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The Time to Prepare for a Stagflation Budget Squeeze: Now

Income tax and sales tax revenue projections are slipping. State and local policymakers need to avoid fiscal giveaways and gimmicks, and they need to beware of potential federal aid clawbacks.

Kansas Gov. Laura Kelly
At an April 24 press conference, Kansas Gov. Laura Kelly, a Democrat, announced her veto of what she termed an “irresponsible” tax cut bill passed by the Republican-controlled Legislature and proposed instead a one-time tax rebate. (Kansas Governor's Office)
State and local government budget officers now worry that a “soft landing” scenario for the slowing economy could be overtaken by a recession where revenues actually shrink. For states like California, Illinois, New Jersey and New York that rely heavily on income taxes from investors’ and traders’ capital gains, the revenue slippage has already arrived.

Nationally, comparable income tax receipts at the IRS were off by 26 percent in April from the prior year. Even beyond capital gains, mainstream income tax projections are shrinking in many states. Skyrocketing mortgage rates have stalled the residential real estate market and commercial property values are sagging, so prospective property tax revenues are in many cases either flat or falling short of public employers’ wage and cost inflation.

Generally speaking, cost pressures are likely to outpace governmental revenue increases in the coming fiscal years. That budget squeeze will require belt-tightening in most jurisdictions.

That’s the overall trend, but the full picture is far more nuanced. Revenue sources for states and localities vary widely, and regional economies are experiencing very disparate rates of change. In the coming months, some will grow modestly while others shrink, given the likely economic slowdown as higher interest rates and the layoffs prevalent in the tech sector bite into production and employment. Some budgets will still be able to keep pace with cost inflation as long as the overall economy avoids a recession — even with the profits slump that many on Wall Street are now expecting — but the going will be harder for many holders of the public purse.

As consumers start pinching pennies to cover inflating prices, a profits squeeze will impair corporate earnings, which in turn cuts business income taxes. States with progressive tax rates and cyclical dependence on capital gains taxes — and their subdivisions that share revenues — are already projecting revenue losses, but those with less reliance on the swings in capital markets and corporate profits should still be able to anticipate a relatively stable revenue base. Even if consumers pull in their horns and buy fewer goods and services, the current national inflation rate is offsetting somewhat lower unit sales volume. Total revenues from sales taxes are therefore stable overall, at least for the time being, but there will be spotty shortfalls as 2024 arrives.

At the local level, where residential property taxes are a dominant revenue source, assessors are still scrambling to deal with the pandemic-era surge in home prices, when mortgage interest rates had fallen to absurdly low levels and money was cheap: Market prices are down in many localities, but property assessments are still playing catch-up, especially in states like California with annual caps on taxable valuation increases.

But even though mortgage rates have risen to painful levels, there is enough demand from younger households to keep valuations steady, at least for now, and older homeowners are not selling because they cannot replace the low-rate mortgages they secured by refinancing in recent years. So there is a fragile equilibrium in the residential property markets, as long as employment levels hold steady and people keep their jobs. Any budget crunch from stagnating residential property taxes will probably not hit most public employers until 2025, whether or not the economy avoids recession.

In the commercial and especially the office markets, it’s a different story, of course. Office vacancies have hit a record high of 12.9 percent nationally. So cities with heavy concentrations of downtown office buildings are doomed to see sagging property assessments, because market prices are slumping with no end in sight. The “dark store” tax assessment slump is hitting municipalities with high revenue dependence on large malls and big-box retailers. But that’s not a big factor in most suburban, exurban and rural communities, economically diversified counties, or breadbasket states. It’s not entirely a red-versus-blue political divide, but the contours tend to follow that demography. So we should not be surprised to see more partisan bickering and finger-pointing about misguided fiscal mismanagement in coming months.

Clawback Politics

Speaking of partisan bickering: The noisy partisan debt-ceiling conflict is top of mind for market pundits right now, with the conceivable potential to tip markets, and thence the larger business world, into a tailspin. Hopefully a long-lasting blowup will be averted. But there is plenty of chatter about the possibility that a compromise congressional clawback of unspent pandemic aid to states and localities could siphon off promised federal reimbursements that their budgeters are counting on. Public health and transportation infrastructure are high on the potential rescission list. Other discretionary grant programs could be frozen.

Never mind that one-time spending rescissions don’t balance multiyear budgets; after all, this is rhetorical politics. Talking-point Capitol Hill grinches cannot unwrite binding contracts that have already obligated federal reimbursements for specified approved projects, but until the fiscal Kabuki theater on Capitol Hill is resolved, budgeters should double-check their paperwork. An open encumbrance — a commitment to pay for goods or services ahead of the actual purchase — is not inherently an asset.

On a more hopeful note, an economic soft-landing scenario in coming months can be manageable for most states and localities as long as the Federal Reserve’s tight monetary policies and higher interest rates don’t ultimately throw multimillions of workers out of jobs this year or next. The best case, and perhaps the base case now, is what market economists would call “a nominal soft-landing but a real recession net of inflation,” otherwise known as stagflation.

Many jurisdictions have built up some financial reserves with rainy-day funds and sustainable budget plans that can adjust to anemic or zero top-line growth and even slightly lower revenues in 2024 while facing continued cost pressures, notably for services and payrolls. Not everybody has been quite so frugal, however. There are a good number of politicians who have shortsightedly appropriated funds to unsustainable levels (the free-spenders) or authorized tax refunds and rate cuts (the anti-taxers). Lawmakers in a dozen states still have tax reductions proposed for fiscal 2024, despite economic and revenue uncertainty. To sanitize the jaded expletive of one veteran budget officer: “I’ve never seen a politician here who won’t fritter away a respectable budget surplus.”

The Payroll Squeeze

As long as the overall economy is able to glide slowly to a lower pace as inflation subsides from Federal Reserve monetary tightening, the soft-landing scenario should allow policymakers to clean up their act and balance revenues with sustainable spending levels. For most, the biggest challenge will be payroll cost inflation, which will be the primary cost driver in most budgets. Unlike private-sector Microsoft, which is freezing base salaries after hefty increases last year, public employees are still playing catch-up from the 14 percent cumulative two-year spike in their cost of living in 2021-2022. As long as revenues are rising, it's naïve to expect that public-sector labor unions and arbitrators will accept less than a catch-up pay raise in the coming year if the employers’ revenues are sufficient. In fact, they have every incentive to push hard for raises right now, before the economy weakens and revenues fall off — with a focus only on the rearview mirror and not the windshield.

While unemployment rates hover near record low levels despite layoffs in prominent high-tech and retail companies, public-sector budget officers will need to scrounge for every nickel they can find to restore their workers’ real purchasing power. Even where unions are not a factor, if public employees find opportunities to jump ship to higher-paying jobs elsewhere the cost of replacing them now will eat further into budget revenues.

Along with payrolls, public pension costs will start to escalate next year, as actuarial calculations take into account the inflation that has already hit payrolls and retiree cost-of-living adjustments. Common actuarial assumptions of 2.5 percent inflation have clearly fallen short of recent reality, and salary adjustments above the retirement systems’ official policy assumptions are commonplace. The resulting underfunding is typically amortized over decades, so the immediate budgetary bite will be deferred, but don’t kid yourself: Those are real costs, and they will be going up faster than payrolls for years to come, even if CPI inflation subsides in coming months.

Even more immediately, group medical and retiree medical insurance premiums will keep escalating faster than revenues this year and next. Those are hard-dollar costs that cannot be swept under the rug.

Recession Roulette

And that’s the best case. The gloomier outlook is that stubborn inflation and Fed tightening will eventually grind the U.S. economy to a standstill and could then compel an actual contraction in 2024. That being an election year, there will be strong incentives for incumbent Washington insiders to do what they can to forestall that outcome, no matter how the current debt-ceiling standoff plays out. What’s pretty clear, however, is that any additional counter-cyclical federal aid along the lines of the 2021 American Rescue Plan is a non-starter in 2024, although the protracted intergovernmental reimbursements under the enacted 2021 infrastructure program will provide modest fiscal stimulus in the coming fiscal year.

What Washington does is always important when it comes to the economy, of course, but household consumption trends and the magnitude of layoffs and cutbacks in the private sector will ultimately be what tip the scales one way or the other. Budget officers and budget committees that sugarcoat revenue projections and ignore downside risks are like audacious Vegas roulette gamblers betting only on black or a snake.

Given this fragility and the potential downside damages of policy errors from over-optimistic budgeting and fiscal giveaways, here are some wiser and hard-headed policy measures that state and local officials should be considering right now, on the heels of budget surpluses:

• Rainy-day funds. The good news is that many public employers have built up their general fund reserves and rainy-day funds as revenues exceeded expectations through most of the pandemic. The temptation now will be to tap those reserves prematurely, to avoid hard decisions. The wiser course of action is to tighten budget belts and keep that powder dry just in case a hard landing plays out in 2024. You can only spend reserves once, and then there’s a Wile E. Coyote budget cliff.

• Debt reduction. For the lucky jurisdictions that are still flush with cash and bountiful revenues, an early repayment of bonded debt and capital leases is a prudent technique to strengthen bond ratings and make it possible to cut taxes after today’s risk of recession has passed.

• Sustainable tax rates. Some of the politicians who could not resist the temptation to send tax refunds and cut tax rates in the past year or so will come to regret such gimmicks if a hard recession hits us next year. If ever there were a year to avoid more tax giveaways, this would be one. If deemed politically necessary, budget approvals with sustainable tax rates can include an offsetting “recession contingency” line item that can be refunded to taxpayers in the future or applied to prepaying debt service if a soft landing actually materializes.

• OPEB funding. At the same time that they were handing out tax refunds and tax cuts, or funding their fiscal sacred cows with nonrecurring revenues, many politicians across the nation have continued to underfund their retirees’ medical insurance programs (“other post-employment benefits” as they are known). If nothing else, budget officers and finance committees should be asking themselves why they should not sock away any loose change they have on hand into an OPEB trust fund. Labor arbitrators can hardly deny the rationale to properly fund OPEB obligations before awarding large or unsustainable pay increases. And the money held in trust can usually still be tapped in lean budget years to reduce budget costs for these retiree benefits, making it an emergency back-door rainy-day fund.

• Contingent salary adjustments. The recession scenario is not a certainty at this point, but any major pay increases awarded now should include a conditional component that can be paid retroactively if revenues hold up as budgeted, but otherwise suspended until the employer again sees revenue increases.

(Pew fiscal researchers have published a thoughtful write-up of similar points that’s worthy of review.)

There is no magic one-size-fits-all strategy for budget officers to promote at times like this, but the message they must deliver to their executives and governing bodies right now is a flashing yellow-orange caution light. The dreaded recessionary hurricane may never arrive next year, but now is a good time to stock up on batteries and avoid regrettable and irretrievable largess.

Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management.
Girard Miller is the finance columnist for Governing. He can be reached at
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