local governments to access emergency borrowing facilities was a great idea, but only a couple of jurisdictions actually used it this year. State and local public policy associations and their financial experts need to sit down with the Fed and iron out the kinks. Besides stabilizing the municipal bond market, which is job No. 1, the MLF should also provide quick operating cash to states and, through them, to municipalities. Every state legislature should enact a reliable permanent financing apparatus for subdivisions seeking emergency bridge loans from the Fed. 2021 is the right year to lay that groundwork, while last spring's "mini muni market meltdown" is still fresh in our minds.
Public pension funds are not out of the woods. The good news is that, contrary to partisan Washington predictions, state and local pension plans did not blow up in the pandemic, and they truly didn't cause state budget shortfalls this year. But don't let the stock market rally fool you into thinking that public pension funds are home free now that we've seen investments trading at record high levels. The funding ratios of many public plans still remain anemic.
At this point, in a bull market at all-time high levels, one would expect real-time actuarial funding ratios to be at 90 percent, or even 100 percent. Anybody who claims that a pension fund running at 80 percent in such a frothy market is "fully funded" is simply ignoring market cycles. To suppress payroll contributions, many systems keep kicking the can of their unfunded liabilities to the next generation. And to make matters worse, many public employers have done little or nothing to actuarially fund their obligations for retiree medical benefits. Each year, the percentage of state and local payrolls devoted to unfunded retirement benefit obligations creeps insidiously larger, weakening the body politic like a nonlethal but invasive tumor.
Personally, I'm grateful to ring in the new year and put 2020 behind us. America has certainly stress-tested its constitutional, political, economic, civic, humanitarian and intergovernmental systems. We dodged the worst-case fiscal scenarios, despite partisan poppycock and the tragic shadows of rampant COVID deaths. The pandemic has revealed cracks in the foundations of fiscal federalism that seriously need repair, so let's get to work on fixing those in 2021.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.