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Fundamental Flaws to the Public Finance System are Revealed: Can Better Policies Fix Them?

Our grantees offer insights on what they have learned so far — and what policy makers should be doing next.

Public Finance Intern Joshua Laven contributed to this report.

The economic fallout of COVID-19 is fracturing state and local public finance systems along known fault lines.

Government budgets are being pushed to their limits in this historic economic downturn. People are staying at home because of shutdowns and fear of the pandemic, pushing consumer spending down over 2019 levels, 6.6 percent in March and 12.6 percent in April. Although spending is beginning to rebound, businesses have already had to shut down or lay off workers. These two issues have resulted in government revenues from business, income, and sales taxes declining dramatically while the need for services like unemployment insurance or added Medicaid spending are increasing. 

Our grantees’ work offers a snapshot of what we’ve learned about this crisis from April to June. The grantees have pivoted to respond to COVID-19 by weighing in on the consequences of the dual health and economic crises, assessing the policy responses to the crises, and providing insight into what should be done to ensure better fiscal sustainability in the future.

It is abundantly clear that states are going to struggle to provide the services that citizens need for added Medicaid spending, education, and greater unemployment insurance claims. The federal government took an important first step, but more will be necessary. What we need is at least one economic relief package that will focus on state and local governments to ensure that cities and states can better cope with the crisis while managing important services. 

Fundamental flaws uncovered

The pandemic has highlighted fundamental flaws in the public finance system, devastating government revenues and harming public programs like Social Security and public pension funds. The Center on Budget and Policy Priorities produced multiple reports describing the budget shortfalls of states due to COVID-19 and are expecting average budget deficits of more than 10 percent this year and 25 percent in fiscal year 2021. The report also notes that states’ initial revenue projections are but a first look at some of the damage the pandemic-induced downturn could cause to state budgets. State budgets currently do not reflect states’ increased costs from fighting the virus and from rising demand for state services. As the pandemic evolves, revenue projections will continue to fall, maybe as much as in the Great Recession. Already New York and Colorado project revenue drops of 17 percent or more this year if the recession is deep.

Average state budget deficits expected in 2020 Source
Average state budget deficits expected in 2021 Source

Arnold Ventures and our grantees have noted that the absence of additional federal aid will lead to drastic spending cuts and layoffs of public employees. For public pensions, the Pew Charitable Trusts published a piece describing the ways a pandemic-induced market downturn could affect public pension funds. The Reason Foundation urged policymakers to use lessons from the COVID pandemic to make pension systems more resilient in the face of unexpected events. With an eye toward the future they published answers to FAQs regarding the pandemic’s effects on the public pension system. This crisis is also highlighting the widening racial and social inequities inherent in our government system.

Policy response

Grantees agree that the immediate federal government response via the CARES Act was necessary and important relief to stem the economic downturn. Experts at the Penn Wharton Budget Model estimate that the $2.3 trillion plan dampened the fall of second quarter GDP by 7 percent and will produce around 1.5 million additional jobs by the third quarter. Some, however, argued the response was not enough, and more needs to be done on unemployment insurance, state and local assistance, and added protections for homeowners and renters.

What’s next?

While steps have been taken the last three months, the work of our grantees shows how much there is left to do both to respond to the current crisis and better prepare for the next one. Our grantees laid out a range of ways that we can be better prepared in the future, including improving the social safety net, strengthening reserve policies, or putting together additional ways that the federal government can respond. 

As the country is roiled by the COVID-19 crisis, researchers at the Urban Institute argue that the pandemic demonstrates the need for a more robust paid medical leave policy among many policies needed to ensure better protection for citizens. Urban’s research found that access to paid medical leave is uneven and substantial unmet needs exist for the country’s most vulnerable workers. For low-income workers, taking weeks of leave to address health conditions without wage replacement would be very difficult or even financially catastrophic. Expansion of this benefit to all workers could have beneficial economic outcomes by reducing income volatility, helping workers to return to employment after taking leave, and supporting greater labor supply and long-term labor force participation. 

One option discussed as a response to COVID-19 is a payroll tax cut. CBPP lays out why payroll tax cuts are not the appropriate form of COVID-19 relief. A payroll tax cut would mostly help high earners, doesn’t do anything about consumer demand — which is the key problem of this economic downturn — and wouldn’t help those without jobs. In the next quarter, watch for robust discussions about response options beyond they payroll tax cut.

Analysts at the Tax Policy Center are also looking ahead to the likely fourth relief package, providing actionable next steps the government should consider. As a start they recommend continuing economic relief for those who need it until the disease is under control; strengthening the social safety net through expanded Medicaid coverage, as permitted by the Affordable Care Act; supporting state and local governments through additional cash infusions to help address impending and massive revenue loss; and assisting homeowners and renters with additional forbearance for private mortgages and rental payments on privately held properties.

While there is a great deal of uncertainty, our grantees have provided a roadmap for changes that will lay the groundwork not only for recovery, but also for a more secure government going forward.