State officials nationwide fear that a substantial decline in tax collections as a result of the coronavirus pandemic will throw their budgets into turmoil. But they will have to wait for the first hard data on how big the decline might be.
When the economy struggles, state tax revenue usually suffers too. States’ two largest sources of tax revenue are the personal income tax and the sales tax. If employers lay off workers or reduce their hours, workers earn less income and pay less in income taxes. If consumers scale back purchases, sales tax revenue drops. These declines are likely to play out over the course of months because there’s always a lag between changes in a state economy and changes in revenue.
As a result, policymakers are facing considerable uncertainty as they seek to maintain balanced budgets in the current fiscal year—and develop budgets for the next one. With these challenges in mind, Congress is providing financial relief to states, most substantially through a $150 billion fund for states and localities that was part of the stimulus bill signed by President Donald Trump on March 27. However, some governors have warned that the aid won’t be enough to prevent dire budget challenges.
Some of the first signs of trouble are likely to emerge in income tax withholding payments. Although taxpayers file their income taxes once a year, employers withhold a portion of each paycheck based on estimates of what the total bill will be, so withholding payments represent a large share of state income tax revenue. If workers’ paychecks shrink, the withholding payments will shrink too, and states will see the effects in a matter of weeks.
An economic slowdown will affect sales tax collections nearly as quickly. Although consumers pay sales tax when they make a purchase, businesses don’t remit those dollars to states immediately. Instead, they are typically required to make monthly payments that are due toward the end of the month after the one in which the purchases are made. As a result, consumer spending declines that began in March will begin to affect state revenue in late April.
Accounting for fiscal year calendars
Most states begin their fiscal year July 1. With key revenue sources at risk of decline starting in April, their current year budgets could fall out of balance in the final few months of the fiscal year.
Adding to that risk, many states have announced extensions of their income tax filing deadlines past the end of their fiscal year, complementing the federal government’s decision to push its deadline from April 15 to July 15. Mirroring the federal extension will provide relief for state tax filers and reduce the potential for a confusing and complex filing process. But it also means that a portion of the taxes these states expected to collect this fiscal year will be delayed until next fiscal year instead, compounding the strains on current budgets. Although states receive income tax revenue throughout the year via withholdings, April is the month when they typically collect the most revenue.
Closing midyear budget gaps always poses challenges for states, and many of the strategies that they typically use—such as leaving vacant positions unfilled—provide less in savings if the problem occurs in the final months of the year.
Although the potential for a severe and rapidly developing economic downturn means that significant gaps could develop quickly, two factors may provide some help. Most states were enjoying reasonably strong revenue growth before the start of the coronavirus pandemic, creating some cushion to keep this year’s budgets balanced. Plus, states now have more money in reserve than at any time in at least two decades, thanks to effort by policymakers to strengthen rainy day funds after the Great Recession. Because states, unlike the federal government, cannot engage in routine deficit spending, reserves play a crucial role in helping them balance their budgets in times of fiscal stress.
An economic slowdown caused by coronavirus also poses significant risks to states’ budgets for the 2021 fiscal year, which begins July 1 in most states. Depending on the severity and length of a downturn, sales tax collections and income tax withholdings could continue to be depressed in fiscal 2021.
Other revenue sources may see effects that develop slowly, with the bulk appearing in that next fiscal year. For instance, stock market losses could take a big bite out of capital gains tax revenue. Although taxpayers with large capital gains often must make payments quarterly based on estimates of how much they will ultimately owe, experts predict that the largest decline in payments will not begin until fiscal 2021.
The economic upheaval comes at an awkward time for states’ upcoming budgets. Generally, states determine how much money they can appropriate for the year based on revenue forecasts that are completed in January or February. This year, however, those forecasts may be far too optimistic, given that they predate the onset of the pandemic in the United States.
A handful of states have already finalized their fiscal 2021 budgets, while others were deep into drafting them before most legislatures started modifying or suspending operations in recent weeks to slow the spread of the virus and protect lawmakers.
If the damage to the economy is as substantial as economists expect, states could face significant fiscal challenges and may have no choice but to revise their revenue forecasts and adjust their fiscal 2021 budgets accordingly. In New York, which is the only state that starts its fiscal year April 1, the state comptroller recently estimated that the state would collect at least $4 billion less than forecasters expected just weeks earlier. But the comptroller also acknowledged that those estimates came with a huge amount of uncertainty.
That uncertainty is common across the country. Not only do states not yet have data on the revenue impact of the slowdown, but they also are only just beginning to receive early data quantifying the economic disruptions that will ultimately reduce tax collections. With that in mind, leaders will need to be flexible in the coming months and be prepared to respond to fast-changing conditions to balance their budgets once the picture becomes clearer.
Josh Goodman and Mark Robyn are senior officers with The Pew Charitable Trusts’ state fiscal health initiative.