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Q&A

The Trillion-Dollar Problem Facing States

A conversation with Kim Rueben of the Urban-Brookings Tax Policy Center on making sense of state budgets during the New Recession.

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State budgets are in their worst shape in nearly a century. Revenues have fallen roughly 25 percent below expectations, forcing states to cut spending by hundreds of billions of dollars. Although the situation is clearly bad, what policymakers can do about it remains uncertain, since the coronavirus pandemic — far from over — continues to reshape economic conditions.

To get a sense of how revenue forecasters are trying to keep on top of this, we spoke with Kim Rueben, Director of the State and Local Finance Initiative at the Urban-Brookings Tax Policy Center. Rueben's interest in public finance was sparked the moment she found out as a junior high student in New York that the city’s near-insolvency meant her favorite programs got cut. She’s been fighting for fair and creative solutions ever since.

Headshot of Arnold Ventures
Arnold Ventures

Why has the pandemic been so catastrophic for state budgets?

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Kim Rueben

The problem is we haven’t ever seen anything like this, where we’ve closed large portions of our economy. We’ve seen state revenues plummet as a result. Most states were actually expecting pretty big increases in their revenues. For three years in a row, they had actual revenues that exceeded forecasted revenues. Instead they’re now seeing, on average, 10 percent revenue declines already this year, and up to 25 percent declines in revenue forecasts for the new fiscal year that begins on July 1.

The part that gets really hard is that states mainly rely on sales and income tax revenues that are very procyclical, which means they increase when the economy’s doing well and decrease when the economy falls. With oil and natural gas prices down, states that rely on extraction taxes are also being badly hit.

Headshot of Arnold Ventures
Arnold Ventures

Talk a little about what the impact of all this revenue loss might be.

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Kim Rueben

The demand on services states provide don’t decline when revenues fall. In fact, they often have to spend more money on services like Medicaid. We’re seeing states reopen and employment improve, but we don’t know how long the aftermath from the shutdowns are going to last. If federal aid isn’t forthcoming, less revenue means less spending and less state and local workers.

It probably means bigger classes in schools and fewer elective classes or extracurricular activities, cuts in social welfare, more potholes going unfilled, and government offices that provide services like renewing driver's licenses being open less often. Already, Louisiana, Maine, and Michigan have public employment levels at 30-year lows. And every state had public employment lower this May than it was last May. If this turns out to be a V-shaped recovery, returning to growth quickly, it might not be so bad — but not so bad means half-trillion-dollar shortfalls for state and local governments. If the recovery is really slow, or we have a double-dip recession, then we could be looking at a trillion-dollar shortfall or more over three years.

Headshot of Arnold Ventures
Arnold Ventures

On top of the economic woes, states are having to wait to find out whether there will be additional help from Washington. They also had to approve fiscal 2021 budgets without knowing what their income tax collections will look like, since filing deadlines were put off until July 15. How do you plan for the future in a situation like this?

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Kim Rueben

It’s impossible. In a normal year, revenue estimators say there’s so much uncertainty, since they don’t know what federal policy is going to be and what that means for their tax policies. After all, state income tax systems often piggy-back on the federal system.

All those conversations are just swamped by where we are right now. I don’t expect this recession to last as long as the Great Recession, but the timing is just truly terrible. Right now, we have states like California and New York that have budgets with billions of dollars in planned cuts, but they say they’ll restore program funding if they get federal money.

It defies logic that the federal government won’t supply aid. If we learned anything from the Great Recession, it’s that not giving aid to state and local government makes it harder to restore the economy. But at this point, places need to assume they’re not going to get that money from Washington in a timely fashion.

Headshot of Arnold Ventures
Arnold Ventures

You mentioned there’s lots of uncertainty about estimating revenue. How do states predict how much tax money they’ll collect each year?

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Kim Rueben

Often, they start with their budget from a year before. As the economic picture changes, they have to revise their estimates. That’s why we’ve seen so many states go from projected surpluses to big shortfalls.

The federal tax changes in 2017 actually resulted in a lot of states collecting more money from income taxes, due to formula changes. And the Supreme Court’s decision in the Wayfair case in 2018 allows states to collect taxes from online sales. All that helps. States went into the pandemic, collectively, with record reserves. But as states have been doing post-COVID forecasts, they’ve just been slashing their numbers. We’re seeing virtually every state revising down their revenue forecasts.

Headshot of Arnold Ventures
Arnold Ventures

You’ve done studies about states with balanced-budget requirements or legal limits on raising tax rates. How will those rules affect their current circumstances?

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Kim Rueben

It makes it harder. Unlike the federal government, revenues coming in have to equal spending going out — states with stricter rules have to either make larger cuts or increase taxes more when faced with unexpected shortfalls. States face a perennial problem where revenue collections look like a rollercoaster going up and down with the economy, while spending looks like an ever-escalating line.

Some states do what is effectively deficit financing: borrowing more through the bond market. They might push spending costs, on paper, into the next fiscal year. My thinking on this has evolved over time, where I now see the benefit of borrowing from other funds in the short term to help maintain service levels. For states that have been responsible, doing a certain amount of shifting of revenues doesn’t seem like a bad idea right now.

Given the level of uncertainty about what is going to happen with the pandemic and the economy, policymakers need to be conservative, but they also need to think about what services are vital right now, such as public health and hospitals, and protect them in a way that might be different than what we’ve seen in the past.

Headshot of Arnold Ventures
Arnold Ventures

You’ve had the chance to work closely with revenue forecasters in Colorado, Kansas and other states. What advice do you have for finance directors, comptrollers, and treasurers around the country?

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Kim Rueben

There are no easy answers. Right now, the part that’s really tough for states is that we just really have no idea what the recovery is going to look like. We’re trying to give information to folks to make good estimates, but they’re going to need to keep a bigger range of possible outcomes in their minds.

Mostly, they’re being pretty conservative and states are checking with each other. If they have to make cuts, they have to figure out how to do that in the least disruptive way possible right now.