Deschenaux and Meyers: How COVID Affects the Budget and How We Can Prepare for Future Shocks

Photo by Alexander Schimmeck on Unsplash

The COVID pandemic has presented us with a string of important medical questions to which we initially had no answers, such as: How contagious is the disease? And which therapies might prevent deaths? We are still uncertain about when a safe and effective vaccine will be widely distributed enough to allow a return to economic and social normality. All this uncertainty has affected and will affect Maryland’s budget.

After we learned that COVID is especially contagious, we took a series of dramatic steps to reduce cases, starting with an unprecedented shutdown of economic activity. This pandemic was guaranteed to hurt  the state’s fiscal position, in part because we had to make unanticipated purchases of medical supplies, but most importantly by reducing revenues.

It would be great if the state’s deservedly-respected tax experts could accurately project that revenue decline — but that task is extraordinarily difficult because of the unprecedented nature of the pandemic. If the revenue losses turn out to be very large, they will greatly exceed what the state saved in the cash balance of the general fund and in the “rainy day fund” (technically known as the Revenue Stabilization Account). Because Maryland must balance its operating budget, deficits that can’t be closed by drawing down savings must result in spending cuts and/or revenue increases. Many people are now worrying, and rightly so, about upcoming cuts.

In May, the Bureau of Revenue Estimates provided its first guess at the magnitude of the problem.  “Grim” would be an understatement of that outlook. Under a pessimistic scenario of economic decline, general fund revenues were projected to decline over several years by almost 12% from their peak ― about as large as that experienced during the Great Recession of the last decade, which led to large cuts to many government programs.

In response, Governor Lawrence J. Hogan Jr. proposed to cut the fiscal year 2021 budget by $672 million. After opposition from state employees and others, who said the proposed savings were premature (and we agree), the Board of Public Works cut the general fund by $395 million, with the University System of Maryland taking the largest hit.

Not as bad as we thought?

But as we have moved into the fall, it appears that the budget problem might be less worrisome. The fiscal year that ended June 30, which was impacted for its last quarter by the virus, saw an unexpectedly small revenue loss of roughly $100 million, only a half a percent, with the personal income tax beating the estimate by 1. In contrast, the sales tax was off the estimate by 6.4% or $317 million.

This pattern of collections may tell us something about our new fiscal landscape. In a recent report, the Brookings Institution concluded that for the nation as a whole, the income effects of the pandemic are less dire than originally feared. The reasons, however, are not especially benign or insignificant.

The most important economic impact of the pandemic is that many consumers are scared to engage in normal commerce outside the home. While sales tax revenues from online commerce have increased, the declines from in-person sales have been greater. This effect is most evident in Maryland’s revenues from casinos — a decline over 40% from the prior year — which reduces financing for the Education Trust Fund. And although the numbers are not yet publicly available, with people spending more time at home, we should expect a large decline in the Transportation Trust Fund.

The pandemic economy has most hurt the workers earning the least. In Maryland, job losses have been greatest in the hotel, restaurant, entertainment, and recreation sectors. Hospitals and health care workers were also hit hard as elective care was vastly reduced. While the impact was mitigated by spending from the federal CARES Act, since President Trump and Congress have taken so long to renew such relief even though the need is still great, what will happen to the economy and to Maryland’s revenues?

Last week the Board of Revenue Estimates released its preliminary forecast, which will be adjusted in the December annual estimate. It projects a general fund revenue loss of $672 million for the current fiscal year (FY2021), a far lesser impact than was feared in the spring. Compared to previously projected levels, the following fiscal year’s revenues (for FY 2022) will be light by about $365 million. Not too bad at all, you might think.

However, the forecast assumes another sizable federal relief bill and no renewed shutdowns of businesses. The latter assumption may be particularly optimistic, according to epidemiologists’ warnings that the winter could see a large increase in cases. So we are clearly not out of the woods. (When accepting the September forecast the Board also asked staff to prepare a less sunny scenario, which is forthcoming.)

Can we rely on the “Rainy Day Fund” to close the remaining deficit?

But revenues are only part of the budget equation. Next come cash balances and expenditures.

On paper, the current fiscal year will start with a sizeable cushion, a general fund balance of $585 million. Over $462 million of that was squeezed out of the FY 2020 budget: $120 million in spending reduced by the Board of Public Works in June, and another $342 million when CARES Act funding was swapped for state funds when the fiscal 2020 was closed out. The rest comes primarily from the balance built into the current year budget. This makes sense: rainy day funds should be used when it pours.

Starting with that big carryforward balance the numbers for fiscal 2021 (the current fiscal year), look pretty good. Also helpful is the potential for reducing as much as $600 million of state spending by substituting remaining CARES Act funds for  those expenses. As a result, even though the revenue estimate was written down by $672 million , the fiscal year could end with a fund balance of $500 million or so.

Following the math through to fiscal 2022, a $500 million balance will more than offset the projected loss of $365 million in revenue. Nevertheless, the outlook for fiscal 2022 is far from sanguine. Before the pandemic, the Department of Legislative Services was forecasting a budget gap in fiscal 2022 of over $600 million, a gap the carryforward balance cannot erase. And for now the federal government is not prepared to ride to the rescue.

It would appear then, that under the September forecast, the sky is not falling. However, relying on fund balance and temporary federal funding to support on-going operations in both fiscal 2021 and 2022 would be an unwholesome practice, because neither the balance nor the federal funds will carry over into the future even as the expenses do. That is, we still will have a structural deficit problem, about which we have heard so much in the past. Looked at from this perspective, in fiscal 2022 the difference between revenues collected from Maryland taxpayers and expenditures incurred could approach $1 billion, about 5% of expenditures.

So what to do?

Expect cuts, but don’t make them quickly and don’t forget revenues

As always, it comes down to reducing spending and/or increasing revenues. Governors often propose only spending cuts, wanting to make them sooner rather than later, because the longer the wait, the more funds have to be cut in the remainder of the fiscal year. This was Governor Hogan’s logic this summer.

We agree that some spending cuts are likely to be part of the solution, but we don’t think that they should be adopted before we get a better idea of how much assistance will be coming from the federal government.

State and local governments have already been directly allocated about $4 billion for pandemic relief. Included is a temporary increase in federal support for Medicaid (about $575 million) and almost $700 million for transit agencies. But the bulk of these funds must be applied to new expenses for addressing the pandemic and may not be used to make up lost revenue. It is imperative that state and local officials continue to make the case for more flexibility in using these funds. Even more important, the feds should provide state and local governments with another round of assistance. Should the Democrats sweep the national election, that assistance could be substantial.

We should avoid any state budget cuts that would increase unemployment and slow our economy by laying off state workers or shrinking the safety net for our most vulnerable citizens. When we cut we should do so programmatically , focusing on spending and tax expenditures that are lower priorities and have yet to show cost-effectiveness. Our list of targeted cuts would start with some business tax credits, such as those for Northrup Grumman and for in-state film production.

We should also look at revenue-raising measures that were vetoed by Governor Hogan after the 2020 session: taxes on tobacco products and gross receipts on internet ads.

After that would come the harder parts. Under current conditions, with the stock market showing none of the pain felt by low-income workers, it would be fairest to ask our wealthiest citizens to help out, as we did in the 1990s and again in 2008.

Can we learn from this pandemic about how much we should save for the next revenue shock?

During the Great Recession, Maryland had to make deep cuts to essential spending. In response, the state adopted two practices to better prepare for the next recession.

First, the state modified its revenue forecasting methodology to adjust for the peak-and-valley nature of non-wage income, especially capital gains. This was done by smoothing the expectations for revenue from those sources to a 10-year average. As a result, in theory, the budget will not assume the continuation of the peaks or the valleys but instead be based on a sustainable average attainment. However, the provision was amended for fiscal 2020 and entirely suspended for fiscal 2021 to add back revenue to the budget.

Second, the state increased its target for the rainy day fund from 5% to 6% of general fund revenues.  However, in the last budget Governor Hogan proposed shifting any funds that would exceed that 5% target to pay for current operating expenditures, and the General Assembly agreed. Our leaders in retrospect may now wish these funds had been saved.

In recent years, the bond rating firm Moody’s has analyzed how the states’ savings compare to the projected effects of mild and severe recessions. These studies showed that Maryland hadn’t put enough aside to offset fully the effect of just a mild recession. Savings would be grossly inadequate for an extended and severe recession, which we still may face.

This analysis and the COVID experience thus suggests that when the pandemic has ended, the state should set a more ambitious target for precautionary savings, and stick to it. The size of that target could be smaller than otherwise if the federal government adopts, as it should, an automatic procedure for assisting state and local governments during future recessions.

— WARREN DESCHENAUX AND ROY MEYERS

Deschenaux ([email protected]mail.com) is a former executive director of the General Assembly’s Department of Legislative Services, and served as the legislature’s chief fiscal analyst.

Meyers ([email protected]) is professor of Political Science and affiliate professor of Public Policy at UMBC; he is a Fellow of the National Academy of Public Administration and has won awards for his research on government budgeting.

They plan to write additional commentaries on the budgeting process in the weeks ahead.