Overall, revenues for the recent fiscal year held up well despite the economic impact of COVID-19. But what about the months ahead?
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This article is from the forthcoming edition of the Lord Abbett Muni Quarterly.
When the COVID-19 pandemic reached the U.S. in March 2020, headlines warned that U.S. states would face unprecedented fiscal distress. Businesses shut down, travel came to a halt, and unemployment spiked to rates rivaling those of the Great Depression. Fears of a precipitous decline in state tax revenues and difficult-to-solve-for budget gaps were widespread. There was even talk about states filing for bankruptcy (which is prohibited by the U.S. Constitution). However, our analysis found that revenue declines have been significantly lower than projected. States, for the most part, have weathered the storm well, revising their budgets accordingly.
States’ Revenues Weathered the Downturn
For the period March through October 2020, which saw the most volatility, tax revenues were down only 5.2% percent from the same period the year before, according to data from the Urban Institute. This is far less than the than 11%-15% that the rating agencies and economists had projected. Broken down by component, personal income taxes were down only 2.8%, sales taxes were down 5.8% and corporate income taxes declined 8.9%.
In prior recessions, rising unemployment rates resulted in lower tax revenues. However, the COVID-19-induced recession behaved differently. This recession has disproportionally affected lower wage earners, while mid- and high-wage professionals have largely remained employed. Most states have progressive tax rate structures, with the highest wage earners paying the most income taxes. This, along with a surging stock market and increasing home prices, have reinforced income taxes and prevented sales taxes from declining significantly.
Stimulus Played a Role
Although these factors were critical in minimizing revenue loss, it would have been much worse if it was not for the federal stimulus funding. Not only did the states receive direct funding of $150 billion, but the $600 checks sent to low income individuals and the expanded unemployment benefits bolstered sales tax revenues. More stimulus funding is expected as new COVID-19 relief legislation was moving through Congress as of early March 2021.
Income Tax a Factor in States’ Resilience
Revenue recoveries have been quicker in those states that tax income, particularly those that tax the wealthiest at the highest rates. States most reliant on travel and tourism for tax collections, and those which do not levy income taxes, are recovering more slowly. Several examples illustrate the better than expected revenue performance this year:
Connecticut estimated a $930 million operating shortfall in fiscal 2020, before closing with a $50 million surplus, and in August, estimated a $2.1 billion shortfall for fiscal 2021 before cutting that estimate 58% by November to $880 million.
California went from forecasting a two-year, $54.3 billion deficit at the height of the crisis to the Legislative Analyst Office now projecting a one-time, $26 billion general fund increase that the legislature can allocate in the upcoming budget process for 2021-2022.
The Illinois Governor’s Office of Management and Budget (OMB) revised the fiscal 2021 budget forecast in November lowering its estimated budget deficit by nearly $1 billion, as revenues are outperformed expectations by 6.5% year to date.
Texas is projecting a nearly $1 billion shortfall for the current budget cycle, down from a July estimate of a $4.58 billion gap.
Figure 1 illustrates the fact that many states outperformed their revenue expectations for the year, through October, significantly.
Figure 1. Many States Exceeded Revenue expectations through October 2020 Year-over-year revenue collections versus expectations for fiscal 2020
*Versus the state’s mid-year updated financial plan, fiscal year-to-date collections through October were 1% below estimates.
Source: BofA Global Research. YOY=Year-over-year. For illustrative purposes only.
Unlike the Great Recession of 2008-09, most state and local governments entered this
recession from a position of strength. State and local government revenues increased over 40% from their pre-2008 financial crisis peak, and governments have been managing their budgets more prudently. The median state rainy-day fund reached 7.6% of general fund expenditures in fiscal year 2019, as compared to 2.1% in fiscal 2008, according to data from the National Association of State Budget Officers. Thus, they have more dry powder to offset the revenue declines that have occurred. Figure 2 shows the less-than-expected revenue impact, as analyzed by Urban Institute.
Figure 2. Overall, State Revenue Impact from the Pandemic was Less than Expected
Change in tax revenue, March–October 2019 versus March–October 2020
Source: State Tax and Economic Review Project, State and Local Finance Initiative at Urban Institute. For illustrative purposes only.
Budget Gaps Emerge
Although revenues have not declined as much as expected, budget gaps have opened. States for the most part have been proactive in taking meaningful corrective measures. At the start of the pandemic, state and local governments immediately furloughed employees. Employment at the state and local sectors was at the lowest level that it had been since 2001. Many states cut back expenditures in their recent budgets. California’s FY21 enacted budget includes $11 billion in spending cuts that will go into effect, barring additional Federal aid. Connecticut’s Governor asked agencies to identify 10% cost-cutting measures. The Governor of Texas proposed a 5% cut for various agencies in the state’s two-year budget.
As the pandemic continues to constrain commerce for large segments of the economy, tax revenues likely will be affected. State governments may face challenges to maintain fiscal balance and take corrective action. Fortunately, states have remained on their feet during this crisis. With possible further federal stimulus, and an acceleration in U.S. COVID-19 vaccination efforts, we think recovery should not be too far off.
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