Facing a coronavirus-induced recession, states and cities are looking at an acute fiscal crisis, with the National Governors Association requesting $500 billion in fiscal relief from the federal government.
In recessions, the federal government has a crucial responsibility to maintain the fiscal viability of states and local governments. Without additional federal revenue, states and localities, faced with balanced budget requirements, will be forced to lay off workers and cut essential services, counteracting the federal stimulus and deepening the recession.
In the Great Recession, state tax revenue declined by 11 percent from 2008-2009. Given the much greater severity of the decline in economic activity from the pandemic, a 20 percent decline in state and local revenue seems likely. If all of this revenue decline were offset by spending cuts, GDP would be dragged down by an additional 2 percent.
There are several ways the federal government could provide states and localities with the necessary funds: allow states to decide how funds are spent or restrict them to coronavirus-related spending, increase the federal sharing rate for programs like Medicaid, and let taxpayers deduct a higher amount of state and local taxes (SALT) from the federal income tax.
Already, the Families First Coronavirus Response Act passed on March 18 provides a temporary increase in the rate at which the federal government shares Medicaid costs, at a cost estimated at about $60 billion. The CARES act, passed on March 27, includes $150 billion in funds to states and cities for additional costs related to the COVID-19 epidemic.
But the best way for the federal government to help is to incentivize states and localities to raise taxes, thereby reducing the likelihood of layoffs and service cuts in state and local programs. Lawmakers can do this by lifting the federal tax code’s $10,000 cap on the deduction for state and local taxes.
By reducing federal taxes, the amounts of tax base potentially available to the states are increased. If a state decides to raise its tax rate to capture some of this additional tax base, the cost to taxpayers of each additional dollar of state and local taxes is lower under deductibility. For those in the 37 percent federal tax bracket, a $1 increase in state taxes costs only 63 cents.
The greater a taxpayer’s income, and the higher are state and local taxes, the greater the benefit. If states don’t respond by raising taxes, then repealing the cap on SALT would provide a windfall that would go mainly to high-income taxpayers — which would do less to help the COVID-19 crisis. However, if states respond by increasing tax rates on those with higher incomes, state treasuries will be able to capture a portion of the additional fiscal base and undo the regressive impact. And that is exactly how states have behaved in response to past economic crises.
In part because of deductibility, states with more progressive tax systems were more likely to raise their top income tax rate during the Great Recession. My research also suggests that over the longer time periods the willingness of states to raise — or not decrease — their top rates was enhanced by being able to shift a portion of the extra tax costs to the federal government. The induced increase in state tax rates could raise significant amounts of revenue, with estimates ranging from $40 to as much as $70 billion. Though spread over a few years, these amounts are within the range of the estimated $60 billion that will flow to states under the increased federal sharing rate for Medicaid.
Of course, some states might balk at raising tax rates during this more severe pandemic recession. To address this issue, the federal government should require the following quid pro quo: In exchange for lifting the SALT cap in a state, the state would have to agree to raise its top tax rate, to recapture a significant proportion of the deductibility windfall.
Though raising the deductibility cap would likely be met by howls of unfairness from low-tax states, the fact that high-tax states would benefit more than low-tax states is actually a benefit from both an efficiency and a fairness point of view. The resulting stimulus will be greater per dollar of federal aid if funds are concentrated in high-tax states, rather than being distributed in the usual per-capita basis. And despite Senate Majority Leader Mitch McConnell’s worry that bailouts are disguised bonanzas for fiscally profligate blue states, restoring deductibility in a time of fiscal crisis would help to right the imbalance between states that already send more dollars to the federal government than they get in return and states such as Kentucky which are huge net beneficiaries.
States and local governments need additional fiscal relief from the federal government. The repeal of the federal income tax cap on SALT, with a requirement that states raise their own top tax rates, is an equitable, efficient and feasible way of providing this relief. It should be an important part of the overall package of policies to provide states with the revenue needed to address the pandemic-induced fiscal crisis they now face.
Howard Chernick is emeritus professor of economics at Hunter College and the Graduate Center, City University of New York. He is the editor of “Resilient City,” a book published by the Russell Sage Foundation in 2005 assessing the economic costs of the 9/11 attacks on New York City.
Morning Consult welcomes op-ed submissions on policy, politics and business strategy in our coverage areas. Updated submission guidelines can be found here.
Correction: A previous version of this piece misstated Chernick as the author of “Resilient City” due to inaccurate information provided by the contributor.