By Ryan Boyle

The former Speaker of the House Tip O’Neill famously said, “All politics is local.”  While national issues and the Federal budget garner the lion’s share of the attention during election years, voters are more directly affected by policies adopted by state and local governments.  As voters head to polling places on November 5, the choices they make in races closer to home will have important impacts.

In general, state and local governments are in substantially better condition than they were during the last election cycle.  While each state has its own revenue mix, all are vulnerable to economic downturns. Funding comes through some combination of income and sales taxes, as well as fees for things like business licenses and vehicle registrations.  Counties and municipalities have additional levies on sales and property. 

The pandemic struck at all of these avenues.  Initially, taxpayers lost their jobs and curtailed their spending, reducing tax collections at the moment government support was most needed.  To help, the CARES Act of 2020 allocated $150 billion of federal emergency funding to the states, most of which was forwarded onward to municipalities or used tactically for healthcare and unemployment programs.  The American Rescue Plan Act of 2021 provided a further $362 billion to states and municipalities for a wider range of acceptable uses.  In total, federal support to states exceeded $9,000 per capita.

Fortunately, the pandemic recession proved brief.  Employment recovered quickly, and stimulus boosted spending and sales taxes.  Inflation lifted nominal sales and wages; sales and income tax collections grew in tandem.  Combined with federal pandemic aid, states found themselves flush.  The surplus led to stimulus grants and tax holidays.  Twenty-seven states even enacted permanent tax reductions. 

The public health emergency has, thankfully, concluded.  That means that states can no longer anticipate further support from the federal government.  Fortunately, many states are in better fiscal health than they were in 2019, having used pandemic supports to firm up their positions. 

Most states have balanced budget requirements, leading their treasurers to maintain stabilization or “rainy day” funds to draw upon in case of unexpected difficulty.  These funds lived up to their name in the early days of the pandemic, when federal support was uncertain: for instance, Nevada put its entire rainy day fund into its general account as it reeled from a loss of tourism.  All states have since rebuilt and added to their contingency funds. 

State treasurers have to achieve a balance.  A large general account and rainy day fund would suggest taxes had been too high.  For larger projects, states can issue debt; the municipal market has been stable and well-performing in this cycle.  A steady level of outstanding debt suggests that states are not over-leveraging.

But the latest Fiscal Survey by the National Association of State Budget Officers (NASBO) tells a story of states once again facing challenges.  Tax revenues peaked in 2022 but have settled down since, while expenditures continue to rise.  Pandemic aid has ended, and the cost of tax cuts is becoming clearer.

Forecasting states’ revenue growth has become more complicated.  States that tax capital gains experienced volatility as poor market performance in 2022 weighed on investment income tax collections in 2023.  Consumer spending since the pandemic has shifted from goods to services—two categories with distinct tax treatments in many states.  The lower demand for office real estate will weigh on property tax valuations and receipts for years.

Further, the solvency of many state pension funds remains weak.  Many states face the prospect of decades of generous payouts ahead with underfunded reserves and too little foreseeable tax revenue growth.  The list of states with the most concerning funding ratios, like Kentucky (47.5%), New Jersey (47.8%) and Illinois (52.9%), are little changed since the pandemic.

Municipal agencies are also not out of the woods.  COVID funding is still supporting public transit in many cities, with a fiscal cliff looming as ridership and fare revenue stabilize at lower levels.  School districts also used pandemic funds to balance their budgets, reservoirs which are now running dry.

Recent news has also reminded us of the uneven risks of climate and other idiosyncratic events on local finances.  Hurricanes Helene and Milton cut unusual paths over the continent.  The costs of cleanup and infrastructure repairs are still being tallied.  The damage was considerable but limited to a handful of states.  While federal aid is reliably provided, states will need to plan for rising tail risks.  And the elevated cost of insurance could constrain future growth in higher-risk areas.

A number of states have experienced substantial in-migration during the past two decades, with both residents and businesses lured by favorable tax terms.  Rapid growth will increase demands on communities to provide the services required by new residents.

Taxation will be a hot topic for voters in the upcoming elections, with 12 states offering referenda to change their taxes and four seeking large bond issuances.  Revenue-raising measures are up for debate, with four states seeking to ease marijuana restrictions and two considering a further foray into gambling; however, greater spending on education and healthcare is also a common thread. 

U.S. states haven’t been able to issue their own currencies for a very long time, so running the printing press will not solve their fiscal challenges.  Sound policies will be critical to keeping local finances and local politics in balance.