Will The Covid-19 Recession Make States Raise—Or Cut—Taxes ?

Covid-19 continues to put serious downward pressure on state and city budgets and spending.  The Biden Administration is proposing significant, but one-shot, budget relief that could help them this year but won’t solve their longer-term budget problems.  What about their own tax policy?  Can they raise—or cut taxes?  Should they?

When the pandemic hit last spring, the economy just fell off a cliff.  Second quarter GDP (April to June) plummeted by -31.4 percent on an annualized basis, but then bounced back (driven by significant federal spending), increasing by 33.4 percent in the third quarter.  The Conference Board expects 2020’s overall annual GDP decline to be -3.5 percent, more than the Great Recession’s 2009 drop of -2.5 percent and the highest single year drop since 1946’s adjustment from a war economy.

All states have lost revenue.  Federal spending is largely responsible for preventing an ongoing disaster.  In 2020, Covid-related spending has been estimated at “more than 13 percent of GDP in 2020” with December’s addition of $900 billion adding more stimulus in early 2021.  The Biden Administration’s proposed additional $1.9 billion would further help the economy, but it isn’t clear that Congress will pass that large an amount.

But many states are doing better than first feared when facing the speed and depth of spring’s economic decline. Based on their industry mix, taxation systems, and prior savings in rainy-day funds, state revenues have been differentially affected by the rapid decline and subsequent rise of the economy. 

The pandemic has hit some industries harder than others, and states depending on the hardest-hit ones are suffering larger revenue declines.  Tourism-dependent states like Nevada, Hawaii, and Florida, with their large leisure and hospitality sectors, have significant job losses, business closures, and lost revenues.  The same goes for states that depend heavily on revenues from extractive industries—oil, gas, and coal—as demand slows and prices fall for those commodities.  They also face a longer-run challenge as renewable energy sources get cheaper and price-competitive with high-carbon fuels.

Finally, some states like California and New York are being helped by their more progressive tax codes, including income and capital gains taxes on the wealthy.  The pandemic recession is hitting low-income workers the hardest while wealthier taxpayers have mostly recovered their jobs and benefitted from rising stock prices, generating more revenue than initially expected.

But they still need revenue.  Budget experts at the Urban Institute tell us that although states had “better than expected tax collections,” the “actual revenue losses experienced by the states are deep and widespread, if not universal.”  And state and local governments hope the Biden Administration’s relief package will pass with its promised hundreds of billions for fighting Covid-19 and also replacing lost revenue.

They also remember that fiscal aid was a major sticking point last December, with Republicans knocking it out of the final package.  So they aren’t sure Washington, even with Democratic control, will get them enough aid.  And that’s leading a few to consider tax increases.

Generally, economists frown on raising taxes in a recession.  We would rather have more spending, including deficit spending, to create jobs and pump up economic activity.  Tax increases can come when the economy is growing.

But some think targeted tax increases won’t hurt the overall economy very much, especially if it comes from the very wealthy, who don’t spending all their income.  The revenue generated can go to jobs and programs for those in need, where the money will get spent and help boost the economy.  Forbes contributor Joseph Thorndike explained this well last November.

Last September, New Jersey extended its top income tax rate of 10.75 percent to incomes over one million dollars; it previously had only kicked in when incomes passed five million.  Democratic Governor Phil Murphy made the increase palatable by using some of the revenue to provide rebates up to $500 for parents earning less than $150,000.  Murphy said:  ”Anyone earning a million dollars and up, we’re asking you to pay a few pennies more, and we’ll put every dime of that into the middle class.”  

But won’t higher taxes drive millionaires out of the state—to Florida or other low-tax locations?  There’s actually not much evidence for that.  As I pointed out last September, a 2014 Stanford University study found “little migration as a result of millionaire taxes.” 

A bigger potential threat to city and state budgets would be movement of businesses.  Some observers are speculating that extended out-of-office working due to Covid-19 is encouraging some businesses to consider relocation.  High-tech billionaire Elon Musk moved his residence and foundation to Texas, while Oracle CEO Larry Ellison moved the company’s headquarters there as well (Ellison is personally relocating to Hawaii.)   And Goldman Sachs is considering moving its asset management business (representing about one-quarter of its revenues) to Florida.  

Texas and Florida lack an income tax, unlike California and New York, so wealthy executives may be partly driven by tax rates.  (There is some evidence that wealthy people relocate—or at least change their address—at the end of their careers, to avoid state estate taxes.)

Advocates in New York State are calling for a small financial transactions tax to help plug budget gaps (the State actually already has a tax on the books, but rebates 100% of it so there’s no revenue generated or cost to taxpayers.). Nashville, Seattle, and Washington D.C. all passed modest tax increases last year.

But politicians are reluctant to raise taxes, so most are hoping for increased federal aid.  As I wrote recently, a one-time injection of funds won’t solve their long-term revenue problems, but anti-tax politics make federal aid more preferable.

Remarkably, a few states (including Arkansas, Montana, Mississippi, and West Virginia) are considering tax cuts even as their budgets decline.  Supporters cite the discredited theory that tax cuts will boost their economies.  But tax cuts are more likely to make their budgets worse while also reducing critical investments in education, infrastructure, and jobs that could help their economies.

Biden and the Democrats could provide longer-term help to states through such steps as federalizing Medicaid or taking over our fragmented and ineffective unemployment insurance system.  But those steps would be controversial—and expensive.  Biden’s priorities right now are stopping the pandemic and keeping the economy afloat, and then focusing on climate change and expanding and fixing Obamacare.

So watch and see what kind of state and city aid passes Congress.  If it is reasonably generous, then states will hold on and hope that a vaccinated population and control of the virus will bring an economic boost later this year.  But if Washington—in reality, the Republican Party—blocks adequate federal aid to cities and states, they’ll have to consider tax increases.  Their budget problems will leave them no choice.