The U.S. Economy Is Still Finding Its Footing. But States Are Doing Pretty Well.

Amidst these confounding economic indicators, it’s worth asking: What is the state of states? After all, states are responsible for delivering the services that citizens expect—and unlike the federal government, they have to keep a balanced budget.

According to Therese McGuire, a professor of strategy at Kellogg who studies state and local finances, despite a year of restaurant closures and increased expenses, many states are doing surprisingly well. How could this be? What about states like Illinois, which entered the pandemic already in financial crisis? And what are states and cities doing to prepare themselves for the next economic downturn?

“The Big Surprise”

The drop-off in revenue for state and local governments, as for the economy at large, was rapid and deep—far deeper than in the Great Recession. States had to dip into their rainy-day funds and borrow as much as they could to cover spending, particularly in areas like healthcare infrastructure.

“Do you remember back in the spring when the city of Chicago took over McCormick Place and tried to turn it into a potential hospital?” says McGuire. “And then of course in late May George Floyd was killed in Minneapolis.” With the cost of additional public-safety measures on top of lost revenues from shuttered businesses, “that was another crisis that hit big cities in particular.”

Still, she says, “the big surprise” is that state revenue started to rebound faster than anyone thought it would. Consider California. Early in the pandemic, the state was predicting a $54 billion deficit. This May, the state estimated a $76 billion surplus.

Part of the turnaround in fortunes comes from payments to individuals provided by the federal government: increased unemployment benefits were taxable over a certain amount, for instance. But a bigger factor was that the hit to sales-tax revenue wasn’t as dramatic as anticipated.

“People were worried about sales-tax revenues for state and local governments because people lost their jobs and were staying home. But a lot of people—particularly higher-income people—kept their jobs and they were buying stuff like crazy on Amazon,” says McGuire. Thanks to the Supreme Court’s 2018 Wayfair decision, retailers are now responsible for collecting taxes on out-of-state purchases, essentially making internet sales in all states taxable. This allowed revenue from the online shopping boom to mitigate some of the pain of the struggling services sectors.

Then came Biden’s election, and with it a $1.9 billion spending package that extended support to individuals and businesses, programs initiated under the Trump administration. It also provided a new program of dedicated funds for states and cities.

“So those monies are coming in, and it’s not chump change either,” says McGuire.

50 States, 50 State Budgets

Still, it’s no secret that some states are emerging in better shape than others.

States like California have been at a particular advantage throughout the crisis, McGuire explains. California has a progressive income tax, meaning much of its revenue comes from the highest earners—the same people most likely to have kept their jobs throughout the pandemic. California also has a tax on capital gains, which provided a major source of revenue once the stock market came roaring back.

On the other end of the spectrum, states that rely heavily on sales-tax revenue didn’t fare as well. Neither did states that lean on tourism.

To some extent, the same can be said of city coffers. “Cities are a similar story, but many cities tend to be even more reliant on tourism than the state in which they sit,” says McGuire. “The city of Chicago saw a bigger hit to revenues than did the state of Illinois because the city relies more on tourism revenues and convention revenues than the state.”

So, what about Illinois, which entered the pandemic in crisis?

“Last spring and summer Illinois was in the most dire situation,” says McGuire. “Early in the pandemic, the Federal Reserve offered to loan money to states, and Illinois was the first and only state to take them up on that.”

Illinois was barred from using the money from Biden’s recovery package to pay back those loans, as well as from using the money to shore up the state’s unfunded pension liabilities. This put the state in a bit of a quandary: “How do they use one-time money to put us on a better course going forward?”

In her view, the state is doing a reasonable job managing the situation. Vendors are now getting paid in a timely way—in 2017, the state had more than $16 billion in unpaid bills; that’s now down to just $3.8 billion. Remarkably, thanks to that one-time cash infusion, Illinois has a balanced budget, and all three major credit agencies have recently issued positive outlooks.

Still, “it’s a structural deficit we face in this state. We’ve got revenues increasing at a slower pace than spending,” she says. “And so we balance the budget this year, but if we don’t change either growth rate, give us a few months: we’ll have a deficit.”

A Better Path Forward

You’ve surely heard the saying, “Don’t let a good crisis go to waste.” So are any states using the pandemic as a chance to press reset on their finances, act on some new learnings, or perhaps experiment with more innovative or equitable revenue sources?

“I haven’t seen anything,” says McGuire. “It’s disappointing. But on the other hand, in their defense, it’s a once-in-a-century recession, a pandemic-driven recession. So maybe there wasn’t a lesson to be learned from this particular episode.”

Which doesn’t mean there aren’t broader lessons that could be applied at the federal level.

In McGuire’s view, the battle to shore up state finances—while ultimately largely successful—took a long time to win, leading to needless suffering for those dependent on government services. She points to research that supports the idea of automatic stabilizers: mechanisms that automatically increase federal aid to states and cities as soon as the unemployment rate passes a specified threshold in that area without requiring political action.

“Then, if you get another recession that’s hitting just one particular industry, the cities and states that rely on that industry can qualify for aid,” she says. “I think a lot of economists would agree with that recommendation.”