What Happens as State and Local Tax Revenues Crater?

March 30, 2020

We can anticipate a federal bailout of pension funds and one-time aid to state and local governments, but bailouts won't repair the eroding foundations of tax revenues.

As we all know, the federal government can "print" money but state, county and city governments cannot. The Treasury can sell bonds to fund deficit spending, and the Federal Reserve can create currency out of thin air to buy the bonds, so federal spending can increase even as tax revenues crash.

State, county and city governments do not have this printing press. Yes, states and counties can sell municipal bonds for infrastructure projects, but they can't sell bonds to support General Fund (i.e. everyday government services) expenditures.

As a result, massive declines in State, county and local tax revenues are already baked in as sales and payroll taxes drop and capital gains taxes--an essential source of revenues for many states--are set to collapse along with the stock market.

Longer term, the other primary source of tax revenues--property taxes--will fall off a cliff as the commercial real estate bubble and Housing Bubble #2 implode later this year. Lower sales, lower employment and lower profits all undermine the fundamentals of real estate, and the institutionalization of remote work and education will gut demand for commercial space.

Real estate transactions are also sources of transfer taxes and capital gains, and as values plummet so will transfer taxes and capital gains.

Every locale has a different mix of tax revenues, but since all sources will fall sooner or later, no state or local government will escape the decline in revenues. Sales (excise) and payroll tax revenues will fall first, and capital gains will vanish as stock market losses replace gains.

In states like California that depend heavily on capital gains taxes, the holes being blown in budgets will be catastrophic. Roughly 10% of all General Fund revenues in California flow from capital gains--over $15 billion in the previous fiscal year. As noted in the California State Revenue Estimate 2019-2020:

"The amount of capital gains revenue in the General Fund can vary greatly from year to year. For instance, in 2007, capital gains contributed $10.9 billion to the General Fund. By 2009, the contribution from capital gains had dropped to $2.3 billion. For 2018, capital gains are forecast to contribute $15.7 billion to General Fund revenue--the highest amount ever."

Were this to drop to previous recession-era lows, that would open a $13 billion hole in tax revenues, completely erasing the state's $8 billion "rainy day fund" and leaving a $5 billion deficit--a sum that will only increase as sales and payroll taxes decline.

Once Silicon Valley Unicorns, Big Tech and zombie corporations start laying off highly paid staff, income tax revenues will crater as well. As the California State Revenue Estimate 2019-2020 explains:

"The highest-income Californians pay a large share of the state's personal income tax. For the 2016 tax year, the top 1 percent of income earners paid just under 46 percent of personal income taxes. This percentage has been greater than 40 percent in 12 of the past 13 years. Consequently, changes in the income of a relatively small group of taxpayers can have a significant impact on state revenues."

Many states and counties are increasingly dependent on a dominant revenue source which may well prove to be an Achilles Heel. California has increasingly come to depend on income taxes from high earners (who also garner most of the capital gains as well):

"In 1950-51, sales tax revenue made up over 50 percent of General Fund revenues while personal income tax revenue made up just more than 11 percent. That relationship has changed dramatically over time, and, for 2019-20, personal income tax makes up 68.8 percent of all General Fund revenues."

A steep decline in tax revenues isn't the end of the pain for local government. Public-sector pension funds heavily invested in stocks are absorbing shattering losses that will have to be compensated by higher contributions by cash-strapped taxpayers. If bond yields rise despite central bank interventions, bond holdings could crash along with stocks.

We can anticipate a federal bailout of pension funds and one-time aid to state and local governments, but bailouts won't repair the eroding foundations of tax revenues. Sales: down. Income: down. Capital gains: down. Vehicle sales: down. Fuel taxes: down. Property taxes: down, once bubble valuations crash to earth.

Cash-strapped taxpayers, many of whom may have lost their jobs, will be in no mood to absorb enormous tax increases to fund insiders, cronies and vested interests.

The gravy train of state and local government spending has just been derailed. The declines in tax revenues will be too steep and too enduring to support the magical-thinking hope that a V-shaped recovery will make all the blown budgets whole next quarter, much less next year.

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