How Congress Can Minimize 'Viral' State and Local Layoffs

Sometime this month, it’s a sure bet that the House of Representatives will take up a bill that could include fiscal aid to state and local governments. The pandemic and resulting curtailment of business activity has already clobbered their income- and sales-tax revenues. Balanced-budget laws will require layoffs once most jurisdictions run out of their rainy-day reserves and freeze their capital outlays.

Having learned from the Great Depression that state and local budget cutbacks can largely offset federal counter-cyclical spending, nobody in D.C. wants to replay that scenario in this election year. House Speaker Nancy Pelosi has informed her Senate counterparts that additional aid to small business must include money for the states. What nobody can predict at this early stage is:

• What will be the size of the aid package for states and their subdivisions?
• How will funds be distributed? To whom? What formulas will apply?
• Will infrastructure be included? If so, how?
• Will this be entirely deficit-financed, or will a tax package be attached?

Size: Nobody can predict exactly how much state and local budget shortfalls will total over the next 12 months. Moody’s analysts estimate that almost 30 percent of U.S. GDP was wiped out last week, but most economists expect some improvement over the next 12 months. Still, we don’t know how long the shutdowns will last or whether the virus will return this fall or winter. The prediction by President Trump’s advisers of a skyrocketing “V-shaped recovery” from pent-up demand is election hoopla: Too many businesses will not survive, and too many workers won’t be able to find jobs that fast. At best, the economic-recovery pattern will resemble an elongated check mark or, more likely, the Nike “swoop” logo well into the new year.

The important metric here is that total annualized state and local government income- and sales-tax revenues last year were about $1 trillion. My best guess today is that 10 to 25 percent of these elastic and volatile revenues will evaporate this year. Thus, the magnitude of foreseeable state and municipal revenue shortfalls is probably in the range of $100 billion to $250 billion. Given the uncertainty factor and the genuine need, a sensible congressional response would begin with a foundational $100 billion appropriation, supplemented by an additional authorized $150 billion to be dribbled out periodically by formula if GDP and actual tax receipts remain below negotiated trigger points over 12 months. The relief should be scaled by the facts, not just the politics.

Distribution formula: The House and Senate will look at the allocation of these funds quite differently. The House will tend to favor blue-state, urban constituencies, and will likely promote formulas based on a percentage of state and municipal budgets. House Democrats will hear the voices of teachers’ unions, even though most school districts rely heavily on property taxes and often receive their income- and sales-tax revenue indirectly, from their states. The Senate would likely try to limit aid to the states, perhaps by allocating it on a per-capita basis. Here are some approaches that might be considered:

• Allocate the funds per-capita, directly to states. This is easiest to administer, favors densely populated states, and leaves allocations for local governments to the state capitals — a modern-day federalist (Red) formulation. It unduly benefits states that rely most heavily on property taxes, which are less cyclical.
• Base funding on the percentage of state and local revenues derived from income and sales taxes for each entity. This (Blue) formula comes closest to addressing actual revenue shortfalls, which House Democrats would like. But it rewards those who tax and spend more heavily, which many Republican senators will resist.
• Limit direct sub-state aid payments to the 200 largest public employers that derive at least 33 percent of their revenues, directly or indirectly, from coronavirus-suppressed sources such as income and sales taxes and gaming revenues (but not OPEC-impacted oil royalties). This will target federal dollars to those most impaired and impacted. It has the same Blue/Red political issues, despite the logic and sharper administrative focus.
• Allocate a fixed dollar amount per public employee, adjusted for localized cost-of-living differentials. This helps direct the aid to preserving jobs (a Blue priority) but avoids rewarding public employers who pay top dollar (a Red bugaboo). Mayors and school superintendents might support a headcount formula, but it ignores revenue sources, which is the basic rationale.
• Use the old 1970s federal revenue-sharing formula. Population, relative income and tax effort were the three components. This template avoids reinventing the wheel and provides a defensible compromise refreshingly grounded in history.

Infrastructure: There is a lot of chatter about infrastructure funding as part of this legislation. The president is talking in terms of a trillion dollars, which would dwarf any imaginable direct fiscal aid to states and localities. One problem with infrastructure spending, however, is that it has almost nothing to do with imminent public-sector layoffs. Worse, the lag time between congressional action and actual spending is so long that COVID-19 herd immunity will arrive before any new infrastructure construction workers actually collect their first paychecks. One need only look at the sluggish outcome of every prior federal effort to prime the pump during recessions in the last 40 years.

That said, state and local lobbyists cannot look a gift horse in the mouth. If the White House somehow cuts a deal for infrastructure with House leadership, that will drive the entire process. And then it pays to Think Big, because this will truly become a once-in-a-blue-moon event. My recent proposal to open the Federal Financing Bank window to the states could then be incorporated to supercharge the fiscal impact.

Funding: Hardly anybody on Capitol Hill wants to pay for all this federal spending by raising taxes, but state and local lobbyists should be prepared to address that issue. It’s pretty obvious that this White House really doesn’t care about deficits. That will be the next president’s problem, and Trump personally “loves debt.” However, doing nothing inherently burdens future generations: It will be Gen X, Gen Z and millennials who will ultimately pay for this 2020 surge in deficit spending. Servicing all this debt will eventually catch up with us. It will crowd out future federal spending, drive interest rates higher someday, and probably bring us a return of inflation or stagflation early in the 2030s. Sadly, few in either party want to address that right now, but it’s a genuine concern.

But taxing the middle class in the midst of a recession is a non-starter politically, and it’s bad economics. Politicians will not even think about that right now.

A reasonable, but contentious, funding proposal that deserves consideration is a “One Percenter” income surtax. This would plug many of the tax loopholes the rich get away with. A 10 percent surtax on the wealthiest households, taxing only their adjusted gross income that exceeds $500,000, would not materially impair GDP or consumption. That revenue would provide sufficient funding for the basic intergovernmental fiscal aid outlined here. But even if paired with more Main Street business relief, the only way this idea can possibly clear the Senate politically is for the revenues to be allocated formulaically to the states in proportion to their historical share of One Percenters’ incomes.

Thereby, Uncle Sam becomes an income-tax collector on behalf of the states, accomplishing what governors or state legislatures cannot otherwise accomplish themselves. Conceptually, any anti-tax Red state could internally bestow an offsetting tax credit to the rich if they wish. Once COVID-19 passes, the surtax revenue can be used thereafter to help repay a sliver of our surging federal deficits.