States Should Borrow Rather than Make Brutal Cuts During a Recession and Pandemic
By Darien Shanske and David Gamage
In a world in which the level of government best suited to act (the federal government) is dysfunctional, subnational governments need to take extraordinary measures. Lest anything that follows be misunderstood, we have already argued that it is the federal government that should ideally borrow and then provide aid in order to stave off savage cuts at the state and local levels.[1] Unfortunately, so far, the federal government has not acted sufficiently, nor given much comfort that it will, at least adequately. In the meantime, state and local governments have already begun to make harmful spending cuts. (This article is a contribution to Project SAFE: State Action in Fiscal Emergencies).[2]
It is against this backdrop of federal failure that we have encouraged the states to raise revenues rather than to just make deep cuts to services.[3] (We are not arguing against smaller measures, like hiring freezes etc.). There are many possible revenue-raising tools available. Indeed, because state and local revenue systems were in such need of reform even prior to the beginning of this crisis, there are lots of sensible reforms that could raise quite a bit of revenue relatively fairly and efficiently.
Especially because state governments face balanced budget constraints, the fact that we are in a recession is not an argument against raising taxes, in light of the federal government’s failure to act sufficiently.[4] Rather, state and local governments should prioritize raising tax revenues from those who can best pay over slashing vital services needed by those who cannot pay, especially because many of those services playing important roles in preventing further harm to state economies.[5]
A much more potent objection to the strategy of raising revenue is that this will not be enough. The cost of the pandemic is so large that even a state that took us up on our complete menu of revenue raising tools would still come up short. This is likely true, but that does not mean states should not try to prevent the cuts they can.
The deeper counter to this objection to revenue raising is that states should borrow, with the borrowing secured by the new revenue (at least in part). It seems quite reasonable to surmise that in three years time that state finances will be looking a lot better even without new taxes. Indeed, state revenues will likely look a lot better still in three years if they do not eat their seed corn this year by, for example, slashing funding for vital services. Consider that, if state budget cycles worked on a five-year cycle, a budget planner would be well-advised to borrow from later in that cycle in order to pay for necessary expenses now, at the nadir.
And so the basic idea is that states should smooth their taxing and spending by borrowing from a better future to sustain the challenging present. In order to make sure that there will in fact be more revenue in the future, the states should improve their revenue systems now. In this way, putting into place a suite of revenue-enhancing improvements now might be sufficient to get states and localities through the current emergency.
To be concrete, suppose California put into place our proposal to broaden its corporate income tax (CIT) base by shifting to mandatory worldwide combination.[6] In better times, this was estimated to have the potential to raise $2bn/year, roughly a 20% increase in California’s CIT revenues. Suppose that California securitized 10% of its CIT base, an estimated $1bn year, for 20 years at a 5% rate. That would be worth about $12bn to California right now, or about a quarter of this year’s deficit. The cost of federal funds is closer to 1% for a borrowing that long and hence if the Fed were to purchase these bonds, as we have argued it should,[7] then California could raise $17bn through this expedient.
Note that — prior to the onset of the Coronavirus crisis — California was running a surplus without this reform, and so, even if the reform were to raise 50% less than expected, California’s net fiscal position when the recession ends would still be the same as it was had been expected to be prior to the crisis and this borrowing. Indeed, even if the reform only raises 8% more, and hence California needs to borrow a little bit of the revenue it would have had anyway in the future, California would be getting a good deal given the urgency of current needs.
To be sure, special debt rules have been part of American public finance for almost two centuries, and for a reason: it is tempting for current generations, especially current politicians, to saddle the future with debt. The states incurred huge debts in the 1830s, building infrastructure (such as canals) and many of these projects ended up in the red when the economy turned. It is this experience of default and near-default that led to special rules as to incurring debt.[8]
However, to review that history and the associated rationales for borrowing limits is to understand why the current situation is different. The current generation is not trying to saddle the future with a speculative white elephant, but rather must ensure that the future generation is provided with schooling and other services at least roughly comparable to what was being provided just a few months ago. States could hardly have socked away $500bn in case of pandemic.[9] And, in fact, seared by the Great Recession, many states entered into the current crisis with a reasonable level of budgetary reserves.[10]
So, then, how can borrowing of this sort be made to work? Can a stream of future tax revenues actually be sold in this way (that is, used to back borrowing in advance of when those future tax revenues are raised)? The answer is yes. Indeed, there is a long history of financing new development projects through, in effect, selling the speculative increase in tax revenue the development is expected to generate. This is called tax increment financing.[11] And there are even more interesting models. For instance, states and localities sold their right to revenue from the tobacco settlement even though it was very unclear how much revenue that settlement would bring.[12] Those bonds contained features to manage the uncertainty in the future revenues,[13] and any issued coronavirus deficit bonds could do likewise.
Another possible objection is that most state constitutions do not permit borrowing. This is partially true. All state constitutions do permit borrowing to an extent (or, at least, this is our understanding), but only with a vote. We think states should consider holding such votes or elections to authorize borrowing under each state’s specific rules. We think the argument we have made as to why is compelling and should carry the day in such votes or elections.
Of course, we appreciate that (for any number of possible reasons) holding such votes or elections might not be appealing or possible. Yet, all is still not necessarily lost, even if so. State-level rules rules generally contain long-standing exceptions to the requirement for an election and the borrowing that we are proposing could fall under one of these. In particular, state law typically has a special fund exception.[14] Under this exception, if all that investors are promised is specific revenue — and no more — then such borrowings are not considered to trigger the election requirement because the general taxing power of the government is not being promised. Satisfying this requirement is another reason that states should put into place new revenue that they can commit to these borrowings. However, note that the details of state law will matter here; states typically have special fund exceptions but not all courts interpret the scope of these exceptions in the same way, and the borrowing we propose will likely present a novel case in many states. If a state does plan on using the special fund exception, then it would be prudent also to create a fast-tracked procedure so that the courts can hear any possible legal objections quickly.
To go back to the beginning, we emphasize again that what we are proposing here is far inferior to the federal government stepping in to do its job adequately. But, especially if the only other feasible choice is savage cuts to needed spending programs, we consider borrowing of the sort that we have proposed to be the superior option by far.
[2] https://www.law.virginia.edu/academics/program/project-safe
[3] https://medium.com/whatever-source-derived/state-governments-should-now-consider-partial-wealth-tax-reforms-ead60814d894 and https://medium.com/whatever-source-derived/reforming-state-corporate-income-taxes-can-yield-the-states-billions-5a79f3d22f9b
[4] See David Gamage, “Preventing State Budget Crises: Managing the Fiscal Volatility Problem,” 98 Cal. L. Rev. 749 (2010), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1505283
[5] Id.
[8] https://www.jstor.org/stable/3875048?seq=1#metadata_info_tab_contents
[9] This is one estimate, at the low end, of the states’ collective need. https://www.nga.org/news/press-releases/national-governors-association-outlines-need-for-additional-and-immediate-fiscal-assistance-to-states/.
[11] https://chicagounbound.uchicago.edu/uclrev/vol77/iss1/4/ .
[12] https://ideas.repec.org/a/fip/fedbff/y2002iwinp1-5n30.html
[13] See id.; see also https://apinstitutional.invesco.com/dam/jcr:bf426594-66ce-4a2a-bcd9-26b69bf88626/IFI_20180202_Tobacco-bonds-An-unfiltered-look-at-a-unique-municipal-asset-class-by-Invesco-Fixed-Income.pdf for a somewhat recent discussion of the market.
[14] https://heinonline.org/HOL/LandingPage?handle=hein.journals/rutlj34&div=31&id=&page=
