Transcript

Charles Gerena: I'm Charles Gerena, online editor for the Research Department at the Federal Reserve Bank of Richmond.

Thank you for listening to "Speaking of the Economy." You can find past episodes on the Richmond Fed's website or Apple Podcasts.

The federal government has spent billions of dollars in financial aid during the COVID-19 pandemic, which has killed more than 700,000 Americans as of early November. State and local governments have benefited from some of this support.

Today, we're talking with two people at the Richmond Fed who have looked at the direct and indirect effects of federal aid to states during the pandemic. Laura Ullrich is a regional economist at the Richmond Fed's Charlotte branch. Sam Louis Taylor is a public policy analyst based in our Richmond office. Both recently contributed posts for our Regional Matters blog on this topic in September and June of this year.

Thanks for joining us, Laura and Sam.

Laura Ullrich: Thanks for having us.

Sam Louis Taylor: It's great to be here.

Gerena: Let's start by rewinding the clock to before the pandemic reached our shores. Laura, how were state governments doing in terms of revenues and spending, especially those in the Fifth Federal Reserve District that we follow the most closely?

Ullrich: Great question, Charles.

Just to level set, federal government revenue collections often are less than the spending that the federal government does. But state governments don't operate in the same way. In fact, most state governments have what are called balanced budget requirements.

What does this look like in the Fifth District? It differs depending on what state you're in. In Maryland, North Carolina, South Carolina and Washington D.C, the rules say that the governor has to submit a balanced budget for the year and then the legislature has to pass a balanced budget. In West Virginia, the legislature has to pass a balanced budget, but the governor's initial budget is not required to be balanced. However, when the governor signs the budget into law, it has to be balanced at that point. Virginia is a little bit different. In Virginia, it's not required for the budget submitted by the governor or passed by the legislature to be balanced. But there is a balanced budget requirement when it comes to execution. So the governor must ensure that actual expenditures do not exceed actual revenues.

That is how state governments have to operate. And because of that, it is typical when there's an economic downturn to see state governments have to cut budgets. They're not able to run deficits.

Pre-COVID, we were in the longest expansionary period in modern economic history in the U.S. It had been a long period of time since the last recession, which is oftentimes called the Great Recession. Because we had seen a lot of growth, especially in the geography that we cover in the Fifth District, all Fifth District states had budget surpluses in 2019.

And pre-COVID, there were active discussions going on in the states about what to do with these excess funds. There's a lot of pressure on the state government to cut taxes, right, to cut the revenue side. There were other recommendations, though, across the District. For example, in Virginia, there were recommendations that the governor had stated maybe they would start doing a low-income tax credit, similar to the Earned Income Tax Credit at the federal level. In North Carolina, they were talking about giving educators bonuses.

While the surplus discussions were actively going on, COVID hit and people were afraid that we wouldn't be able to meet budget [and] that revenues would be cut. Before that time, all these surplus funds were being funneled into what are called rainy day funds at the state level. The rainy day funds are to help states in the event of a budget shortfall. The good news going into COVID was that because we had budget surpluses, the states in the Fifth District did have relatively healthy rainy day funds, which helped in the very early days of the pandemic. Because of that, they were far less likely to cut spending early on in the pandemic than what we saw right when the Great Recession happened.

Gerena: Thanks for that context. What's your take, Sam?

Taylor: Laura makes a lot of great points. Because of those surpluses, those reserve accounts were already really prepared for kind of a worst-case scenario to help stave off some of the worst cuts that could have happened.

Before the pandemic, many states were still working to bring those spending levels of their budget back to where they were, even before the financial crisis occurred more than 10 years ago. Across the District, we were seeing state economies mirror the overall growth of the national economy. If you believe that bond ratings are a good indication of financial health, then our states in the Fifth District are generally seen as being some of the most fiscally prudent states in the country. You have North Carolina, Virginia and Maryland whose bonds are all rated at AAA, and that's AAA across the board. South Carolina is the mix of AA+ and AAA and West Virginia is kind of a mix of AA and AA-.

Gerena: Sam, what happened to their income and sales tax revenues when the pandemic struck?

Taylor: I think with this question, it's worth discussing both the projections for what was going to happen and then the reality of what states had to deal with.

As with all of us, the beginning of the pandemic brought a lot of uncertainty for states' fiscal picture. As things started to shut down at the beginning, particularly for some of our tourism-dependent states here on the coast, states were projecting some dramatic drops in revenues for 2020 [and] 2021, even up to 2022.

For example, West Virginia was projecting a 10 percent shortfall in revenue collection through 2021. Virginia had projected a 7 percent shortfall [and] North Carolina a 7 percent shortfall as well in 2020, and then an additional 10 percent shortfall in 2021. In South Carolina, [it projected] just an 8 percent drop, still significant, through 2021. A lot of our states within the District made very conservative and very prudent decisions to simply freeze spending across much of the government as the pandemic was unrolling across the country to make sure that they could adequately respond to the health crisis.

It's important to remember that it's not like we have a lot of recent experience creating financial models or even domestic response models for a global pandemic. It's basically been a century since our states and our governors have had to deal with an outbreak at this level. So many states budget officers were in a position to really plan for the worst, and then hope for the best.

Fortunately, in terms of fiscal impact, we didn't really hit that worst-case scenario in a lot of cases. Fortunately, states did have historic levels of reserves to fall back on, so they didn't end up having to cut quite as much as they were projecting, if they had to cut at all. Many states saw very surprising levels of revenue collection and were able to avoid those cuts.

Some of this can be attributed to the quick recovery in consumer spending that we've seen throughout the economy as many sectors started to reopen in 2020 [and] heading into 2021. Just as an example of the kind of surpluses we're talking about, West Virginia ended their fiscal year 2020 with a surplus of $243.9 million. They entered fiscal year '21 with a surplus of $450 million. The state going into the current year has continued to see really high revenue collection. Virginia ended fiscal year '21 with a record surplus of $2.6 billion. That's billion with a "B."

Gerena: That sounds like a very dramatic shift. Laura, what have you seen?

Ullrich: Sam's right that when COVID first hit, we were hearing from all the states across the District that they were fearing declines in state and local tax revenues.

That's normally what happens — you have a contraction or you go into a recession and state and local tax revenues are hit. There is typically a bit of a lag in that decline in state and local tax revenues, but we do see it happen. In the past two recessions, tax revenues fell notably and it took a long time for them to recover.

For example, in the Great Recession — the Great Recession was from 2007 to 2009 — total state and local tax revenues on an annualized basis decreased from a high of $1.37 trillion in the second quarter of 2008 to $1.25 trillion a year later. It took until the fourth quarter of 2011 for state and local tax revenues to recover.

This time, it was just very, very different. When everything shut down in 2020, people went home. It's not surprising that state and local tax revenues began to fall. People were spending less money, so sales tax revenues went down. People were making less money, so income tax revenues fell. During the second quarter of 2020, state saw both income and sales taxes – which are the two biggest tax revenue categories for states – take a significant hit. This was in line with what we expected.

However, state and local tax revenues quickly rebounded in the third quarter to record high levels. Much of that has to do with the fiscal support that came from the CARES Act. The support from the CARES Act was support to people, was support to businesses, support to both state and local governments. That propped up sales tax revenue as well as income tax revenue for the rest of 2020.

Taylor: I'll add in here, there have been a lot of comparisons between the Great Recession and the fiscal aftermath that we've seen over the last year. I'm not sure that that comparison is always useful. One, we're talking about a major financial and housing crisis that really dealt with deep-seeded problems in the economy. What we've had now is a healthcare crisis laid on top of what was otherwise a relatively healthy economic picture. But I do think it's probably worth discussing the difference between the austerity measures we saw in 2008 and how that compares to the response to the pandemic.

Since most states and local government draw the bulk of their revenue from taxes – income and sales taxes, personal property taxes — the public sector was really hit hard in the Great Recession. Most states had to shrink their budgets to varying degrees.

In 2008 the federal government, through some of the recovery plans, did send some money to state and local governments. But it's largely been seen in hindsight as being too small to deal with that crisis. By all accounts, it's kind of clear that the austerity of the Great Recession led to slower than possible economic recovery in a lot of areas of the country.

This time, states and local governments have been relatively flush with federal dollars. In many cases, they were able to just pause a lot of spending programs.

Gerena: Laura and Sam, tell me more about the CARES Act. Many people have called it a "stimulus bill" even though it was intended to be an emergency aid package.

Ullrich: I think it's important to remember when the CARES Act was passed. The CARES Act was passed on March 30, 2020. It was passed really quickly as we entered the most severe part of the pandemic.

Part of the CARES Act was direct relief to state and local governments. It was $150 billion. Policymakers expected state and local governments to experience significant revenue shortfalls. We had seen what that did to government agencies in the Great Recession, and they lobbied hard to make that a part of the CARES Act. Most of the money was distributed in states based on population, but there was a stipulation within the CARES Act that no state would get less than $1.25 billion.

These dollars were limited in terms of what they could be spent on. That money had to be spent on anything that met the three following criteria. It had to be spending that was incurred because of COVID-19. It had to be spending that was not accounted for in the budget passed prior to COVID-19, so something that came up during COVID that you wouldn't have expected otherwise. And then it had to be expenditures incurred between March 1, 2020 and December 30, 2020. A perfect example was additional PPE that you would have to buy to protect your workforce, or maybe testing supplies, cleaning supplies, things like that.

State governments also benefited significantly in indirect ways from other funds provided by the CARES Act. There were support to individuals. There were stimulus payments that were made. There was also enhanced and expanded unemployment insurance. Also, companies got significant aid via the PPP or the Payroll Protection Program loans.

That relief, alongside the recovery that was happening, led to increased personal income in the third quarter of 2020. Normally during the recession, we would expect to see personal income fall significantly. That increase in personal income brought record high state and local income tax revenue collections by the third quarter of 2020. Data suggests that states ended 2020 with an overall decline in revenue of only about 0.2 percent. Nearly half of the states the United States, including North Carolina and Virginia, saw revenue increase overall in 2020 compared to 2019. It was a much different 2020 by December than what people thought it might be when the CARES Act was passed March 30.

Taylor: For a health care pandemic, I don't know that the concept of a stimulus bill and an emergency aid bill are necessarily mutually exclusive. It's also important to remember that the CARES Act was the third pandemic response bill passed between the beginning of February and the end of March 2020.

What we did see from the CARES Act is that a lot of states were using those funds not just to respond to the pandemic, but eventually to help their states reopen. So, in a lot of ways, [the] CARES Act actually supported some of that resurgence in consumer demand, as more businesses and schools and communities were able to open back up.

Gerena: Interesting.

We've talked a lot about what happened to state revenues during the COVID-19 pandemic. What about the spending side of the budget?

Ullrich: You might initially think, "Oh, well, obviously state and local governments had to spend more during the pandemic. They had to buy all this extra cleaning supplies. They had to test people. They had to pay for health care, maybe in different ways."

There were increased expenditures that states faced and, no doubt, one of those categories was higher public health expenditures. Frontline workers — the people that were having to go into work, these essential workers that we often heard about — many of them were getting paid overtime or hazard pay for that. Also, Medicaid expenditures increased because enrollment grew by 11.7 percent between February and November 2020.

You also had higher education expenditures. When everybody had to go home to start doing education from their house, local school districts to big state universities … were having to provide additional technology to students, faculty [and] staff. They were providing supplemental nutrition to students at home.

At the same time, those states did see a decline in other expenditures. State and local employment fell at the beginning of the pandemic and it still hasn't recovered. In the case of state and local government, salaries are a huge part of their budgets. It wasn't that states were laying people off or firing people. In many cases, states instituted hiring freezes right away because of these fears of declining state tax revenues and local tax revenues. As people left jobs, they just didn't fill them.

Also, think about public transportation — the buses and the light rail and the public transportation systems were shut down for a period of time. That saved them money in terms of gas and maintenance.

So, if you look at the overall impact, on net, state expenditures were relatively flat through 2020.

Gerena: How did fiscal support from the CARES Act factor into spending?

Taylor: When you talk about the spending side of this equation, it's important to remember that the CARES Act was not just a blank check for states to do anything they wanted to with it. The money was given for a very specific purpose, which was to help states respond to the pandemic and to deal with the fallout to their education systems, their transportation systems, and their economies more generally. Those funds could not be used to backfill revenue shortages.

Even with those limitations, states did have some leeway in how they could spend the money. Many states used those funds to invest in improved broadband access, something that became critical to families who needed access to remote schooling. That's just as true in the middle of [an] urban area like Charlotte or Charleston or Richmond as it is in rural areas of Appalachia or eastern North Carolina. In addition to that, other states provided low-cost loans to small businesses and hard-hit sectors like tourism and the restaurant industry. Most states used these funds to bulk up supplies of PPE and, eventually, to build up the response infrastructure needed to distribute vaccines. As vaccination rates have continued to rise over the last year, that's directly correlated with increased economic activity around the country.

Gerena: Given where states were fiscally at the end of 2020, then you have the American Rescue Plan Act that came into play, how did that factor into the states' budgets?

Ullrich: The states' tax revenues recovered much faster than people initially thought. The states appeared to be in a decent place fiscally. But the federal government still included $350 billion in additional relief for state and local governments in the American Rescue Plan Act or ARPA as I'll call it, which was signed into law March 2021. I think this is pretty staggering – according to the Tax Foundation, the aggregated state aid that states got from ARPA is 116 times larger than the revenue losses that they had from the pandemic.

ARPA funds represent a tremendous influx of dollars into Fifth District states and local governments. It's hard to overstate how significant these funds are. For example, in Virginia, they had a record budget surplus of $2.6 billion in 2021 fiscal year. In addition to that surplus, the state received $4.3 billion in ARPA funds and local governments in Virginia got $2.9 billion in ARPA funds.

Going back to your question about how this impacts budgeting, it is important to note a few things about the ARPA funds. The ARPA funds are broader in terms of what they can be spent on. However, they're not recurring, so this is a one-time influx of funds that must be spent by 2024. Because these funds aren't recurring, states will be unlikely to consider the funds much when actually setting a budget, right? You don't want to set up a program in 2022 that's going to require funds each year that would rely on these one-time funds. Instead, the funds will be more likely to be spent on one-time capital projects; on deferred maintenance, which is a major issue across states; and/or other projects that won't require recurring funds beyond 2024.

However, states also are going to have budget surpluses again this year. We're going to likely continue to hear about what should be done with those funds, right? States are going to continue to face pressure to cut taxes or to adjust their spending programs to account for these surplus funds.

Taylor: I'm not sure if it would be fun or terribly challenging to be in charge of spending decisions and budget decisions at the state level right now. You all of a sudden have a massive amount of surplus money and federal money coming in that policymakers and citizens have a lot of leeway to figure out what to do with. At the same time, you've also got increased competing political demands on those funds. It's quite a balancing act that a lot of these legislators are going to have to figure out over the next couple of years.

When comparing that to the CARES Act, a response to the immediate crisis, ARPA in a lot of ways is slightly more future looking. It's intended to build a ramp towards economic growth in the sort of the short term to medium term. A lot of governments and localities are looking at this as an opportunity to invest in some future looking needs for their states, which could be helping tourism-dependent areas of their states recover and [setting] them up for economic growth in the near future. It could be modernizing cybersecurity infrastructure. It could be helping students catch up from learning loss from having to be remote.

We've already seen that states have been using these funds to give hazard and special pay to healthcare workers. There's still a major health crisis that we're experiencing on a daily basis. States are also using those funds to build up a lot of the basic public health infrastructure that has been really strained by the pandemic. And they're continuing to use it to support immunization drives so that the economy and a lot of sectors can continue to operate and start to operate more openly if they're not doing so already.

Gerena: What have you seen state governments in the Fifth District doing with some of this ARPA money?

Taylor: Within the Fifth District, we've seen most states use ARPA funds to bolster their unemployment insurance systems that, in many cases, have been really under invested in since the end of the 2008 financial crisis and the Great Recession a decade ago. Those systems have faced substantial strain and stress with the onslaught of unemployment claims during the last 18 months. You can pick up any newspaper and probably still read about some delays that people have experienced getting unemployment claims.

We've also seen states like Maryland and Virginia make historic allocations into expanding broadband access and are making promises to effectively end the digital divide. North Carolina has created some special grant programs for the hospitality and tourism industry. I'm hoping to help those businesses recover and bridge some of the still persistent uncertainty around COVID and travel hesitancy that we're likely to see for some time to come.

Ullrich: Deciding how to spend this money is very difficult for these agencies, and that's true at state and local levels. They're not used to having this kind of opportunity, right? I read about a school district in Wisconsin that spent a good bit of their money on building turf football fields.

This provides states the opportunity to do some things they've wanted to do for a really long time. If this money allows states to do some things like that, it's going to be an amazing opportunity. There's going to be controversial decisions that have to be made and some good discussions across our states in terms of the best ways in which to spend this money to get the type of economic and personal benefit that we want people to get.

Gerena: You bring up a really good point about the challenges that states are going to face as they're deciding what to do with these billions of dollars of funds that are non-recurring, and you point out some opportunities there but also some interesting decision points.

Laura and Sam, thank you for doing a deep dive for us into this topic.

Ullrich: Thanks for having us.

Taylor: You're welcome. Thanks for the opportunity.