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States Weathered the Pandemic, But Fiscal Warning Signs Are Ahead

May 23, 2022, 8:45 AM

When the Covid-19 pandemic hit, states and localities braced for significant revenue shortfalls. But the pandemic-induced recession and associated revenue losses were short-lived, despite being very steep. A little over two years later, a new set of worrying fiscal trends is starting to emerge.

Early in the pandemic, tourism, restaurants, and certain other services were hit hard, leaving millions of Americans without jobs. But many companies were able to adjust quickly to the new reality. Relying on technology, the remote work environment became a reality and allowed many workers to continue their jobs without any interruption.

Jobs that could be performed online tended to be for higher-wage workers, while those lost were for people earning less. This kept individual and corporate income tax collections strong, especially for higher-income earners. In addition, many states had passed laws to tax online sales transactions just prior to the pandemic. This came in handy as more consumers turned to e-commerce to follow social distancing guidelines and states’ ability to collect online sales taxes solidified another major revenue source.

Still, state tax revenue showed substantial volatility because of disruptions earlier in the pandemic. Delayed income tax filing due dates both in 2020 and in 2021 led to significant timing shifts in tax collections. And in many states, the 2020 changes led to revenue moving from one fiscal year to the next.

Overall, state tax revenue ended up declining by 0.8% in fiscal year 2020 but increased by a whopping 17.6% in fiscal year 2021, reflecting the shift in tax revenue and stronger taxes due to federal stimulus payments and a recovering economy. So, while states were forecasting steep declines for FY 2021 caused by the pandemic, they ended up with sizeable surpluses.

But the revenue bonanza for the states could soon be over due to expiring federal programs and inflation pressures. Indeed, even as many states consider yet another round of tax cuts, there are signs that fiscal forecasts are weakening due to individual stimulus payments ending, rising inflation, and the Federal Reserve’s raising interest rates in response. According to preliminary state revenue forecast data for 48 states collected by the Tax Policy Center, FY 2023 forecasts show substantial weakening in overall revenue, coming in just 0.1% higher than the prior year, including an 8.6% year-over-year decline in corporate income tax collections.

Both individual income and sales taxes growth are expected to stay positive, but they have each leveled off significantly. States are forecasting year-over-year gains for individual income tax collections to be only 0.4% for fiscal year 2023. Meanwhile, state sales tax revenue is expected to grow by 1.9% in fiscal 2023. It’s also important to note these revenue forecast figures are still preliminary, and states may revise final forecasts upward or downward after they finalize the analysis of income tax returns that were due April 18.

Increasing Economic Headwinds

No one expected the surge in revenue to last forever, but current economic indicators suggest growing fiscal challenges and uncertainties ahead.

A strong stock market usually means states can expect strong capital gains tax collections. In 2021, the S&P 500 index rose by 33%, marking the highest growth rate in more than six decades. That partly drove the increase in estimated income tax payments, which increased by more than $35 billion—or nearly 50%—in calendar year 2021.

However, the stock market has shown substantial volatility and sizable declines in the last few weeks, related in part to geopolitical crises underway this year and continuing uncertainty about Covid-19 outbreaks and inflation. Stock market declines will translate into income tax revenue declines. Also, as people begin to travel more, the shift toward spending on goods that we saw earlier in the pandemic is reversing. People feel more comfortable leaving home and consuming services that are less likely subject to sales taxes.

Inflation is more of a mixed bag strictly from a revenue standpoint. Year-over-year inflation is already above 8%, well above the Federal Reserve’s usual 2% annual target. That could increase state revenue in the short term, especially in states with progressive tax brackets that do not adjust for inflation. Higher prices could also temporarily boost state sales tax revenue.

But in the longer run, the factors pushing up inflation could make revenue forecasts even more challenging. Rising oil prices caused by the current global turmoil are one reason for high inflation. These benefit states that rely more heavily on energy industries and severance taxes.

But oil-dependent states also saw annual revenue fluctuations even before the pandemic and would be better served by diversifying their economies and tax structures. High energy costs are a problem for everyday Americans, especially for lower-income households and non-oil dependent states.

Supply chain bottlenecks and ongoing geopolitical uncertainty are partially driving inflation and could also hold down economic growth for the foreseeable future, as the Fed raises rates to tame the economic overheating. State revenue will slow if wages fail to keep up with prices and consumers shift their spending habits and look for cheaper alternatives.

Another reason the revenue slowdown could be more sudden than expected is timing. For much of 2021, wealthy households and corporations may have anticipated Congress adopting at least parts of President Joe Biden’s expansive menu of tax increases. That could have prompted both individual and corporate taxpayers to shift income and capital gains realizations from tax year 2022 into tax year 2021, also temporarily raising state tax revenue.

It’s clear that the main story of the last two years has been uncertainty and higher volatility—with the immediate declines being less severe than expected but the next few years also involving considerable uncertainty.

Are States Ready for a Fiscal Adjustment?

With the fiscal and economic landscape rapidly shifting and federal stimulus aid expiring, are states prepared for a moderation in revenue and economic growth, or did they use up too much of their flexibility with tax cuts?

Twenty-nine states and the District of Columbia passed some form of tax cuts last year, and at least 20 have done so again this year. Some of these cuts were either temporary or in the form of rebates. But others have locked in permanent tax deductions that could make it difficult to replace lost revenue from those cuts and maintain current rapid growth in spending levels caused by inflation.

Whether or not we will see another economic downturn, forecasters in the states must finalize revenue projections on the heels of this historically volatile time. And then there are longer-term spending pressures such as aging populations. The global pandemic is still not over, and ongoing geopolitical crises further complicate matters. But, unfortunately, it appears states are once again trapped in short-term fiscal planning.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Lucy Dadayan is a senior research associate with the Urban-Brookings Tax Policy Center at the Urban Institute, where she is leading the State Tax and Economic Review project.

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