I spoke with an sfgate.com reporter recently about how the COVID-19 crisis could impact Bay Area local governments. As always, there is a lot I said that didn’t make it into the article so here’s a bit longer ramble. I’m working on updating the numbers and data underlying these thoughts, so this is just some general concepts we should be thinking about.

How is this recession different from all other recessions?

The short answer is that every recession is different from every other recession—people (ahem, economists) tend to greatly overestimate our ability to predict how recessions and recoveries will unfold based on previous experience. The recovery from the Great Recession was quite different from previous recoveries (tl;dr: terrific stock market performance but very unsatisfying labor market performance from the perspective of workers).

People with far greater expertise in labor economics / macroeconomics have already discussed how this crisis may unfold, although I think we really are in some uncharted territory here. The key differences I see as relates to local government impacts include:

1. The impetus

The immediate trigger for the current slowdown is a public health order that has forced businesses across the economy to abruptly cease or reduce activity, regardless of their economic soundness. The Great Recession had several drivers, including inflated property values, complex financial instruments, stagnant wages suppressing actual consumer buying power, etc.—this all came to a head when financial markets famously collapsed in 2008, but many local governments had been seeing revenue slowdowns in the preceding months. In the current recession, the impetus is much more abrupt and steeper, although some of the underlying economic factors may impact the depth of recession and the recovery. The overall stagnation / decline of consumer power and labor market precarity is higher by some measures than before the Great Recession, but the immediate impetus for the slowdown is a public health order, which means that revenues will drop *very steeply* and that many businesses which were fundamentally sound and prospering in February will not exist in June or whenever the economy reopens. The consumer buying power that drove their revenues won’t have evaporated, but the businesses themselves simply won’t have the cash flow to stay alive. This all has implications for the timing of revenue losses and when / how we should expect to see revenues recover. (And of course, people work for those businesses, so the cycle of unemployment and business failure will repeat itself over the coming months.)

2. Uncertainty

All recessions bring uncertainty about when the end will come, what recovery will look like, how people and firms and governments will respond, and how those responses will weave together and feed off each other. In this case, the uncertainty is also driven by scientific uncertainty: how quickly a vaccine can be produced. These scientific and behavioral and social uncertainties add a level of complexity specific to this circumstance.

3. The spending impact:

In any recession, the biggest challenge governments face is declining revenues at a time when governments should be spending more money: on unemployment insurance, food aid, income supports, etc. COVID-19 has perhaps made this doubly true: we have unexpected costs managing a public health crisis, paying for scarce medical supplies, setting up temporary hospitals, closing up public parks, policing public health orders, housing vulnerable residents, along with all of the income support and other spending that accompanies an economic downturn. These spending imperatives to protect human life and health are atypical, and the federal government’s inaction (along with our complex healthcare system) make it very hard to estimate the total volume and distribution of this spending.

4. The role of geography:

In part because of the housing market’s relationship to the Great Recession, geographic impacts were fairly uneven, depending on economic diversity, fiscal structure, and other factors. Cities that had experienced huge growth driven by inflated property values (e.g. Las Vegas), and whose employment base was heavily concentrated in construction (e.g. California’s Central Valley) were hit particularly hard with unemployment and foreclosure rates (which translated into property values plummeting and unpaid taxes). Other cities rebounded much more quickly, including (famously) the Bay Area. The current crisis is nationalized to a much greater degree, although the impact of the virus itself may be more uneven, leading to divergent recovery rates. Economic diversity still matters a lot (can most of your businesses transition to work at home? Or is your town dominated by a meat supplier that just closed down?), but the impacts on workers and industries will be different than previous downturns, because they’re at least initially driven wholly by the public health emergency and the government’s determination of “essential” businesses and workers.

Which cities will be hit the hardest? Some of that is a public health question: New York City and State, if left on their own, would be the most devastated if current trajectories hold (obviously other viral waves will pop up in different places). We can expect that federal aid will mitigate some of that disparity, but perhaps not much of it. Some of that is an economic question—which businesses survive?—and some is a revenue mix question—which places were better prepared for a fiscal downturn? In the short term, cities that rely particularly on tourism-related revenue sources (e.g. San Francisco, as stated in the article) will see a steeper falloff in revenue. It would take some deeper analysis to predict which cities are most vulnerable in the long-term, but revenue mix and the ability of cities to adapt fiscally (i.e. by raising taxes, borrowing, or shifting money around) will matter a lot.

Here are some more detailed thoughts on a few of these items:

Revenue impacts

Local governments rely on several sources of revenue, some of which they control absolutely (e.g. revenue sources that are collected by local governments and absorbed into their general fund), some of which are locally-raised by earmarked (e.g. ”soda“ taxes), some of which are collected and redistributed by the state (e.g. property taxes), and then intergovernmental sources (state and federal funding – sometimes called “aid” but that’s a bit of a misnomer). Here’s how the revenue impacts may differ from previous recessions:

Sales taxes

Local governments are already experiencing an abrupt drop in sales tax revenues driven not (only) by reduced consumer power caused by income loss, but by the fact that people can’t leave home to spend their money, or are feeling hesitant about their economic prospects. Some households may not be reducing consumption much, but the spending may shift to different jurisdictions and activities. Others will postpone spending, and still many more households will simply not have as much to spend in the coming weeks and months because of lost income. Much of the essential spending consumers are still making is exempt from sales taxes. Much of the spending that isn’t happening now will never happen, so it’s safe to say that sales tax revenues for the 2019-20 fiscal year will be significantly below the projections on which budgets are based. Sales taxes also dropped quickly in the Great Recession (followed by income and property taxes, which are more time-lagged), but the drop-off was not nearly as steep as it is now. California relies heavily on sales taxes for state revenue, as do cities and counties (disproportionately when compared to other states, because they have so much less flexibility on property taxes).

Income taxes

We have seen unemployment numbers after just a few weeks exceed the numbers for an 18 month period in 2008-09, and there are predictions that the number of new unemployment claims will increase by as much as 25%. In California, the unemployment rate statewide and in our large cities hit about 12% over the Great Recession; we may see twice that rate by summer, although it may bounce back more quickly. These employment impacts have enormous implications for lost income tax revenues and huge federal and state expenditures on unemployment insurance (expenditures is my next post…). This is a compacted impact on income tax revenues that we haven’t seen before; some of that loss will be realized when taxes are filed in early 2021, but keep in mind that much of that income tax is withheld from paychecks every month—this means we can estimate some of the impact, but also that the state will realize that dip in its cash flow in the very immediate term. Predicting the total loss of state and federal revenue from income-based revenues alone will be a sobering task (and that also includes paycheck withholding for social security, state paid leave programs, etc.). States working on their 2020-21 fiscal year budgets will need to include that in the revenue projections they’re making now. Local governments need to plan for reduced state support and reduced state spending.

California’s income tax structure depends heavily on very very rich people having a lot of income. People have warned for years that this leaves California vulnerable to recessions and market downturns: we’re about to live that reality. The stock market could close 2020 as much as 10% below where it started; in fact, that seems all but certain. It’s unclear yet how the stock market impacts will differ from the patterns in the Great Recession, but it seems likely that many of California’s wealthiest taxpayers will have no capital gains in the 2020 tax year. Given the impact on businesses already, we can also expect that California’s corporations will be reporting much lower taxable incomes for all of calendar year 2020.

Property taxes

In the wake of the Great Recession, property tax revenues fell soon after sales and income taxes did, as the value of properties fell through reassessments or sales (commercial owners in particular are quick to demand reassessments downward); property transfer taxes, which Oakland and San Francisco both rely on heavily, fell much sooner and more steeply. Unlike property taxes, which are collected twice a year based on existing assessments (which means their decline takes longer to appear in city budgets), transfer taxes are paid at the time of sale. When the property markets froze up in 2008-09, those revenues fell immediately. We don’t know yet how COVID-19 will affect property values, although transactions have declined already, that could theoretically rebound when shelter in place orders are lifted.

The longer term impact on property values is less clear. Commercial real estate will likely be impacted far more, and more rapidly, than residential property, particularly in the Bay Area as restaurants and retailers go out of business and other companies reduce the amount of office space they need through teleworking. The distribution of property taxes in California is incredibly complex, but in general this will hit counties, special districts, and particularly school districts.

Fees and fines

Many local jurisdictions (cities, counties, and special districts) also rely on fees and fines extensively (license fees, transit fares, bridge tolls, court fines). These have plummeted very quickly for some entities (especially in transportation), and more slowly for others (court fines, license fees, construction permits). Some agencies can expect federal support until revenues rebound, but we can expect a slow climb back to normalcy depending on (1) the depth of overall economic decline (for which previous recessions may be informative) and (2) the effect of ongoing social distancing on things like commuting and public transit (more difficult to predict). The short version is: revenues will drop precipitously, and for some entities this will be catastrophic without aid.

Cash flow

There are other cash flow impacts beyond these differences in time frame. Governor Newsom announced a one-year reprieve for small businesses to pay sales taxes. State and federal income tax returns are now due July 15, rather than April 15. This means both refunds and payments are delayed (although filers expecting refunds may have filed earlier anyway). States and the federal government are able to manage cash flow issues much more than local governments; how Newsom manages the delay in sales taxes (much of which goes to city and county governments) remains unclear. The Federal Reserve announced last week a program to buy up short-term municipal debt for large cities (more on that in the next post).

There has been no postponement of the April deadline for property tax payments (and unlike income and sales taxes, property taxes are mostly paid in two lumps), but many counties will not collect late payment fines. Landlords who aren’t evicting tenants for lack of rent payments may not pay property taxes; homeowners who get mortgage payment breaks may also forego escrow payments. Of course, some of this happens during any recession, but again the abruptness and depth of the shutdown, along with the prohibition on eviction, will produce a different outcome.

Revenue mix and fiscal flexibility (aka fiscal policy space):

The reporter asked me specifically about California’s history of setting fiscal policy by proposition and whether that would hurt the state’s ability to adapt. The article highlights one issue: California’s reliance on capital gains taxes. I’m going to write about this in another post—I do want to emphasize that taxing the very wealthy proportionally is desirable, for many reasons. But designing tax structures that leave your state overly vulnerable to economic cycles (particularly to the stock market) exposes you to significant revenue volatility. (Not necessarily a bad strategy, as long as you bank the upswings in a reserve). Allowing voters to constrain your fiscal options is also undesirable: Proposition 13 constraints local autonomy, depresses the tax base, and creates enormous inequities between taxpayers. It’s one reason California is more dependent on the more cyclical sources of revenue (income and sales taxes). There are other propositions that constrain the state legislature’s spending options, reducing flexibility. 

State and city relationships

What happens at the local level will depend a lot on what the state and federal government do in the next few days, weeks, and months. On a webinar last week about the funding in the CARES act available to local and state governments, one of the presenters said: “Now is not the time to have arguments between city and state government.” This sentiment sounds great, but is very complicated in reality. I’ve written a lot about the dynamics between cities and states in times of fiscal crisis. We’re lucky in California that there is not a clear anti-urban bias at the state level: in fact our largest metro areas wield a great deal of power at the state level and the Bay Area has produced the two most recent governors (Jerry Brown was the mayor of Oakland; Gavin Newsom was the mayor of San Francisco). We don’t have the same ideological battles that have dominated Wisconsin and Michigan for example, or the many states whose legislatures have preempted local government policies such as minimum wages or paid sick leave.

That said, states often find it impossible to resist or avoid passing their own fiscal troubles onto cities. In the interview I said that Jerry Brown was hard core about making local governments absorb some of the state’s revenue losses; his elimination of redevelopment agencies* and other locally-controlled tax breaks was but one measure for doing that. It’s hard to know at this point what Newsom’s strategy will be.

After the Great Recession, we saw a resurgence of both municipal bankruptcies and of state control over municipal finances (through a variety of tools), Detroit being the most extreme example of both.

* The article says that Brown cut funding for redevelopment agencies; this simplifies things quite a bit—redevelopment agencies allowed local areas to capture tax revenue increases and use those funds for a variety of things. The state backfilled those revenues for counties and school districts, in part. Eliminating the redevelopment agencies saved the state a lot of money.

Reserves

In general, states and cities cannot deficit spend (unlike the federal government, which can borrow and/or print money to do so). But states and cities do have some flexibility in how they prepare for fiscal downturns. One of the biggest variations in state fiscal context is whether are permitted to accumulate surpluses, such as California’s rainy day funds. Many states and local governments built up higher reserves after the Great Recession, including California. This is likely to insulate California, and therefore California’s local governments, significantly more than other states.

School districts in California, on the other hand, are on the whole much worse off in terms of reserves than they were going into 2008. Most school districts are barely achieving the state-mandated 1-3% reserve 3-years-out (1% for larger districts), and have been deficit spending for several years. There is simply no capacity at the local district level to absorb a fiscal shortfall like this.

Next post(s):

I saved a few things for next time:

  • Debt and other obligations, including public pensions: this was a big part of the story in the Great Recession. What role will debt, municipal debt markets, and related entities play in the crisis and recovery?
  • Expenditures: obviously a big variable in whether any entity can withstand lost revenue is how much expenditures can be reduced. For many government entities, the ability to downsize spending is very limited, and the need to spend more (see above) may outweigh any discretionary spending cuts.
  • Federal stimulus: how does the federal government’s response in 2008 and after compare to the federal response to date?