By Kate Davidson and David Harrison 

WASHINGTON -- Spending cuts by state and local governments grappling with the coronavirus pandemic pose a headwind to the U.S. economic recovery as lawmakers consider how much federal aid to provide.

State and local governments reduced spending at a 5.6% annual rate in the second quarter as they laid off workers and pulled back on services to offset plunging tax revenues. More cuts are on the way.

Moody's Analytics estimates that without additional federal aid, state and local budget shortfalls will total roughly $500 billion over the next two fiscal years. That would shave more than 3 percentage points off U.S. gross domestic product and cost more than 4 million jobs, said Dan White, head of fiscal policy research at Moody's.

Talks in Congress on another economic relief package have stalled, with assistance for state and local governments among the sticking points. Democrats are pushing for $950 billion.

Republican leaders, who didn't include aid for cities and states in their initial plan, have offered $150 billion. They cite concerns about growing U.S. deficits and debt, and they say some state budget woes predate the pandemic.

President Trump, in a tweet on Monday, suggested Democrats "only wanted BAILOUT MONEY for Democrat run states and cities that are failing badly."

Estimates of state revenue shortfalls show that the effects of the pandemic will reverberate in red and blue states alike, although its severity and the extent of lockdowns varies by state, and there are Republicans among the lawmakers calling for aid.

"I understand concerns about spending, but the cost of doing nothing is worse," said Sen. Bill Cassidy (R., La.). His home state of Louisiana has been hit hard by the virus and faces a 46% revenue decline, Moody's estimated. Mr. Cassidy has introduced a measure with Sen. Bob Menendez (D., N.J.) that would provide $500 billion for state and local governments.

"The United States cannot fully recover economically if local communities cannot provide basic services, allowing commerce to flow," Mr. Cassidy said on the Senate floor last month.

State and local governments spent or invested $2.33 trillion in 2019, equivalent to 10.9% of gross domestic product. They employ 13% of U.S. workers, whose spending fuels economic growth and who help deliver essential services and safety-net programs, such as unemployment insurance and nutrition assistance.

"Not supporting state and local governments is kind of shooting yourself in the foot," said Louise Sheiner, policy director at the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution.

State and local governments received $150 billion in the last major economic relief package, which was limited to coronavirus-related expenses. About 75% of the funds have already been allocated, said Wesley Tharpe, deputy director for state policy at the Center on Budget and Policy Priorities. Lawmakers from both parties have called for loosening restrictions on how the remaining money can be spent.

Analyses of state finances show many were well-prepared for an economic downturn -- just not the biggest one since the Great Depression. As of 2019, the median state had 7.8% of its general fund set aside in reserve, according to the National Association of State Budget Officers, up from 4.8% on the eve of the 2007-09 recession.

The U.S. economy shrank 9.5% in the second quarter from the previous three months, the steepest decline on record. Economists say the $3 trillion in economic relief already provided by Congress, including money for small businesses, direct payments to households and expanded unemployment insurance, prevented a much deeper slump.

Michael Strain, director of economic policy at the right-leaning American Enterprise Institute, said Congress should take similar steps to fill the budget hole for state and local governments, which have seen revenues decline by 15% to 20% in some cases.

Unlike the federal government, which can borrow to close the gap between expenses and revenues, almost all states are required to balance their budgets each year. So they must cut costs, increase taxes or dip into reserves to close the gap. State and local governments have cut 1.2 million jobs from March through July, the Labor Department said last week.

"The more state and local employees who are laid off, the higher the unemployment rate goes and the longer it takes to get the economy back to normal," Mr. Strain said.

The potential size of budget gaps is difficult to measure, given uncertainty about the trajectory of the virus. The Tax Policy Center, a Washington think tank run by a former Obama administration official, estimates state shortfalls could total $125 billion in the fiscal year ending next June 30, while the Center on Budget and Policy Priorities puts the gap at around $290 billion. Those estimates don't include local government funding needs.

As challenged as their budgets are, states have a cushion in the form of rainy day funds built up during the past few years, when the strong economy boosted tax revenues. California was among several states that tapped into reserves this year, using about half, or roughly $9 billion, to help balance its $202 billion budget in June.

Still, states have been wary of using all their reserves this year, said Brian Sigritz, director of state fiscal studies at the budget officers' association. Next year could be worse, and hurricanes, earthquakes or other natural disasters could strike at any moment.

Many states, fresh from their last round of budget cuts, are bracing for an even more challenging year ahead.

"As you've already made spending cuts, it becomes more difficult to make cuts going forward," Mr. Sigritz said.

Write to Kate Davidson at kate.davidson@wsj.com and David Harrison at david.harrison@wsj.com

(END) Dow Jones Newswires

August 12, 2020 05:44 ET (09:44 GMT)

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