Comment: State and local ‘rainy day’ funds may aid ‘soft landing’

Those reserve funds could limit an economic downturn, but it may make it harder to reduce inflation.

By Karl W. Smith / Bloomberg Opinion

Lost in the debate over whether the U.S. economy is headed for a recession is the extraordinarily robust condition of state and local government finances. Flush with funds, municipalities are providing a sort of stealth fiscal stimulus that promises to keep the economy from going into a downturn, but also makes the Federal Reserve’s battle to tame inflation even harder.

Historically, when economic growth slowed and tax collections fell short of trend, state and local governments were compelled to cut spending. Yet, by cutting spending they weakened the overall economy even more. But over the years state governments established rainy day funds to mitigate this effect. The idea was that states would save money when the economy was good and then use those savings to offset lower revenues when times were bad. Leading up to both the 2001 and 2008 recessions, the median state had the equivalent of 17 days of operating costs in their rainy day funds.

But thanks to federal government stimulus plans designed to support the economy through the pandemic, the median state had an estimated 42 days of spending in its rainy day fund at the end of 2022, or a total $135.5 billion according to Pew Charitable Trust’s State Fiscal Health Project. The numbers imply that a typical state could weather a roughly 12 percent drop in revenue over the course of a year without cutting spending, as opposed to only a 5 percent drop in 2001 and 2008. On top of that, state and local governments still have between $150 billion and $200 billion in pandemic relief funds that have been allocated but not yet spent, mostly on education.

The trends underlying the fiscal health of state and local governments are likely to persist for the foreseeable future. For example, the single most important factor causing rainy day funds to swell has been an unexpected surge in revenues. On average, sales taxes make up about 24 percent of state and local government revenue. Such taxes are levied primarily on consumer purchases of tangible goods. When covid-19 hit and the government flooded the economy with cash, all consumers could spend their money on was tangible goods. One year after the start of the pandemic, in March 2021, expenditures had rebounded and were 20 percent higher than they had been in February 2020 even after subtracting the effect of inflation. That means state governments saw a large boost in sales tax revenue, above and beyond a simple increase in prices, which they would have been forced to pay as well.

Recall that Congress also provided state and local government with hundreds of billions of dollars in covid relief. Much of that was earmarked for specific uses, but the $350 billion provided via the American Rescue Plan allowed recipients to spend the funds on almost anything, from investing in broadband access to a loosely defined category of supporting communities impacted by the pandemic. Even more narrowly targeted aid, such as the $180 billion in funding that Congress provided for low-income schools, will likely be used to offset spending that state and local governments would have undertaken on their own.

The other thing to consider is that state and local government employment hasn’t rebounded as fast as the private sector. Since August 2021, private sector employment has expanded by 6 percent while state and local government has grown by 2.3 percent. That means state and local governments on average have yet to replace all the positions shed during the pandemic, much less bring on more staff to expand services. This may be because many municipal workers are first responders who faced grueling conditions during the height of the pandemic. It may also be because the private labor market has provided workers better pay and flexibility, in terms of hours and work-from-home options. Regardless, this inability to hire workers is saving state and local governments money they would otherwise pay out as compensation.

Neither the surge in revenue due to higher spending on tangible goods nor the slowdown in state and local hiring will go away anytime soon. Neither will money flowing from the federal government. Congress opened up the $369 billion in climate funding provided by the Inflation Reducation Act to state and local governments by allowing them to receive grants for any activity that would make a private investor eligible for tax credits.

It’s all a glorious confluence of affairs that may allow the economy to come in for a so-called soft landing, thereby avoiding a recession. It also means that the Fed may need to raise interest rates higher than many expect and keep them there longer. For now, though, we should appreciate the strong fiscal finances of state and local governments.

Karl W. Smith is a Bloomberg Opinion columnist. Previously, he was vice president for federal policy at the Tax Foundation and assistant professor of economics at the University of North Carolina.

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