What Happens Without More Aid to States and Local Governments?

June 8, 2020

By Dan White, Director of Public Sector Research at Moody’s Analytics

State and local government policymakers are facing the most challenging budget environment in at least a generation. The good news is that states and local governments as a whole are better prepared to weather a normal recession than they’ve ever been. The bad news is that this is no average recession.

The baseline economic outlook calls for a GDP decline more than twice the magnitude of the Great Recession, but what level of federal help will be coming remains very much up in the air. In the meantime, revenues are falling precipitously, and social services spending is accelerating at a record pace across the country.

Dealing with this level of fiscal shock is something that few state and local governments are prepared for. That is not an indictment of most state and local fiscal practices but is instead a testament to the sheer magnitude of the current crisis. Many governments who have been exceptionally prudent will still need to make some very difficult fiscal decisions in the months ahead.

The reason being that state and local budgeting, unlike at the federal level, is a zero-sum game. Budgets must balance, and for all practical purposes states and local governments are forbidden from borrowing across fiscal years for operational purposes. There is no Plan-B. The federal government has the ability to smooth out business cycles through the use of debt, states and local governments do not.

As a result, some devastating fiscal actions will need to be taken without additional aid from the federal government.

How devastating? Assuming that states receive no more assistance from the federal government, our Moody’s Analytics’ stress tests estimate that state governments will need to cut spending or raise revenues by approximately $200 billion through June of 2021. Accounting for similar actions that will need to be taken at the local government level conservatively raises that estimate to roughly $300 billion.

Based on past recessions, we have previously estimated an economic multiplier on state and local government aid during a re-cession of 1.39, giving an overall economic impact of more than $415 billion over the next year . For context, that represents 2.1 percentage points off of national GDP and roughly three million jobs.

Some regional impacts would be much worse, however, reflecting a state’s expected level of fiscal shock and its preparedness. States such as Louisiana, New York, and New Jersey, where the impacts of COVID-19 are plentiful and budget reserves are scarce, spending cuts and their economic consequences will be most significant. 

However, even in states with much lower COVID exposure and who have diligently prepared for the next budget adjustments will still shave a full percentage point or more off of their gross state product. 

This highlights the fact that without more flexible federal aid to states and local governments, above and beyond the restricted COVID specific relief provided so far, the eventual economic recovery will be much slower all across the country.

Once we accept this reality, two key questions need to be answered.

How much do states and local governments really need? There are many estimates of potential shortfalls floating around due to the unprecedented uncertainty in the economic outlook. Most of these estimates, including those accounted for in the House’s latest stimulus proposal, are much larger than what our stress testing exercises project. Based on our modeling, states and local governments need additional flexible aid of approximately $500 billion to make it through the next two fiscal years without having to make crippling budget cuts or tax increases.

How quickly does new legislation need to be passed? As soon as legislatively possible. State officials are already grappling with how to close out the current fiscal year, ending June 30th for most. Then they must cope with new revenue forecasts and likely convene special legislative sessions in late-summer and early fall to address shortfalls for fiscal 2021. The longer they fly blind on how much federal aid will ultimately be available, the more conservative their decision making will have be, to the detriment of the entire U.S. economy.