COVID-19 Fiscal Impacts: What can we expect?

Published May 14, 2020 as part of the UC Berkeley Labor Center’s Covid-19 Series: Resources, Data, and Analysis for California.

The economic consequences of the COVID-19 pandemic have been severe: at least 30 million people have lost their jobs and millions of others have seen their incomes decline. Governments are spending billions of dollars on public health and the safety net. As state and local governments grapple with the revenue loss and spending increases associated with the pandemic, the specter of significant cuts in public spending threatens the livelihoods and employment of public sector workers in a second wave of economic contraction. State and local governments will need an estimated $1 trillion to avoid massive cuts, according to the federal government’s own economic projections.

On May 14, the Governor of California released his revised budget proposal for 2020-21 projecting a revenue decline of 22.3% and a $54.3 billion shortfall. Many cities, counties, and school districts have already begun budgeting for the coming fiscal year and face similar deficits. How will these fiscal impacts affect California’s economic recovery?

In this post we examine the likely impacts of the pandemic on local budgets, the factors still unknown, and the principles that must guide California’s response to this ongoing crisis.

The Factors Shaping Local Budgets

The timing and severity of the fiscal impacts from COVID-19 on local governments will depend on several factors that are difficult to estimate, adding significant uncertainty to the local budgeting process:

• The public health crisis will drive both public health expenditures and the length of economic shutdown; its evolution will depend on the development of treatments and vaccines, testing capacity, and the behavior of the virus in coming months. California’s reopening roadmap will guide county modifications to stay at home orders.
• The long-term economic effects of the pandemic: business survival and reemployment rates, consumer purchasing power, individual and corporate debt burdens, and many other factors will shape the economic recovery. Many experts have dismissed the possibility that the economy will completely bounce back in a “V-shaped” recession: a short and sharp shock followed by a return to previous levels of employment and economic growth. Instead a U or L-shaped recovery looks more likely.
• Federal aid to state and local governments: this could take the form of direct allocations, lending, increased categorical funding (e.g. for medicaid or education), or other means. The CARES Act funding for state and local governments is only the beginning of what’s needed. The California Legislative Analyst’s Office (LAO) has analyzed COVID-19 funds flowing to the state. Democratic policymakers have proposed $1 trillion in federal aid to state and local governments.
• The California state budget: the legislature must adopt a budget by June 15, 2020, but given revenue uncertainty this will likely be a “baseline budget” for 2020-21, with possible revisions in August after sales and income tax revenues are fully known. The Governor’s budget proposal of May 14 includes significant program cuts, 10% pay decrease for state workers, some new revenue sources (including temporary suspension of some tax breaks), as well as borrowing and drawing on reserves. It will take several months to know the impacts of the state’s budget on local governments, the number of public jobs and income of public workers.
• Finally, state and local policy choices made in the coming weeks and months will determine whether the public sector helps California’s economy recover or holds it back. After the Great Recession, California’s public sector lagged the private sector in job recovery, creating a drag on the economy and exacerbating poverty and inequality. Fiscal policy that invests in the public sector—rather than cutting services and jobs—will be important for the state’s long-term recovery, particularly given the importance of public health infrastructure to permit reopening of businesses, schools, and other facilities.

How California Revenues will be Affected

The LAO publishes a comprehensive guide on California’s tax system. Here are some basics about how different jurisdictions are funded: 

• California’s state revenues come from personal income taxes (67%), sales and use taxes (18.4%), corporate income taxes (10.4%), and other sources (fees etc.; 4.2%). (2020-21 proposed budget). Half of California’s personal income tax revenue comes from the top 1% of earners.
• Cities rely on sales and use taxes, gross receipts taxes, property taxes (including property transfer taxes), business license taxes, hotel taxes, and utility user taxes. Cities can also levy parcel taxes for specific purposes.
• Counties: the bulk of county programs are funded by intergovernmental revenues including state and federal funds. Local sales and use taxes, vehicle license fees and property taxes are the primary sources of funding for programs that are not funded by state or federal funding sources (although these programs may be governed by state mandates even if locally-funded).
• School districts receive most of their funding from the state budget (58%), local property taxes (22%), other local funding (including parcel taxes; 10%), federal funding (9%), and state lottery proceeds (1%). Most districts receive a calculation of revenues from the Local Control Funding Formula (LCFF) which is partially need-based. The amount the state distributes through LCFF depends on the state’s overall budget (Prop 98 guarantees schools a percentage of the state budget). The state also provides districts with earmarked funds for specific activities (e.g. special education) based on need. Federal funding is also need based. A small number of “Basic aid districts” are funded entirely from local revenues, with limited supplemental funding from the state and federal sources. The Governor’s May budget includes a 10% cut in LCFF funding, with some preservation of special education categorical funding.
• Special districts typically rely on service-based revenue streams (e.g. bus fares, bridge tolls), but some (e.g. fire and hospital districts) may get a share of property taxes.
• Higher education receives state funding, fees for tuition and student services, and some federal funding. UC is the most dependent on tuition and fees; community colleges receive more state support per student, similar to K-12. UC and CSU are particularly dependent on revenues associated with student activity: housing revenues, meals, athletic events, and parking.
  

Here’s how these different revenue sources have been or will be affected by the pandemic: 

• Consumer purchases have fallen sharply because of lost income and shelter in place orders—sales tax revenues will fall sharply for the 3rd and 4th quarters of fiscal year 2019-20, continuing into 2020-21. There is a time lag between when businesses collect sales taxes and when they send those funds to the state, so we don’t have clear estimates yet. The Governor also gave small businesses a 12 month grace period to send taxes of $50,000 or less. The nature of this public crisis—with mandated business closures—may result in more dramatic suppression of consumption than in previous recessions, particularly for certain retail sectors such as restaurants. For example:
  • Los Angeles County projects $1 billion in lost sales tax revenue through June 30, with another $1 billion lost in 2020-21.
  • UC Davis estimates that gasoline sales tax revenues have fallen 75% a week, as gas prices fell and driving ground to a halt.
  • California personal and corporate income taxes for 2020 will be significantly lower than the state’s original projections due to widespread job and income loss. The Congressional Budget Office projects 14% unemployment in the second quarter of 2020, and a 12% decline in GDP. 2019 income tax revenue will not be affected, but because the state delayed filing from April 15 to July 15, income tax revenues cannot be accurately projected until after state and local budgets for 2020-21 have been adopted. We have already seen a decline in payroll tax collections. California’s reliance on taxes on the highest income earners and capital gains will cause a steeper drop in income tax revenues than other states if the financial markets close significantly lower in 2020. Recovery of income tax revenue will be driven by the economy; income tax collections typically recover more slowly than sales taxes.
  • We have already seen enormous drops in tourism-related revenues—such as car rental excise taxes and transient occupancy taxes. Some of these revenues will remain at nearly zero while hotels are closed and nonessential travel generally prohibited. For example:
    • San Francisco projects a 32% drop in hotel taxes for FY 2019-20
    • San Diego projects a 14% drop in transient occupancy taxes in FY 2020-21
    • Reduced economic activity will cause declines in income from fines and fees (e.g. new businesses opening, new licenses, construction permits, bridge tolls, etc.). This is particularly affecting revenues tied to transportation—parking tickets, bridge tolls, gas taxes, transit fares. This drop will last through shelter in place orders, with recovery dependent on the nature of returning to work and broader economic recovery.
    • There has been no delay in property taxes due April 10, On May 6 Governor Newsom issued an executive order that suspends until May 2021 the ability of county assessors to levy late fees for property tax payments. Reduction in the number of property transactions will drive a drop in property transfer taxes, at least temporarily. A lengthy recession (which most local governments are treating as a worst-case scenario) could reduce property values (which we are already seeing in the commercial rental market), sparking downward assessments and reductions in sales prices.
    • Lost revenues for governmental activities that are self-sustaining in normal times (e.g. after school care, school meal programs, and collegiate athletics) will create shortfalls that must be covered by general funds.

    Expenditure impacts

    All recessions are accompanied by increasing demand for safety net expenditures; this crisis is no exception, although the magnitude of need has already outpaced the Great Recession. The pace of job loss is much faster and the number of unemployed significantly higher.

    Equally important, unlike previous recessions, the pandemic has increased the need for high levels of spending on public health, housing, and other measures to prevent virus spread. CSU reported $50 million in COVID-19 related expenditures as of May 12; California projected $7 billion in such spending through June 30.

    Throughout 2020-21, the additional cost of providing public services—everything from transit to K-12 education—while complying with public health directives will be significant. Only some of these expenditures will be offset by federal relief. The state is also spending significant amounts of money on Unemployment Insurance (UI) benefits and MediCal as people lose their jobs and health insurance, although both programs have their own funding structures separate from the state’s general fund.

    The contributions that local governments are required to make to public pension plans may also increase if investment returns fall short of targets. As of March 31, CalPERS returns were at -4.1% for the fiscal year, well off from its 7% target for the fiscal year (this predates the April and May market rally, so it’s possible some of that loss will be recovered). Jurisdictions with their own plans may also face increases in annual required contributions. School districts already faced ongoing increases in state-mandated contributions to CalSTERS.

    Reserves

    California will enter the 2020-21 budget year with an estimated $20 billion in rainy day reserves. School districts are required by state law to demonstrate minimum reserves, but actual reserve levels vary widely; large districts typically have well under 10%. Cities and counties adopt their own reserve policies. Many local governments are entering this downturn with greater reserves than the last recession, although school districts and some cities were already significantly fiscally stressed before COVID-19.

    General fund reserves can help jurisdictions bridge revenue shortfalls and emergency expenditures, but will be quickly exhausted if local governments do not receive external funding. Local jurisdictions will likely be exploring ways to access or borrow against restricted funds and reserve balances as the crisis wears on.

    Borrowing

    Local governments generally cannot engage in long-term borrowing for operating expenditures (most debt that governments carry is related to capital expenditures approved by voters). While state and municipal governments are not generally permitted to borrow for operating expenses, local governments (particularly larger units) often carry short term debt—revenue anticipation notes (RANs) or revenue anticipation warrants (RAWs)—to cover cash flow when revenues lag expenditure needs. More units will need this ability with state delays in tax collection and distribution. The Federal Reserve announced its willingness to purchase short-term debt for states and large cities as a means to ensure access to capital markets.

    Unlike the Great Recession, financial markets have not collapsed, so we are not seeing the debt-related problems that faced local governments in 2008-09, although some governments will see borrowing costs increase if their credit ratings are downgraded. Moody’s has already downgraded one California school district and the City of Sacramento.

    School districts can borrow against future revenues from county boards of education, which will be necessary for some districts as the state has delayed its June apportionment payment until July, straining districts with low reserves.

    Principles for Responding to Fiscal Crisis

    There is still much unknown about how state and local budgets will be affected by the COVID-19 crisis in the next year and until we achieve a full recovery. In the short-term, local policymakers have limited tools for raising revenues, although borrowing and accessing reserves and other local assets may help bridge budget shortfalls. State policymakers have more flexibility in terms of revenue measures and access to capital.

    The recovery from the Great Recession, a decade after its official end, was incomplete and inequitable. Although unemployment was low and the stock market setting records, incomes had been stagnant for most workers, employment was part-time and precarious for many, inequality was widening rapidly, and public service levels were significantly below 2007 and 2000, the years before our two previous recessions.

    As we consider the impact of fiscal shortfalls on the California economy, four key principles must guide the state’s response:

    1. Provide additional federal aid to states and local governments. There simply is not sufficient fiscal capacity in the states to maintain services without federal aid. The CBPP estimates that states face $650 billion in lost revenues over the next three years. Governor Newsom has said that $1 trillion in federal aid to states is needed. The federal government must use its ability to borrow and deficit spend in order to stave off catastrophe for our state and local public sectors. The Democratic proposal made May 12—the HEROES Act—could provide the level of economic stimulus needed to avoid a severe depression and dire economic consequences for American households.
    2. Restructure state and local revenues to provide more equitable and stable funding. Many essential state functions were severely underfunded going into this recession, and experts have long agreed that California’s tax structure is volatile and full of tax breaks that benefit those most likely to maintain prosperity through this crisis. A measure on the November 2020 ballot would phase-in a return of market-rate assessments for commercial property taxes, with funding to go entirely to local governments and K-14 education. States may want to consider progressive wealth taxes or improving taxation of multinational corporations.
    3. Build a robust public health infrastructure. Our economy’s ability to reopen and rebound will depend on a public health system capable of testing Californians, tracing contacts, isolating outbreaks, and housing and treating those who lack adequate healthcare. A federal jobs program approach to public health (which California is likely to attempt in part) could provide much-needed economic stimulus.
    4. Find ways to avoid the public sector job losses of the Great Recession. California should not repeat the mistake of allowing cuts to the public sector to drag down the economic recovery. Public sector jobs have been a pathway to the middle class for African-Americans and women in particular. Public jobs are an important source of stability for many communities, especially those already hit hard by this pandemic. Low-wage workers are especially reliant on public services such as transportation, child care, and public school programs, and will suffer if those services are cut. Preserving public jobs—through job sharing, new revenue sources, borrowing against public assets, and targeted salary reductions instead of across-the-board cuts—is a crucial piece of the economic recovery puzzle.