State Budget Surpluses, the COVID-19 Impact, and ARPA Funds

Introduction

Unlike the federal government, most state governments cannot carry deficits from year to year. Nearly every state, and all Fifth District states, have balanced budget requirements, so states’ tax revenues must equal or exceed operating expenditures. During economic recessions, consumption and employment typically fall, so state governments collect less from income and sales taxes. Because the economic shock of the COVID-19 pandemic was the most severe since the Great Depression, economists and lawmakers initially anticipated dire revenue losses for state governments in 2020. However, in all Fifth District states except West Virginia, state revenues increased in the last eight months of 2020 relative to the same period in 2019. Fifth District states’ surprisingly high revenues led to record state budget surpluses on top of the surpluses gained since the Great Recession. In addition, states are receiving substantial aid from the fiscal stimulus bills passed in 2020 and 2021. Of course, now Fifth District lawmakers must decide how to use this influx of cash.

Pre-COVID-19 Budget Surpluses

After over a decade of economic expansion, state budget surpluses in the Fifth District were robust pre-COVID-19. In 2019, all five Fifth District states had budget surpluses, and there were active discussions across the district about what to do with surplus funds. Unsurprisingly, this included pressure to cut taxes. Other recommendations included a low-income tax credit in Virginia and additional bonuses to educators in North Carolina. At the time the pandemic began, these debates were still actively occurring across the district, and meanwhile, many of the surplus funds were funneled into district states’ Rainy Day Funds (RDFs). These funds exist to assist states in the event of budget shortfalls. When the pandemic began, Fifth District states had robust RDFs and were far less likely to cut spending during the early days of the pandemic than in the Great Recession.

The Impact of the COVID-19 Pandemic

At the start of the pandemic, many feared declines in state and local revenues. In the past two recessions, state and local tax revenues fell notably, and it took a considerable amount of time to recover. For example, during the Great Recession, total state and local tax revenues decreased from a high of $1.37 trillion (annualized) in the second quarter of 2008 to a low of $1.25 trillion a year later. State and local tax revenues did not recover fully until the fourth quarter of 2011. During the recession in the early 2000s, state and local tax revenues fell from $928 billion (annualized) to $902 billion. This was a smaller decline than in the Great Recession, but revenues did not recover fully until the third quarter of 2002. In both recessions, state and local governments faced significant deficits, and agencies were faced with significant cuts.

In many ways, the COVID-19-induced recession was different from previous recessions. State and local tax revenues declined during the second quarter of 2020 but then quickly rebounded in the third quarter to record high levels. During the second quarter, both income and sales tax revenues took a significant hit as many people experienced income losses, and many businesses remained shuttered. The federal government responded quickly: On March 30, 2020, Congress passed the Coronavirus Aid, Relief and Economic Security (CARES) Act, the first major fiscal relief. Altogether, state and local governments received $150 billion in relief. Most of the funds were distributed to states based on population, with the stipulation that no state should receive less than $1.25 billion. These dollars could be used for government spending that met all three of the following criteria:

1. Expenditures incurred due to the COVID-19 pandemic.
2. Expenditures not accounted for in the budget passed prior to COVID-19.
3. Expenditures incurred between March 1, 2020, and Dec. 30, 2020.

The CARES Act also included a large amount of aid for individuals and businesses. This relief, alongside the rapid recovery of many businesses, led to increased personal income in the third quarter of 2020.  Real disposable personal income fell from an annualized $15.1 trillion in February 2020 to $14.8 trillion in March 2020. It then spiked to $17.2 trillion in April 2020. This increase in personal income brought record high state and local income tax revenue collections by the third quarter of 2020. Data suggest that states ended 2020 with an overall decline in revenue of only around 0.2 percent, and nearly half of the states, including North Carolina and Virginia, saw revenue increase in 2020.

This year proved to be an even stronger year financially for Fifth District states. As of writing this post, Maryland is the only Fifth District state that has not yet reported its fiscal year 2021 data. In three states, expenditures fell slightly during fiscal year 2021, while revenues grew considerably in all four states. The substantial increases in revenues led to large budget surpluses in each of the states in fiscal year 2021, ranging from $413 million in West Virginia to $2.6 billion in Virginia. States are also predicting this surplus trend will continue into fiscal year 2022. North Carolina does its budgeting on a two-year cycle, and it is now predicting a $6.5 billion budget surplus for fiscal years 2022 and 2023.

The Impact of the American Rescue Plan Act (ARPA)

Despite the quick recovery in states’ tax revenues in the latter part of 2020, the federal government included about $350 billion additional relief for state and local governments in the American Rescue Plan Act (ARPA) of 2021, which Congress signed into law in March.

The ARPA funds represent a tremendous influx of dollars into Fifth District states and local governments. As mentioned previously, in 2021, Virginia had a record budget surplus of $2.6 billion. In addition to this surplus, the state received $4.3 billion in ARPA funds, with local governments receiving $2.9 billion. According to the Tax Foundation, the aggregated state aid via ARPA is 116 times states’ revenue losses from the pandemic.

ARPA is not only unique for the size of its aid, but also its funds are very flexible, giving states unprecedented fiscal opportunities to enact a wide array of programs and infrastructure improvements. ARPA funds must be spent before 2024 for any of the following purposes:

1. To respond to the COVID-19 emergency or its negative impacts. This could include assistance to businesses, households, or nonprofits, as well as aid to industries.
2. To provide premium pay to workers deemed essential or to provide grants to employers that employ essential workers.
3. To offset losses in state or local revenues due to COVID-19.
4. To make needed investments in water, sewer, or broadband.

State and local governments must now decide how to spend both the increased federal funds and the surpluses accumulated during the pandemic.

Conclusion

State and local governments face difficult choices on how to spend stimulus funds and budget surpluses. Most states will face political pressure to cut taxes, as well as pressure to spend money on infrastructure and the deferred maintenance that has accumulated on many state-owned assets. The federal money and the surpluses present state and local governments with a unique opportunity to spend on both long-term capital and short-term operating initiatives that could improve economic conditions. It is important, however, to acknowledge that there is no guarantee of positive outcomes, and spending decisions must be made carefully and thoughtfully for the long-term development of each state’s unique economy.

Have a question or comment about this article? We'd love to hear from you!

Views expressed are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Richmond or the Federal Reserve System.