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Stress Test the States

State finances offer an enormous systemic risk for the country as we have seen recently. For the too large to fail banks, the remedy for managing this type of risk has been stress testing and it should be extended in a politically appropriate way to the states.
Stress Test the States
State fiscal conditions during the pandemic represented systemic risk. Ways to handle this should include stress testing the states.

Yes, this was an exceptional recession. The economy has recovered very nicely. But before we raise the wine glasses in celebration, let’s note that the economic volatility was extreme, and the analysis was often poor, especially at the state level. This recession’s great budgetary results were a pure Deus ex Machina – no vaccine, especially no mRNA vaccine, no celebration.

The state budgetary results were too much of a surprise. The states are the great American laboratories. A look at their budgets can teach us a good deal about economic policy in the recession. Generally, the states are in good economic shape, at least in the short run. Nevertheless, the great condition of state and local budgets in the post COVID era is as surprising as it is good news.

State and local governments are where the rubber hits the road and data from them is especially critical. Much of our data is top down from the usual federal sources, which makes state level and municipal tax and employment information especially valuable. Looking back, we can now see that the estimates were too often well off base. In some cases, they were downright terrible projections coming from the state and local level.

States are As Systemic as Banks

The states, like the mega banks, are too systemically important not to stress test their budgets in a consistent national fashion. State level estimates are being excused because the pandemic was supposedly a once in a century event. But was it? How about HIV or Polio? And purely economic collapses like the Great Recession? We could toss in a few wars. Catastrophes are not as rare as we would hope.

We would not expect the states to be in competition for data with the Commerce Department, but we have to rely on them for an accurate read on state and local revenues and their budget impact. No one is saying that state and local budgeting is easy, but we need to learn from this pandemic. The reasons that state budgets risk being unpredictable in a crisis like this are multiple, but we can start with the structure of the tax bases.

Tax bases produce volatile revenue. The volatility of state budgets in the Pandemic reflects the high degree of leverage in many state economies. Of course, the natural resource economies, led by Alaska, are dependent on commodity prices which have swung widely in recent years. PEW Charitable Trusts reported that state tax receipts in second quarter 2020 fell 25% year over year with policy moves compounding the Pandemic’s economic impact. Alaska and resource dependent states topped the list but the high tax states were not far behind.

Long before the Pandemic, the increases in top personal income tax rates were destabilizing state budgets. The debate about the effect of raising top rates was, however, focused on whether higher rates drove taxpayers out of state. That issue seems largely settled now in many jurisdictions—taxpayers or at least their revenue leave as rates rise.

Tax Rates Exacerbate Volatility

The other impact of rising state tax rates, which is rising volatility of tax income, was given far less press than the moving van scenarios but it proved the more serious consequence in the Pandemic. The decline in state income from the outmigration of the rich is small compared to the collapse of tax from high income individuals in a recession.

The test case, as always, is California. With a top marginal tax rate of 13.3% it leads the nation but is not far ahead of a number of other states. California’s personal income taxes account for 70% of the General Fund, and even a small decline in state economic activity will imply a shock to tax revenues.

The ultimate California budget result was unexpected given the tax structure. The COVID collapse was massive, but the state income tax revenues held up. The state projected a $54 billion budget deficit, which quickly exploded to a $75 billion surplus as high incomes surged on the back of a surging stock market and other capital gains. Then the Federal government kicked in an extra $26 billion in the American Rescue Plan Act of 2021 to bring the total California surplus to a staggering $100 billion.

Yet different states have different results. It was California’s legacy of wealth and good fortune which produced a shocking result. Shocking at least for analysts. High tax rates led to state surpluses and a surge in wealth concentration.

It didn’t have to be such a result. Oregon is an example. Its top marginal income tax rate is 9.9% and its economy far smaller than California’s. State agencies proposed a 17% reduction in their budgets at the beginning of the Pandemic. Oregon’s budget now looks in good shape after being saved by Federal programs and a stronger economy.

Tax policy has many masters, but the Pandemic shows the volatility produced by natural resource dependency and high individual tax rates. The Covid Pandemic should be seen as a special case of convenient factors and not a model for the future. Nor did we see that rainy day funds were nearly large enough to save the day.

The panic unleased novel efforts too. The Fed created an essential dose of liquidity in the municipal note market with the Federal Reserve Municipal Liquidity Facility. Only Illinois and New York issued debt but many others could have.

A call for formal state budget stress tests should be made. The Pandemic experience demands an improvement in state and local budgeting. State budgetary stress tests need to be voluntary but under the guidance of Federal oversight to ensure a consistent set of results for the country. Some states like Utah have initiated stress testing their budgets but more robust analysis is needed to handle this level of a disaster. The tests need to be formal, and in the nature of other systemically essential institutions. We were fortunate so far with Covid, let’s make sure that it is not just luck next time.

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