The coronavirus pandemic is
hitting America hard.
Countless Americans are being advised to
stay home as much as possible.
And governments are telling nonessential
businesses to stay closed.
But governments themselves are
also taking a hit.
Much of the economy has either slowed
down dramatically or ground to a
halt. And with all that lost
economic activity come the tax revenues
governments depend on to pay
for their massive budgets.
On April 21st, Senator Mitch McConnell said
he would support the idea of
letting states declare bankruptcy.
Later, he walked back his comments.
But the episode resulted in
a firestorm of media commentary.
"Come on, man, that is
completely and utterly irresponsible.
This is no time for
bankruptcies and wishing bankruptcies."
"The most un-American, uncharitable, ugly
statement of all times." Of
course, there are reasons to be
concerned about state's fiscal health.
"I think the big difference between this
downturn and what we saw in the
Great Recession or the recession of 2001,
2002 is the speed with which it
came on and the severity
with which it came on.
That really makes it unprecedented
from a credit standpoint.
States entered this in a stronger position,
but they're going to have to
use all of the tools that they
have available to them to maintain their
credit quality through this."
An array of industries have been badly
hurt since the coronavirus began to
spread. Travel and
tourism have tanked.
Stores are shuttered and restaurants are
relying on takeout and delivery
to try to stay afloat.
As all that business dries up, so do
the sales and tourism taxes that go
with it. Some states, such as
Washington, Arizona, Nevada, Louisiana, and
Tennessee all rely heavily on
sales tax for their revenues.
A number of states with high sales
taxes collect no state income tax at
all. But income taxes are
also taking a hit.
A staggering 30 million Americans
have filed for unemployment benefits.
The federal government has also extended
the tax deadline from April 15th
to July 15th, and many states
have adjusted their own deadlines
accordingly. That means that for the next
three months, they will have to
do without whatever state income
tax revenue would otherwise remain.
Meanwhile, states have to
keep paying for services.
Roads need to be maintained.
Government workers still need
to be paid.
And governments are now also
saddled with medical and unemployment
expenses. There could be more hurt
ahead for city and state finances
across the U.S.
By law, municipalities such as
cities can declare bankruptcy.
But states cannot, and
they never could.
However, some in the legal world
have argued that state bankruptcy should
be a viable option and it's
a better alternative to bailouts.
University of Pennsylvania law professor David
Skeel is one of them.
He and fellow U Penn professor
Robert Inman co-authored an editorial on
May 5th arguing that McConnell was right
to say that emergency aid from
Congress should not be a bailout for
state deficits that have nothing to
do with the pandemic. They argue that
Congress should act as an insurer of
last resort and only hand out aid
to states for losses incurred during the
pandemic, and not
for pre-existing problems.
Skeel has argued in the past that
states in deep financial trouble should
be allowed to file for bankruptcy.
Inman is skeptical.
But it is clear that McConnell is
not the only person who has expressed
support for the idea.
So legally, why can cities, towns,
or school districts declare bankruptcy
when states are unable to?
Since 1937, the federal bankruptcy
code has allowed municipalities to
declare bankruptcies. Municipality is a
broad term that basically includes
all kinds of subdivisions of states,
such as towns, cities, and counties,
but also school districts and some
government organizations within a state
that collect revenue but don't cover a
geographic area, such as a bridge
authority. But the contracts
clause of the U.S.
Constitution prohibits states from impairing
the obligation of contracts.
Subsequent Supreme Court decisions have
generally supported the notion
that states cannot refuse
to pay their debts.
"So in our constitutional system of
federalism, there's really only two
sovereigns. There's the sovereign United
States government and there's the
sovereign state governments.
There's no such thing as
a sovereign city government.
And so the idea is that the United
States has been thought not to be
allowed to do things that would impair
the ability of the states to
function as governments.
But there's no similar principle that
would prevent the federal government
from doing things that would impair the
ability of cities to function as
governments, because cities are not dual
sovereigns the way states are."
So for states to even legally
allow themselves to declare bankruptcy.
Congress would have to pass a
law adding language to the federal
bankruptcy code that explicitly allows
states to declare bankruptcy.
Then individual states would have to each
pass a law that allows them to
declare bankruptcy.
Finally, the Supreme Court would have
to determine that all that
legislation does not conflict
with the Constitution.
So if a state declared bankruptcy, then
necessarily that means that some of
their creditors would not get paid in
full what the state owes them.
And so those creditors would take that
case to the Supreme Court and argue
that it was unconstitutional for the states
to be relieved of the debt to
the creditors. So that's how we
get to the Supreme Court.
That would be the last
step in the process.
So if it's even possible, it's not a
process that would be likely to happen
quickly. The question of whether states
should be able to file bankruptcy
is a thorny one. And there are some
critics of the idea that say allowing
states to file for bankruptcy would,
for example, raise the risk of
lending money to states.
It could also put the interests
of creditors against the interests of
states. But the idea
does have support.
David Skeel, the University of Pennsylvania
law professor, made the case
for letting states go bankrupt when the
country was in the depths of the
recession, spurred by the
financial crisis of 2008.
At the time, several cities and
states were in deep financial trouble,
which some, such as Skeel,
attributed to runaway expenses.
"Allowing states to file for bankruptcy
would save taxpayers a great deal
of money," he said. Such laws could
be squared with the Constitution and
could be structured in a way
that ensured bankruptcy courts did not
override the states abilities to
pass their own laws.
"Anyone who proposed even a decade ago
that a state shouldn't be permitted
to file for bankruptcy would have been
dismissed as crazy," Skeel wrote in
2010. "But times have changed."
"States always have the ability to
pay their debts by raising taxes.
There's some views that would say that's
not a good thing to do.
And then states also have the ability
to pay their debts by borrowing.
But there's often even more consensus that
that's not a good thing to do.
And a lot of states actually operate
under their own state, a balanced
budget amendment which are
in their state constitutions.
So states could change those.
There's no federal requirement that
states balance their budgets.
But a lot of states have
imposed that requirement on themselves.
And so if you think that a
state should keep a balanced budget, it
shouldn't raise taxes and it doesn't-
And the state doesn't have enough
money to pay all its bills.
Then bankruptcy starts
looking attractive.
Right. So I think there's some there's
some people who want to take those
other two options off the table.
And then they say, well, if you're
not going to contemplate those other
two options of raising taxes or
borrowing money, then bankruptcy is the
most orderly way to figure out how a
state is going to pay pay some bills
if it doesn't have enough money
to pay all of them.
But I think, you know, people on
the other side of that partisan divide
have not been as opposed to
states sometimes raising taxes or sometimes
borrowing. And those would be alternative
ways of getting the bills paid
without really requiring
the creditors.
But the situation prompts another
financial question: whether coronavirus
is even putting states in a position
where they would need to declare
bankruptcy if it was a legal option.
And none of the research from the
three largest credit rating agencies in
the U.S. suggest any states are in
danger of defaulting on their debt
obligations. "Nearly all of the states
are in very strong credit position.
And that's not even something that
they need to think about.
There certainly would be constitutional
issues of the federal government
somehow overseeing state finances.
But it's not an issue." In fact,
states tend to have pretty high credit
ratings. "So two-thirds of our states
are in our two top rating
categories. And that really reflects the
broad range of powers that states
have over their finances.
They determine what taxes they have.
They determine what tax
rates they have."
The reason is that despite the trouble
they face, states have a pretty high
degree of financial flexibility.
They tend to have
very large tax bases.
Of course, that varies depending on the
size of the state's population and
the health of its economy.
But overall, their sheer size gives them
a deep well to draw from.
They also have two
fundamental levers to pull.
They can raise taxes
and cut spending.
States can push some expenses
down to local governments.
Aside from that, they
can also issue debt.
State debt issuance activity has been
relatively flat over the last
decade. "States generally only borrow
for capital purposes to build
schools, jails, essential
government facilities.
They don't really borrow
for operations overall.
They're in a strong position
as it relates to debt.
We might see some states do
deficit financing through this crisis
depending on how bad
the revenue situation is.
That is atypical for the sector.
But it is another option for states
that also generally have very good
market access." In fact, many states
are not out of cash yet.
The financial recovery of the last 10
years or so has allowed many states
to build up rainy day funds that can
be quite large and hold some of them
over for a while. In mid-April,
the median available state governmental
fund was 8% of fiscal 2018 year
spending, according to Fitch, one of the
three major credit rating agencies.
"25 states had reserve levels high
enough to cover the largest revenue
decline they had
had before coronavirus.
And we, of course, don't expect that
states will solely solve their budget
problems with reserves, and coronavirus
probably has created revenue
problems that their reserves
can't handle altogether.
We expect to see states take
structurally-balanced solutions, but they have
significant powers over
their finances."
As of April 30th, credit rating
agency Moody's had not downgraded any
states because of
the coronavirus pandemic.
It had, however, lowered outlooks
on a few states.
A lowered outlook means there could
be some downward financial pressure on
states, and it also means that they are
at a greater risk of a downgrade
in the future. In early May, Moody's
lowered its outlook on all U.S.
states from stable to negative, citing
uncertainty as to when life will
return to normal across the country.
That does not mean states are all going
to be downgraded, but it does mean
the economic downturn has accelerated, and
there are rising state revenue
headwinds, especially in sales
and income taxes.
"That sector outlook really reflects
that the operating environment for
states is much weaker than it
was going into the coronavirus crisis.
The employment situation
has weakened significantly.
Consumer sentiment has
weakened significantly.
Spending has weakened significantly.
And all of that is having
negative impacts on state tax revenue.
We estimate that in the current fiscal
year and the next fiscal year that
starts July 1, that state tax revenue will
be 15% lower than it was in the
last fiscal year."
The three states that have Moody's
lowest credit ratings are Illinois, New
Jersey, and Connecticut.
All three have deep structural
financial difficulties that pre-date the
pandemic. Of the three, Illinois is
by far in the worst shape.
"There are two states in particular,
Illinois and New Jersey, that had
pre-existing credit conditions coming
into the coronavirus crisis.
Those two states have very high fixed
costs for debt service pensions and
retiree health care relative to their
revenue compared to other states.
That just limits their financial flexibility and
how they will be able to
manage through this.
That contrasts sharply with triple-A rated
states like Utah or Tennessee
that have very low fixed costs.
And that just gives them a lot of
runway to be able to manage through this
crisis." Credit rating agency Standard and
Poor's lowered its outlook on
New Jersey April 29th, in
part because of coronavirus-related effects.
The state still has an A-minus
rating, well within investment grade.
However, Fitch downgraded Illinois to
BBB-minus, the lowest investment
grade, on April 16th.
But even for states in relatively good
shape, there are a number of
concerns on the horizon.
"The problem for state finances probably
really started in March, when
social distancing and quarantine policies really
began to have an impact
of economic shutdown.
And that's had a very sudden and
severe impact on sales tax revenues, in
particular because people are really
only consuming the essentials right
now: groceries, pharmaceuticals,
and the like.
And those largely aren't taxed.
Sales taxes for states are
about 30% of overall revenue.
But in some states, that's
as high as 70%.
Despite a record $115 billion dollars
in aggregate cash reserves on hand
for all states combined, few will be
able to cover their projected tax
losses with cash, Moody's said
in a recent report.
The agency expects coronavirus will reduce
state tax revenues by $160
billion dollars from fiscal year
2019 to fiscal 2021.
Fiscal 2021 tax revenue is expected to
be $200 billion dollars less than
governments would otherwise collect if there
were no downturn and moderate
growth. Even if an upturn were to
begin in 2022, Moody's base case
projection doesn't see state tax revenues
returning to 2019 levels until
2024. "Achieving revenue consistent with a
moderate growth path is even
more out of reach," the agency said.
Arizona, for example, finished 2019 with
a $1 billion dollar surplus.
But a recent report from the
state's Joint Legislative Budget Committee
projected a $1 billion dollar deficit by
2021, due in large part to the
effects of the virus.
There are other red flags popping
up around the country that credit
agencies are watching.
Hawaii's State Council on Revenues
recently lowered the general fund
revenue forecast by about $300 million
dollars through the next fiscal
year, primarily due
to coronavirus effects.
In the state of Washington, the
Department of Health asked for an
additional $100 million dollars from the
state legislature to combat the
virus. In California, San Francisco's
city controller recently reported
sharp declines in hotel occupancy and
airport traffic, and he estimated
city revenue losses in the
tens of millions of dollars.
2019 was a record year for tourism
in the city, according to the San
Francisco Travel Association.
Tourism brought in $819.7 million dollars in
taxes and fees for the city
that year, a 6% increase over 2018.
About 51% of that amount
came from hotel taxes alone.
The Federal Reserve established the
municipal liquidity facility to help
state and municipal governments deal
with cash flow pressures.
The facility will purchase up to
$500 billion dollars of short-term notes
directly from U.S. states, including
the District of Columbia, U.S.
counties with a population of at
least 500,000 residents, and U.S.
cities with a population of
at least 250,000 residents.
The federal government has set aside
one $150 billion dollars for state
and local governments through the CARES Act,
and there will also be an
additional $10 billion dollars through
Medicaid per fiscal quarter, much
of which is likely to be
eaten up by virus costs.
There is also a $45 billion dollar
Disaster Relief Fund and $25 billion
dollars for mass transit.
But state and local governments are
asking for another $750 billion
dollars from the federal government, five
times the enough allocated in
the CARES act.
And there is no clear idea of when
case numbers will drop low enough to
allow the country to
get back to work.
