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Looming state, local budget squeeze threatens to hinder US recovery

The fiscal squeeze facing U.S. states and localities is set to be another drag on the post-pandemic economic recovery.

The combination of a shortfall in revenues and an increased demand for services means state and local governments face tough decisions when looking at their budgets for next year. Because state and local governments, whose spending accounts for 13% to 14% of GDP, have legal obligations to balance their budgets annually, they will be left with two options: raise taxes or cut spending.

"What that means is you essentially risk long term drag on the economy and private sector activity as a result of tighter state and local government budgets," Greg Daco, chief U.S. economist at Oxford Economics, said in an interview. "They have been hit by unprecedented shock and seen a significant shortfall in demand, which has affected revenues. For the cities and states more oriented toward the services sector, it's been even greater."

An analysis by the policy research group Brookings Institution found that state and local government revenue could plummet by $155 billion in 2020, $167 billion in 2021 and $145 billion in 2022, shrinking state and city budgets for years.

"The fiscal austerity on the state and local government level doesn't happen in a bubble," said Michael Pugliese, economist and vice president at Wells Fargo Securities. "Maybe that means a big decline in capital investment spending or infrastructure spending, or it may simply mean less employment, and that has a private-sector impact."

The ripple effect

Tighter budgets often result in reduced hiring or even shrinking of the government workforce. Roughly 1.3 million state and local government jobs have been shed since the U.S. coronavirus outbreak this past winter, including 184,000 jobs in September and 130,000 in October even after a relative bounce-back in hiring over the summer.

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"All of this tends to constrain private sector activity and impose additional restraint on economic activity," Daco said.

Moody's Analytics said in a September report that state shortfalls in tax revenue eventually would mean the fiscal shock could be as high as $450 billion, or 2.2% of the U.S. economy, under a baseline scenario and $650 billion under a "severe" scenario.

Brookings' analysis concluded that the pandemic could lower fees to public hospitals and higher education institutions by $33 billion in 2020, $22 billion in 2021 and $22 billion in 2022. The researchers said the sharp decline in health expenditures this spring led to layoffs, reduced hiring and a cutback in supplies.

At the same time, state and local governments will need to increase their typical spending to provide "crucial" public health services as the pandemic worsens, Louise Sheiner, a policy director at Brookings, said in a note.

"One lesson from the years following the Great Recession is that cutbacks by state and local government can be a substantial restraint on the vigor of the economic recovery, and so ensuring that state and local governments have enough funding is important both for ensuring that needed services are provided and that the economic recovery is as robust as possible," Sheiner said.

'Sharp' cuts

Most state and local governments are well into their fiscal year, said Robin Prunty, managing director and head of analytics and research at S&P Global Ratings, meaning they are going to have to make "sharp" cuts in order to restore balance to their budgets.

The Coronavirus Aid, Relief, and Economic Security Act, passed in March, provided $150 billion to state and local governments, though that was seen as a stopgap until either the pandemic subsided or more federal help arrived. Holes were plugged and states did not have trouble spending the money, but there was not nearly enough revenue replacement to cover unbudgeted expenditures.

The Health and Economic Recovery Omnibus Emergency Solutions Act, blocked by Republicans in the Senate because of what they saw as an exorbitant price tag, would have allocated an additional $500 billion to state governments and $375 billion to local governments.

President-elect Joe Biden has promised to provide money to state and local governments to try to plug budget holes blown open by the pandemic, but any sweeping action would require the cooperation of the Senate.

"They're going to be forced to balance their budgets at year end," Beth Ann Bovino, U.S. chief economist for S&P Global Ratings, said in an interview. "No stimulus means more cuts at the state and local level, and with that even more people unemployed."

The muni market

A viable alternative for some states to shore up a diverse mix of revenue could be the municipal bond market.

"We see an active and vibrant municipal market as a key component to fiscal recovery," Geoff Buswick, managing director and U.S. public finance sector lead at S&P Global Ratings, said in an interview. "It's happening across all sectors, so maybe not a lifeline but an ever-present support tool. We expect states and other entities to take advantage of capital markets."

The Tax Policy Center, a collaboration between Brookings and the left-leaning Urban Institute, estimated that state and local governments held $3.85 trillion in outstanding debt at the end of 2019, 98% of which had a maturity of 13 months or longer. Munis are a widely used tool, with 40% of muni debt issued by states and 60% issued by local governments last year, according to the think tank.

But this comes with its own limitations, as state and local governments are hamstrung by constitutions that limit how they can use such funding, including from the Federal Reserve's Municipal Liquidity Facility introduced in April that can purchase up to $500 billion of municipal notes.

"Additional borrowing in munis or tapping into the Fed's facility is an avenue but state and local governments operate on a different playing field than the federal government," Pugliese said. "The federal government can borrow $3-4 trillion no questions asked. State and local governments often face constraints when they borrow ... how it has to be used and limitations on total borrowing."

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