Federal Fiscal Aid to States: Insurance or Bailout?

One major reason for the difficulty of arranging a second major federal Covid-19 relief package is disagreement between the Senate majority and the House majority regarding federal fiscal aid to state and local governments.  The issue of providing fiscal aid to states has been so difficult that the proposed legislation is now split into two separate bills – one containing less controversial items, and the other containing proposed support to state and local governments.  Why is this such a stumbling block?  What does economics have to say about this stalemate?
 
There are two major perspectives to consider.  First, almost all states have balanced budget requirements that constrain them to varying degrees, while the federal government has no such constraint and hence can use deficit financing. In our federal system it makes sense for the federal authority to provide insurance against economic downturns, basically by borrowing during the downturn and distributing monies to the states. 
 
However, the second perspective is that, whenever there is insurance, there is the possibility of what is called a ‘moral hazard,’ the temptation of the insured to be reckless (in this case overspending by state and local governments) or to otherwise take advantage of the insurance provider and, in the end, of all the other insured entities.  Of course, each state will have the incentive to behave this way, leading to a situation where all states are profligate.  The expectation of federal fiscal aid in times of crisis may well have contributed to past fiscal imprudence on the part of the state and local governments, and providing such aid in the present crisis may well encourage future fiscal imprudence.
 
In addition to the economic considerations, there are political considerations. These are separate from the economic considerations but clearly related. Basically, many states with the largest budget problems are also relatively high spending states and might be considered ‘blue’ states, while other states are relatively lower spending states and might be considered ‘red’ states.1 There are also differences in the response to the pandemic itself – states were forced to choose the severity and length of lockdowns and other restrictions that arguably improved public health outcomes while harming their economies.  In any event, it seems that many ‘blue’ states imposed relatively stronger restrictions on economic and social behavior, accepting greater economic harm in exchange for mitigating public health concerns.  It also seems that many ‘red’ states imposed less stringent restrictions, imposing less economic harm while accepting greater public health problems. These different choices led to differential outcomes for state economies and state government budgets.  In dealing with the pandemic, these different policy choices are also related to differences of public opinion on the appropriate level of federal funding to be provided to states and its allocation across states.
 
To be more concrete, the two tables below illustrate how a state’s political culture might have influenced its public pension debt prior to the pandemic, and its public-health and economic performance so far during the pandemic.  The so-called “blue” states tend to have higher levels of public pension debts than the so-called “red” states. Table 1 below lists both the top 10 and the bottom 10 states according to public pension debt per household.
 
Rank Top 10 Bottom 10 Rank
1 Alaska ($99,624) Missouri  ($2,026) 50
2 Connecticut ($88,698) Tennessee ($9,090) 49
3 California ($83,738) Georgia ($9,245) 48
4 Hawaii ($67,807) Indiana ($13,952) 47
5 Illinois ($61,986) Maine ($16,642) 46
6 New Jersey ($59,192) South Dakota ($18,656) 45
7 Ohio ($58,877) Idaho ($19,193) 44
8 Massachusetts ($53,781) Nebraska ($20,266) 43
9 New Mexico ($52,227) North Carolina ($21,988) 42
10 Nevada ($47,962) Montana ($22,484) 41
Table 1: Top and Bottom 10 states according to public pension debt per household as of 2018.  Data source: www.pensiontracker.org/

Among the ten most indebted states, seven (Connecticut, California, Hawaii, Illinois, New Jersey, Massachusetts, and New Mexico) are solid “blue” states, whereas only Alaska is a solid “red” state.  Among the ten least indebted states, on the other hand, eight (Tennessee, Georgia, Indiana, South Dakota, Idaho, Nebraska, North Carolina, and Montana) are solid “red” states, whereas only Maine is a solid “blue” state. As this shows, the political divide on whether to provide aid to states is complicated by the fact that states from one political side face less budgetary problems, especially with respect to unfunded pension obligations, while states on the other side face more budget problems.  This is even prior to the way that states in these two camps responded to the pandemic itself.

Table 2 below lists both the top 10 and the bottom 10 states according to the Pandemic Misery Index (PMI) developed by the Private Enterprise Research Center at Texas A&M University. A state’s PMI for a specific period is equal to the average unemployment rate during that period plus the number of deaths per 10,000 people during that period.
 
Rank Top 10 Bottom 10 Rank
1 New Jersey (29.96) Utah (7.61) 50
2 New York (29.19) Nebraska (8.25) 49
3 Massachusetts (26.76) Maine (8.33) 48
4 Rhode Island (23.02) Wyoming (8.39) 47
5 Louisiana (22.74) Vermont (8.74) 46
6 Nevada (21.96) Idaho (9.78) 45
7 Connecticut (20.88) Montana (10.31) 44
8 Mississippi (20.26) Alaska (10.54) 43
9 Michigan (19.71) Kansas (10.72) 42
10 Illinois (19.28) Oklahoma (10.99) 41
Table 2: Top and Bottom 10 states according to the Pandemic Misery Index (March 2020 – October 2020).  Data source: https://perc.tamu.edu/PERC-Blog/PERC-Blog/PERC%E2%80%99s-Pandemic-Misery-Index-Updated-How-the-State

Among the ten states with the highest PMI values, seven (New Jersey, New York, Massachusetts, Rhode Island, Connecticut, Michigan, and Illinois) are solid “blue” states, whereas only Louisiana and Mississippi are solid “red” states.  Among the ten states with the lowest PMI values, in contrast, eight (Utah, Nebraska, Wyoming, Idaho, Montana, Alaska, Kansas, and Oklahoma) are solid “red” states, whereas only Maine and Vermont are solid “blue” states. Comparing each state’s responses to the pandemic highlights yet another political divide.
 
Arguments for Fiscal Aid to States
 
All states in the U.S. except Vermont have some requirements to balance the state government’s operating budget (the general fund) every year.2 This borrowing restriction was apparently self-imposed by each state with various degrees of rigor, from "soft," where a state's constitution or statue only requires the government to submit a balanced budget, to "hard," where a state must balance their budgets at the end of a fiscal year by cutting spending and/or raising additional revenues. It is required to keep states, which cannot print money to pay for their bills, from running up debts that may lead to insolvency.

Importantly, this no-borrowing requirement does not apply to a separate capital fund budget that covers infrastructure and other capital projects.  States can borrow, or issue bonds, to finance their capital fund budget. Still, the no-borrowing restriction restricts a state’s ability to close gaps between expenditures and revenues during a crisis.  After the onset of Covid-19 earlier this year, it was estimated that the fiscal shortfalls for state governments in the next couple of years will rival those occurring during the Great Recession.  Moreover, because of the speed with which the Covid-19 recession occurred, the states’ fiscal conditions are deteriorating more rapidly than during the Great Recession.3  Because state governments cannot borrow to cover their general fund deficits, these must be dealt with using some combination of three things – spending cuts, tax increases or outside revenues.4
           
Essentially, federal fiscal aid during a crisis provides state governments with insurance that the states cannot provide on their own due to the borrowing constraints. This can occur automatically via what are called ‘automatic stabilizers,’ such as unemployment insurance supplements, and also by discretionary ‘block grants’ to states.  It makes sense for the federal government to be the insurer because the federal government can run deficits.  Federal fiscal aid provided to a state during a recession enables the state to avoid drastic spending cuts and tax increases.
 
Arguments against Fiscal Aid to States
 
The main concern with providing federal fiscal aid to states is that it may amount to federal bailouts of some financially irresponsible state governments. Federal bailouts can be viewed as rewarding those states that have badly managed their finances at the cost of states that have managed their finances relatively more responsibly. This is a road that leads to fiscal disaster because it would create a common-resources problem. Federal funds are common resources funded by all the states, and with ongoing bailouts, a state can get back a larger share of federal funds by getting itself in a deeper financial hole. In the end, the rational behavior of all state governments in the presence of federal bailouts is to over-spend and under-fund, leading to chronic state fiscal shortfalls.
 
How can a state overspend when it is constrained by a balanced budget amendment?  Much of the overspending is occurring off-budget, especially in promises of pensions and other benefits for retirees.  Providing large grants to states with severely compromised budgets that are, in large part, due to what may be overly generous promises to state retirees causes a moral hazard, where states have an incentive to overspend in the expectation of a federal bailout.  Asking federal taxpayers in other states to pay higher taxes to help Illinois meet its under-funded pension promises does not seem palatable to many other states.  Further, an ongoing expectation of such action encourages all states to behave in a similar way.
 
Of course, the federal government does not have a legal obligation to bail out a badly managed state government. States are not allowed to declare bankruptcy as per the U.S. Bankruptcy Code. Moreover, the contracts clause in the U.S. Constitution (Article 1 Section 10) barring states from "impairing the obligation of contracts" has been previously interpreted by the U.S. Supreme Court as ruling out state bankruptcy.  Nevertheless, federal fiscal aid to states in response to crises, if ill-designed, sets a precedent and an expectation that can easily lead to a situation where all states increase spending because they count on a future bailout. There is evidence that the Recovery Act enacted to provide states with fiscal aid in the wake of the Great Recession resulted in elevated state spending levels - levels that were not all reduced once the federal funding expired.5
 
 
Formulate Federal Fiscal Aid as Insurance not Bailout
 
To formulate federal fiscal aid as insurance rather than a bailout, the amount of federal grants to a state should be directly related to the losses the state has incurred due to the effects of pandemic itself.  Such losses are called “covered losses” in insurance economics.  In the case of the pandemic, there is no preexisting insurance contract, and it is hard to see that there is even an implicit contract among the states, given the difficulties in coming to an agreement.  Some of the financial costs of the pandemic are truly beyond the control of a state government, but much of the financial cost is influenced by how states responded to the pandemic, how they chose to trade off public health concerns for economic concerns.  State budgets are tied to state economic performance, and the more a state shut down various economic activities, the more it harmed its budget situation.  States that put more weight on public health concerns as opposed to economic concerns can thus seem to have a larger claim on federal funds, but that larger claim is due to state actions.  This is further clouded by the pre-pandemic differences in state budget situations.  In any case, there are grave difficulties in dealing with this issue, especially in ex-post legislative deliberations.

Certain spending seems relatively easy to agree on, including funding for vaccine research, funding for PPE equipment, funding for hospital and lab capacity, and to some extent funding for the unemployed.  But the acceptable funding needed to address state and local government fiscal conditions is more difficult to agree on, and has held up legislation to address these issues.

Is there a way forward?  It might be useful to opt for a simple formula to allocate federal fiscal aid among the states, perhaps based on population and infection rates, although even here states with higher infection rates might have better economic and budgetary conditions if the higher infection rate is due to a less restrictive set of public health restrictions on their economies.   As noted above, this is a difficult issue in practice, both from an economics perspective and from a political perspective.  Given the difficulties, it is perhaps not surprising that Congress has been so slow in coming to a resolution of this issue.
 
 
1 While the exact definition of red and blue states, and the classification of states at a point in time are somewhat varied, one comprehensive classification is provided by The Hill, and we adopt their classification here.
See Bohn, H., and R.P. Inman, 1996. “Balanced Budget Rules and Public Deficits: Evidence from the U.S. States,” NBER Working Paper 5533, and U.S. General Accounting Office, 1993. Balanced Budget Requirements: State Experiences and Implications for the Federal Government. GAO Document GAO/ARMD-93-58BR, General Accounting Office, Washington, D.C.
3 McNichol, E., M. Leachman, and J. Marshall, 2020. “State Need Significantly More Fiscal Relief to Slow the Emerging Deep Recession,” Center on Budget and Policy Priorities, April 14, 2020.
4 In response to the Great Recession, for example, states reduced general fund expenditures by $64 billion in fiscal years 2009 and 2010, and enacted $39.7 billion in revenue increases over this same period. See National Association of State Budget Officers, 2013. “State Budgeting and Lessons Learned from the Economic Downturn,” National Association of State Budget Officers, Summer 2013.
5 National Association of State Budget Officers, 2013. “State Budgeting and Lessons Learned from the Economic Downturn,” National Association of State Budget Officers, Summer 2013.

References
Bohn, H., and R.P. Inman, 1996. “Balanced Budget Rules and Public Deficits: Evidence from the U.S. States,” NBER Working Paper 5533.

McNichol, E., M. Leachman, and J. Marshall, 2020. “State Need Significantly More Fiscal Relief to Slow the Emerging Deep Recession,” Center on Budget and Policy Priorities, April 14, 2020.

National Association of State Budget Officers, 2013. “State Budgeting and Lessons Learned from the Economic Downturn,” National Association of State Budget Officers, Summer 2013.
U.S. General Accounting Office, 1993. Balanced Budget Requirements: State Experiences and Implications for the Federal Government. GAO Document GAO/ARMD-93-58BR, General Accounting Office, Washington, D.C.
 
The Hill’s blue/red state rankings can be found at https://thehill.com/blogs/ballot-box/house-races/221721-how-red-or-blue-is-your-state
State-level public pension data can be found at www.pensiontracker.org/

The Private Enterprise Research Center’s Pandemic Misery Index  (PMI)  can be found at
https://perc.tamu.edu/PERC-Blog/PERC-Blog/PERC%E2%80%99s-Pandemic-Misery-Index-Updated-How-the-State
 

Posted: December 16, 2020 by Dennis W. Jansen, Liqun Liu