Fiscal Effects of COVID-19

Source: Alan Auerbach, Bill Gale, Byron Lutz, Louise Sheiner, The Brookings Institution, Brookings Papers on Economic Activity, BPEA Conference Drafts, September 24, 2020

The COVID-19 pandemic and the associated policy responses have had a significant impact on government budgets. Federal spending has skyrocketed. State and local governments, almost all of which face some form of annual balanced budget rule, confront fiscalshocks on both the revenue and spending sides that threaten to make the recession deeper and slow the recovery. This paper examines the impact of COVID on the fiscal status of the federal government and the states.

Section II provides new projections ofthe federal budget outlook, with five main results. First, we document that the pandemic and the policy responses to it rapidly and substantially raised federal deficits, but only on a temporary basis. Spending and revenue are projected to return to pre-COVID baseline values relatively quickly. Second, the long-term fiscal outlook through 2050 has deteriorated somewhat. Under the Congressional Budget Office’s (CBO 2020f) assumptions for GDP growth and interest rates, we project that the debt-to-GDP ratio, currently 98 percent, will rise to 190 percent in 2050 under current law, compared to a pre-COVID baseline projection of 180 percent. CBO (2020f) obtains a similar projection – 195 percent –using a slightly different set of assumptions.

Third, although the economic downturn and COVID-related legislation raise debt permanently, sharply lower projections of interest rates for the next dozen years help moderate future debt accumulation. Nevertheless, even during the period when interest rates are projected to be low, the projected debt-to-GDP ratio rises steadily due to substantial and rising primary deficits, driven largely by rising outlays on health-related programs and Social Security. As the economy grows and debt accumulates, interest rates are projected to rise and to exceed the nominal GDP growth rate by increasing amounts starting in the early 2040s.

Fourth, under a “current policy” projection that allows temporary tax provisions –such as those in the Tax Cut and Jobs Act of 2017 –to be made permanent, the debt-to-GDP ratio would rise to 222 percent by 2050 and would continuing rising thereafter. Fifth, the long-term projections are sensitive to interest rates. If interest rates remain low (that is, at their projected level for 2025), rather than rising as in the CBO projections, the debt-to-GDP ratio would equal157percent in 2050 under current policy.

We discuss several aspects of these results – including how the current episode compares to past debt changes, the role of historically low interest rates, and recent Federal Reserve Board policies. Because of the macro-stabilization effects of fiscal tightening, and because low interest rates create “breathing room” for fiscal policy, we do not see the large, short-run debt accumulation resulting from the current pandemic as necessitating any immediate offsetting response. But the long-term projections show that significant fiscal imbalances remain and will eventually require attention.

Section III discuss the effects on state and local governments. We examine several recent estimates of the effects of the pandemic on state and local budgets — some of which find relatively modest effects and others which find effects that dwarf those experienced during the Great Recession. We note that the very unusual nature of the current recession meansthat relying on the historical relationships between the state of the economy and state and local tax revenues may produce misleading results. We instead attempt to calculate the impact on state and local government using a “bottom-up” approach that accounts for the geographic variation in the distribution of unemployment and consumption declines, the fact that low-wage workers have been particularly hard hit this recession while higher-income workers have been much less affected, and the fact that the stock market has not responded to the economic downturn as it has in the past.

Our findings suggest that this pandemic is indeed having very unusual effects on state and local revenues. We estimate far smaller income tax losses than would have been expected on the basis of historical experience, which we attribute to the fact that employment losses have been unusually concentrated on low-wage workers, the unprecedented increases and expansions of unemployment insurance benefits and business loans, which will shore up taxable income in 2020, and the fact that the stock market has held up so far, unlike most of the prior economic downturns. On the other hand, our estimates of the losses in sales and other taxes and fees are much larger than one would have expected—the decline in use of transportation services alone seems likely to depress revenues by over $45 billion this year. In aggregate, we estimate that state and local own source revenues, excluding fees to public hospitals and institution of higher education — which we view as somewhat distinct —will decline $155 billion in 2020, $167 billion in 2021, and $145 billion in 2022. Including lower fees to hospitals and higher ed would bring these totals to $188 billion, $189 billion, and $167 billion.

We then turn to a discussion of federal aid. We estimate that the legislation enacted last spring provides about $212 billion in aid to state and local governments, excluding aid to public hospitals and higher ed, and $250 billion including that aid. While this appears to be larger than the total revenue declines expected thisyear, that doesn’t mean that the aid has been sufficient to preclude tough budget choices and poor macroeconomic outcomes. First, should the economy remain below its pre-COVID baseline for many years, as the CBO projections suggest, these governments will face significant shortfalls in coming years. Knowing that, they are likely to restrain spending somewhat this year, and make additional cuts in coming years. Second, the pandemic itself has likely increased the demands on state and local governments—for public health spending, virtual schooling, help for the elderly, etc. Simply maintaining pre-COVID levels of spending may not be enough to assure that necessary services aren’t cut. Finally, our analysis shows that smaller states got much more generous aid relative to their losses, and that states like New York and California will likely be facing budget shortfalls in the current year even without consideration of the spending demands brought on by COVID-19.

Section IV provides concluding remarks.

Related:
State and Local Fiscal Conditions and COVID-19: Lessons from the Great Recession and Current Projections
Source: Congressional Research Service, CRS INSIGHT, IN11394, Updated July 8, 2020

Without Another Massive Federal Stimulus, State and Local Governments Will Face Brutal Austerity
Source: Colin Gordon, Jacobin, November 10, 2020

States Grappling With Hit to Tax Collections
Source: Center on Budget and Policy Priorities, November 6, 2020