The Case for Revenue Sharing: Fiscal Equalization and the COVID-19 Recession

Toolkit - Public Finance

By James K. Galbraith, Michael Lind and Martin J. Luby

The COVID-19 pandemic is pushing state and local governments across America into a state of crisis as revenues collapse and deep, damaging, and counter-productive cuts in essential public services, including medical care, are being contemplated. According to the Center on Budget and Policy Priorities, state budget deficits may be nearly $110 billion in FY 2020 and more than $290 billion in FY 2021.[1] These projected deficits are just now showing up as dramatic drops in state tax revenue. In Texas, general fund tax revenue in the current biennium ending on August 31, 2021 is estimated to drop by 8 percent ($4.4 billion) in FY 2020, and 15 percent ($8.8 billion) in FY 2021.[2]

The ability of most state and local governments to cover such shortfalls by borrowing, even in a recession, is strictly limited by their constitutions or laws, which require balanced budgets for operating expenses and generally restrict deficits and debt to capital projects. The federal government faces no such constraints, but emergency transfers from the federal government to states and localities, when they occur at all, take the form of bailout packages which are often too little, too late, too narrowly targeted, and impeded by sectional and partisan rivalries.

The CARES Act, enacted on March 27, 2020, established the Coronavirus Relief Fund, which provided $150 billion in federal payments to state governments (80 percent) and large local governments (20 percent), along with a Municipal Liquidity Facility (MLF) that can provide up to $500 billion in direct loans to state and local governments. But to date, the MLF has been utilized only by one state (Illinois) and one government authority (the NYC Metropolitan Transportation Authority) since the interest rate is set at a premium over market rates and thus is only attractive to borrowers who can't access the credit markets on reasonable terms. Moreover, the MLF is a short-term lending program to help state and local governments manage their cash flow needs. It does not provide resources to offset sustained revenue declines or increased spending caused by the pandemic, and cannot be used for ordinary operating expenses, even Medicaid payments, which increase significantly during recessions and epidemics.

In addition, states and localities have been unsure which restrictions on the use of CARES Act funding will ultimately apply; as a result much of the CARES Act funding has gone unspent four months after passage of the law.[3] In consequence, states and cities facing severe drops in their revenues may have to lay off teachers, police, and first responders or defer spending on capital projects, even if they receive more federal funds for pandemic-related health care. In July, 2020 almost 100 mayors of cities in Texas asked Congress for more flexible funding to help address the shortfalls caused by the pandemic. [4]

More flexibility would provide two critical advantages. First, it would permit states and localities to maintain essential public services, including education, health care, public safety, and core amenities, as well as critical infrastructure and environmental quality. Second, the funds would support local economic activity, already severely compromised by cutbacks in consumer and investment spending during the pandemic. During slumps, the feedback from lower sales and sales tax receipts to lower public spending and lower personal incomes worsens economic conditions, compounding the problems facing state and local governments and those who rely on them for essential services. The question, therefore, is how best to address this problem? We argue for fiscal equalization in the form of federal revenue sharing.

The Organization for Economic Cooperation and Development (OECD) defines fiscal equalization as "a transfer of fiscal resources across jurisdictions with the aim of offsetting differences in revenue raising capacity or public service cost. Its principal objective is to allow sub-central governments to provide their citizens with similar sets of public services at a similar tax burden."[5] In Canada, fiscal equalization dates back to 1957 and was enshrined in the Canadian Constitution in 1982: "Parliament and the Government of Canada are committed to the principle of making equalization payments to ensure that provincial governments have sufficient revenues to provide reasonably comparable levels of public services at reasonably comparable levels of taxation."[6]

The U.S. is the only major democracy that does not have a system of fiscal equalization at the national level, although many state governments address local property tax disparities with equalization policies. This has not always been the case. Between 1972 and 1986, the U.S. had its own fiscal equalization policy in the form of the General Revenue Sharing (GRS) program, in which federal funds went to state and local governments, which enjoyed wide discretion in their use.

The U.S. is the only major democracy that does not have a system of fiscal equalization at the national level.

First proposed by the Democratic economist Walter Heller, chair of the Council of Economic Advisers under Presidents Kennedy and Johnson, the GRS program was pushed through Congress by Republican President Richard Nixon. It enjoyed the support of Hubert Humphrey, Barry Goldwater, Ronald Reagan, Nelson Rockefeller, Gerald Ford, and Thomas P. "Tip" O'Neill Jr. Administrative costs of revenue sharing were low, only one-tenth of 1 percent. In the state of New York, "revenue-sharing paid for teachers in Manhattan and streetlights in Buffalo, provided snowplows for Adirondack villages and built the community hall and ice rink in New Hartford."[7]

Support for revenue sharing was broad but shallow, and the opposition of an odd coalition of anti-government conservatives and liberals who preferred narrowly targeted federal programs was intense. Ultimately, after 14 years of operation, revenue sharing was abolished in the interest of deficit reduction by the Tax Reform Act of 1986.

Federal revenue sharing should be revived now as an emergency measure for the duration of the economic crisis caused by COVID-19. Revenue sharing would reduce the need for one-time, last-minute congressional rescue packages, and eliminate the partisan impasses that we are presently seeing across the country.

Federal revenue sharing should be revived now as an emergency measure for the duration of the economic crisis caused by COVID-19.

The allocation of $150 billion for state and local governments by the CARES Act provides one model for a revenue-sharing formula that could be sustained over several years. Funding for local governments with more than 500,000 people was divided among local jurisdictions themselves (45 percent) and state governments, to be used for the same jurisdictions. State governments controlled 100 percent of the funding for populations in localities with fewer than 500,000 residents, and each state received a minimum of $1.25 billion, regardless of population. Funds were also earmarked for U.S. territories and the District of Columbia and tribal governments.[8]

Following the present crisis, Congress might consider making the temporary system of federal revenue-sharing permanent. Revenue-sharing could become a part of the economic toolkit known as automatic fiscal stabilizers—available as needed in situations that states and localities cannot control. During downturns, the federal government would provide funds that state and local government could use to cover gaps in their operating expenses, providing a lifeline to teachers, first responders, and other public employees. The economic effect of revenue sharing would be counter-cyclical, moderating economic declines. Revenue sharing might phase back down as the state and local economy and tax base improved.

If a prolonged but temporary program of emergency revenue-sharing were converted into a permanent system, numerous questions of program design would need to be addressed. The federal funds could be drawn from general revenues, or from an earmarked (hypothecated) tax, like the resource taxes on oil and gas which the Canadian and Australian federations distribute among their sub-units as part of their fiscal equalization programs. Earmarked taxes for revenue-sharing might be sequestered in a trust fund. Limiting revenue-sharing to funding of public services rather than contributions to social insurance, such as the state portions of Medicaid and unemployment insurance (UI) funding, might improve the likelihood of the program's adoption.

The economic consequences of the COVID-19 pandemic would have been less severe if Congress had not abolished the General Revenue Sharing program. Fiscal equalization in the form of a temporary but automatic system of federal revenue sharing, which could be converted into a permanent program in the future, can still do much to promote recovery. Should it be made permanent, it would significantly reduce the harm caused by future economic disasters as well.

James K. Galbraith holds the Lloyd M. Bentsen Jr. Chair in Government/Business Relations at the LBJ School of Public Affairs and a professorship in government at The University of Texas Austin. Michael Lind and Martin J. Luby are, respectively, a professor of practice and an associate professor at the Lyndon B. Johnson School of Public Affairs at the University of Texas Austin.