State and Local Government Austerity

Are we doomed to repeat the mistakes of the past?

By Amanda Page-Hoongrajok | January/February 2021

This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org

This article is from the January/February 2021 issue.

Subscribe Now

at a 30% discount.

Since the onset of the coronavirus recession, state and local governments across the United States have announced deep cuts in spending. The state-local government sector lost 1.5 million jobs in April and May. After a slight rebound, 320,000 additional jobs were cut between September and November. These cuts are occurring at the same time that public workers, such as school teachers and bus drivers, are risking their lives to provide essential services. A recent New York University study reported that nearly 25% of New York City transit workers have contracted Covid-19. Instead of receiving thanks and appreciation, these workers are getting laid off and furloughed en masse.

Not only have these cuts led to devastating job losses for government employees that are on the frontlines of the crisis, but they have also reduced the size and scope of public services just when all of us need them most. Are these layoffs and cuts on the state and local level inevitable, or are there ways to resist this austerity?

Balanced-budget rules are the key to making sense of why these cuts are happening. In the 1840s, the federal government ceased its tradition of bailing out states that were on the verge of bankruptcy. To try to avoid bankruptcy, many states then passed balanced-budget rules that constrained their legislatures ’ decisions about budgets. To this day, states adhere to this mindset, matching expenditures with revenues. Although the stringency of these rules varies across governments, balanced budgets are the norm. This means that without additional borrowing, any blow to revenues will severely impact a government ’ s ability to spend.

Since the Covid-19 pandemic began, state and local government revenues have declined in lockstep with the decline in sales transactions and employment. The mandated lockdowns and ongoing quarantine measures have reduced consumption and overall economic activity. This, in turn, has led to layoffs that began in the leisure and hospitality sector and have spread to other industries as well. Sales and income tax revenue are two major sources of funds for state governments. As sales and incomes have declined, tax revenues have declined as well, creating a budget gap between expenditures and revenues.

Why is State and Local Austerity a Problem?

The federal government is usually thought of as “ the ” government, but in reality, people engage with state and local governments far more often. Local governments administer and manage essential services like public parks, libraries, K-12 education, and utilities while state governments handle larger programs like Medicaid, unemployment insurance, and public universities. To provide these vital services, state and local governments—which are together called “ subnational ” government—depend on federal government funds and the taxes they collect themselves such as sales, income, and property taxes. The aggregate state-local government sector represents all of the 50 state governments and 90,000 local governments, combined. This sector ’ s spending has averaged about 11% of U.S. GDP from 1970 to 2020, meaning subnational government spending contributes substantially to economic output each year.

In the wake of the Great Recession, state and local governments made deep cuts to spending. From 2009 to 2019, state and local spending fell by about 2% of GDP, weakening overall demand and contributing to high unemployment rates. These spending contractions offset stimulus efforts on the federal level and slowed the recovery from the 2008–2009 downturn. One study by the Economic Policy Institute found that if state and local spending after the Great Recession had grown at a pace similar to previous recovery periods, unemployment rates would have reached their pre-recession levels by early 2013 instead of 2017. If the precedent set by the 2009 recovery continues, we can expect state and local government budget cuts to create even larger reductions in aggregate demand (the total quantity of goods and services demanded by households, businesses, government, and the international sector) and higher job losses. The job losses resulting from local cuts aren ’ t just the lost government jobs, but ripple effect losses as those newly unemployed teachers, bus drivers, sanitation workers, and City Hall clerks cut back on their spending, and then a line cook at their favorite diner gets laid off, or their barber ’ s income drops. This is called the “multiplier effect” (see sidebar).

State and local austerity causes immediate and quickly multiplied pain and suffering, and it can also cause long-lasting damage to future growth and prosperity. Mass layoffs and decreased compensation reduce household incomes and the means to a decent standard of living. The typical “ adjustment mechanisms, ” or ways that state and local governments close the gap between revenues and expenditures, is to cut education spending (both K-12 and higher education) and capital spending. For example, California ’ s most recent budget included a $1 billion cut to higher education, while the University of Missouri system lost $40 million in state aid. The National League of Cities estimates that 65% of U.S. cities have cut spending on infrastructure and equipment. Education spending is a long-term investment in the care and well-being of children, while capital spending is a long-term investment in the physical infrastructure of the nation. Access to a quality education and freely accessible public goods like libraries, parks, and sturdy roads are not only desirable in a moral sense but increase the nation ’ s productivity in the long run.

What Can We Do?

Coronavirus-induced revenue losses have created substantial budget gaps for state and local governments. Historically, governments have relied primarily on spending cuts to close these gaps. However, there are a number of alternative paths state and local governments can pursue to prevent the suffering from massive layoffs and losses of income associated with austerity.

The federal government should provide additional relief funds to help struggling governments stabilize their spending. The federal government can borrow at an ultra-low cost due to the Federal Reserve ’ s control over short-term rates and the fact that investors across the world deem U.S. treasury bonds as one of the safest assets available. State and local governments historically have not issued bonds to pay for operating expenses because of balanced budget rules. However, even if they did, they would not be able to borrow at federal government debt rates. Therefore, it makes sense to have the borrowing occur at the federal level and have the federal government make transfers to state and local governments.

Opponents of federal relief sometimes claim that state and local governments will just save transfer funds instead of spending them. The data say otherwise. Research shows that state and local governments do rely on and use federal relief funds during downturns. A 2014 study by the Political Economy Research Institute at the University of Massachusetts-Amherst found that state governments spent two-thirds of the American Recovery and Reinvestment Act funds transferred to them during the Great Recession.

If Congress is unable (or unwilling) to provide these much-needed relief funds, it is worth asking what state and local governments can do independently to stimulate their local economies and hold back austerity. First, state and local governments could draw down their rainy-day funds. A “ rainy-day fund ” allows a government to save unexpected or above-average revenue for use at some point in the future when it is needed. During the Great Recession, state and local governments drew down their rainy-day funds before engaging in budget cuts. However, the savings they had accumulated before the downturn were woefully inadequate to cover the amounts needed to plug budget gaps. Although there is evidence that state and local governments built up strong levels of reserves prior to the Covid-19 recession, the levels are still unlikely to adequately cover the massive losses in tax revenue.

Instead of cutting spending, another way to close a budget gap is to raise revenue. Traditionally this is done through a tax increase. However, raising tax burdens across the board is not an ideal fix for a budget deficit for two reasons. First, increased tax burdens create additional hardships for individuals and families that are already struggling to make ends meet. Second, taxing people ’ s income drains much-needed demand out of the economy. Higher taxes decrease disposable income, which means people have less money to buy goods and services.

However, tax increases that specifically target wealthier households are more desirable because they produce less of a drag on aggregate demand. Wealthier individuals and families spend smaller proportions of their disposable income than low-wealth households. Or, in economics jargon, the marginal propensity to consume is smaller for wealthier households. For example, a low-wealth household might spend 90 cents out of each additional dollar of disposable income they get, but a wealthier household might only spend 50 cents out of each additional dollar. One reason for this is that wealthier households are more likely to save or invest in financial assets. These actions do not directly contribute to aggregate demand or stimulate job growth. Taxing a wealthy household and using that money to keep a modestly-paid municipal employee on the payroll will do more to keep the diner and the barber in business than leaving it in the wealthy household ’ s savings account.

Tax increases on the wealthy are also more desirable in terms of equity. Wealthy households have more financial resources to weather downturns and therefore are more equipped to pay for tax increases. Pew Research recently reported that about 44% of low-income adults have used money from savings or retirement accounts to pay their bills since the virus took hold in February. Additionally, about one-third of low-income individuals report having to get meals from a food bank or pantry. At the same time, the wealthy have seen their fortunes grow. Jeff Bezos ’ s wealth alone has increased by $74 billion so far this year. In the backdrop of this increasing inequality, popular support for a “ millionaire ’ s tax ” has strengthened. A recent survey conducted by Ipsos found that 78% of New York City residents think there should be an additional tax on millionaires in order to help with the city budget deficit caused by Covid-19. As of September 2020, nine states were considering tax hikes on wealthy households, with potentially more on the way. As budget gaps continue to grow, state and local governments are increasingly looking for equitable ways to shore up more revenue.

The coronavirus-induced damage to state and local government budgets has pushed policymakers to think more creatively than ever about ways to avoid austerity. Although almost every state has a rule instructing governments to balance their budget with varying degrees of stringency, most of the compliance is derived from tradition and expectation. In other words, state and local governments feel compelled to balance their budgets not because they fear punishment, but because it is the political norm. At present, state and local governments that borrow to weather downturns are labeled “ fiscally irresponsible ” whereas governments that lay off public workers who have been risking their lives to provide vital services are viewed as “ fiscally prudent. ” However, it may be time to rethink these labels. Governments that borrow during downturns can stabilize incomes and spending, reducing economic damage while governments that engage in austerity face a downward spiral of declining incomes, spending, and growth. During the current downturn, more cities and states have considered breaking the balanced-budget stranglehold. For example, New Jersey ’ s most recent budget included $4.5 billion in borrowing for operating expenses, while New York City Mayor Bill de Blasio has also suggested borrowing to pay for the city ’ s current bills.

Avoiding Past Mistakes

The Covid-19-driven lockdowns and quarantine measures have reduced transactions and employment, devastating sales and income tax revenue. If state and local governments choose to balance their budgets primarily with spending cuts, as was done in the last downturn, we can expect weak demand, high unemployment, and an overall sluggish recovery. However, the mistakes of the past do not have to be repeated. First, the federal government needs to provide additional relief funds to struggling governments. Not only are borrowing rates for the United States extremely low, research shows that state and local governments can and do spend relief funds. If the federal government will not provide additional funds, states and cities still have options to prevent austerity and stimulate their local economies. Progressive income taxes are an equitable way to raise revenue. As New Jersey ’ s budget actions have shown us, engaging in austerity at the state-local level because “ there are no other options ” is no longer acceptable.

Amanda Page-Hoongrajok is an assistant professor in the Department of Economics and Finance at Saint Peter ’ s University in Jersey City, N.J. Her work focuses on the intersection of state and local government finance, business cycles, and macroeconomic countercyclical policy.

Did you find this article useful? Please consider supporting our work by donating or subscribing.