Making government work, and work for all.

State and local governments are a major piece of the U.S. economy, accounting for about 13% of all employment. However, unlike the federal government, state and local governments typically have balanced budget requirements, which mean that shortfalls in revenues must be offset with spending cuts or tax increases, actions which hurt taxpayers and impede the economic recovery. Since the beginning of the pandemic, state and local governments have cut employment by about 7%—or roughly 1.3 million jobs.

Analyses of the previous recession—the Great Recession that started in 2007—suggest that cutbacks by state and local governments were a significant restraint on economy recovery. As such, promoting a rebound in state and local government employment will be an important avenue for ensuring a more robust post-COVID economic recovery.

The COVID-19 relief package approved by Congress in December 2020 provides roughly $125 billion to these governments for education, health, public transit, and highways, but no general aid to states or localities to cover revenue losses. As such, the issue of aid to state and local governments continues to be an important point of contention.

State and local employment fell faster than revenues

As revealed by a recent Brookings Paper on Economic Activity, the revenue losses from the pandemic appear to be much smaller than originally anticipated, and federal aid provided to date is likely to exceed them in the aggregate, at least over the next few years. Of course, state and local governments are facing higher demands on spending as a result of the pandemic and revenue losses in some states are likely to greatly exceed federal aid, so budgets may still be under strain. Nevertheless, the huge fall in employment seems out of proportion with the amount of fiscal stress.

So why has employment declined so much? Social distancing, and all that it entails, is likely a very important factor. But there is also evidence that tight fiscal conditions have led to employment declines in local education, which accounts for roughly 5% of the overall U.S. workforce. Furthermore, state and local governments, having been scarred by the Great Recession, are likely being very cautious about spending given the tremendous uncertainty about the economic outlook, and some states—those particularly reliant on tourism, for instance—are clearly facing very difficult budget conditions. The recently enacted aid, as well as the prospect of widespread vaccination over the next few months, should help spur state and local government spending and strengthen the economic recovery as a result.

As Alan Auerbach, William Gale, Byron Lutz, and Louise Sheiner noted in their recent paper, this recession is quite different from previous ones. Many of these differences suggest the revenue losses will be smaller than in the usual recession: employment losses have been concentrated to an unusual degree among low-wage workers (who pay less in income taxes); the stock market has risen, not fallen (which drives capital gains tax receipts); and the unprecedented $2 trillion CARES Act fiscal stimulus enacted last spring supported consumption, and hence sales tax revenues, as well as taxable income (in part because unemployment benefits are taxable in most states). On the other hand, consumption patterns have changed dramatically as a result of the pandemic, decimating fees and taxes collected on airport use, gasoline sales, recreational services, mass transit, and the like. On net, however, the authors concluded that the state and local government revenue losses from the recession would be moderate and far smaller than some had predicted on the basis of the increase in the unemployment rate.

Recent data have suggested that these estimates were likely too large. While these estimates have not been formally updated, a rough back-of-the-envelope calculation suggests that state and local government revenue losses (including losses by public hospitals and higher education institutions) will likely be something on the order of $140 billion in 2020, $110 billion in 2021, and $100 billion in 2022—that is, $350 billion over three years—roughly 5¼%, 4%, and 3¼%, respectively, below what they would have expected pre-COVID.

If the revenue losses are not that large, why has employment changed so much?

The decline in state and local employment appears to result at least in part from the need to socially distance during the pandemic. As schools went virtual in March and April, the need for bus drivers and cafeteria workers fell; declining enrollment in both K-12 and universities also meant that fewer staff were needed. (The V-shaped pattern in local education employment in the figure above reflect this—normally, bus drivers and cafeteria workers are laid off in the summer. In these seasonally-adjusted data, the early layoffs showed up as declines in the spring but increases in the summer.) Similarly, closure of parks and greatly reduced traffics on roads and at airports and ports reduced the need for staff.

Were tight budget conditions also a factor? Using the 2020 projected revenue losses (excluding losses at hospitals and institutions of higher education) and estimated federal aid by state allow an assessment of the degree to which employment declines are correlated with tight fiscal conditions. Findings suggest that local education employment declined more in states where large revenue declines were projected and less in states where federal aid as a share of own-source revenues was greater. These relationships are statistically significant and economically important as well—roughly 40% of the state and local workforce is in local education.

Does this mean that additional federal aid—like the $125 billion in the recent fiscal package—won’t increase state and local spending?

No. First, much of the aid is targeted to the entities that are most under stress—K-12 schools, health, transportation, and higher education. Second, even if the declines in employment outside of local education aren’t well explained by revenue shortfalls, that doesn’t mean that they are solely due to social distancing. It is quite likely that state and local governments—remembering the long, slow recovery from the Great Recession and the years of budget cutting—have been cautious in their spending even as their revenues come in stronger than expected. Increases in federal aid should provide the cushion that will allow these governments to increase spending without fear of future budget problems, which will help them provide essential services to taxpayers and also improve the overall economic recovery. Third, some state and local governments are clearly facing very difficult budget conditions—e.g. states reliant on tourism. In these locations the aid will help reduce the need for additional spending cuts.

Read the full blog and underlying analyses on website of The Brookings Institution:

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