New Jersey lawmakers face an estimated $10 billion gap in the state budget for fiscal years 2020 and 2021, attributable largely to sharp tax revenue declines linked to the COVID-19 pandemic. They are considering whether to tap into a new federal borrowing program to help close the shortfall and keep pace with required contributions to the state’s underfunded pension system—including scheduled payments of $4.7 billion in the fiscal year that started July 1.
The money would come from the Federal Reserve’s recently announced Municipal Liquidity Facility (MLF), a first-of-its-kind borrowing option intended as a last resort for state and local governments experiencing cash flow pressures stemming from steps taken to shutter the economy and slow the pandemic’s spread.
The Fed created the facility in April as municipal credit markets came under stress. The board of governors agreed to purchase up to $500 billion in short-term notes directly from state and local governments as a bridge to help these governments manage revenue losses and delayed collections. After initially offering loan terms of up to 12 months for repayment, the nation’s central bank extended the maximum term length available to borrowers, first to 24 months and then to three years. The extra time potentially gives states the option to finance parts of their current budgets over multiple fiscal years.
At the request of the New Jersey Legislature, The Pew Charitable Trusts recently conducted an analysis that determined that the MLF could be used to help close the state’s projected budget deficit and keep up with scheduled pension contributions. Pew’s analysis estimates that the facility could provide additional budget capacity of approximately $1.4 billion under the current terms of the program, and up to $4.5 billion if terms were extended to allow for borrowing over five years instead of three.
High borrowing costs, which include the Fed’s penalty rate above the typical market rate, may limit widespread use of the MLF as anything other than a last resort. However, MLF pricing as of early July is favorable for New Jersey and Illinois, the two states with the lowest credit ratings and largest unfunded pension liabilities per capita.
In May, Illinois was the first state to access the program. Lawmakers authorized borrowing up to $5 billion from the MLF to balance the state budget, which includes making required pension contributions. In June, the state borrowed $1.2 billion to help reduce a multibillion-dollar backlog of unpaid bills. Illinois officials have indicated a willingness to borrow more to help cover the projected deficit in fiscal 2021 if the federal government does not provide additional direct aid.
Pew based the New Jersey assessment on a model designed to more evenly distribute projected state revenue over the next three to five years. The methodology assumes one-time borrowing this calendar year, to be repaid in fiscal 2023 to 2025, when the economy is expected to be in recovery.
The latest national economic projections from the Congressional Budget Office (CBO) and a Pew-generated forecast of New Jersey’s own-source revenue (OSR) over the next five years informed the findings. As tracked by the U.S. Census Bureau, OSR includes taxes and fees that are controlled by the state. The Fed also uses this calculation in determining MLF borrowing caps.
To successfully implement the program, New Jersey policymakers would have to develop a borrowing plan that follows state law and is fiscally prudent. The Pew analysis addresses both issues. Most crucial are potential constraints on deficit financing imposed by the state constitution, which limits its use to emergencies.
In addition, a viable repayment plan would have to account for the wide range of uncertainty about the length and shape of the economic recovery. Current forecasts for national gross domestic product (GDP) from the CBO and Moody’s Analytics illustrate how the economy could take starkly different paths by the third quarter of 2020 from pre-pandemic projections. (See Figure 1.) This uncertainty calls for regular monitoring of the economic outlook as well as controls around spending to ensure timely repayment. This could include, for example, a more limited use of borrowed funds this year if the outlook for state revenue improves.
Pew’s analysis also describes how this type of revenue anticipation financing could be applied to the broader budgetary challenges every state is facing, including how to preserve essential government programs and replenish rapidly depleted reserves. In January, states reported rising revenues and record reserve levels that allowed officials to increase spending in key areas. However, as a result of the pandemic, state tax revenue could plunge by a total of more than 10% in fiscal 2020 and 2021, based on data published by the Center on Budget and Policy Priorities. That would be greater than the decline that states experienced in the two years after the Great Recession began in late 2007.
Despite the gradual reopening of the economy, the lost revenue will not be replaced immediately, but analysts are cautiously optimistic that the recovery could be faster than in the last recession. The stock market has already rebounded from heavy losses experienced in March, although pension funds are still expected to fall short of their target returns. For New Jersey, which has the lowest funded ratio among all 50 states, this means that making required contributions must be a top priority.
Still, the usual approaches for managing fiscal difficulties, many of which have already been attempted in New Jersey, may not be adequate to plug the staggering budget gaps stemming from the unusual shape of the COVID-19 downturn. If New Jersey and other states implement and follow disciplined controls, the MLF could prove to be an important policy instrument to help manage immediate budget problems until conditions improve and to ensure that contributions continue as planned to critical public employee pension funds.
Greg Mennis is a director and Ben Henken is an associate with Pew’s public sector retirement systems project.