New research: When states cut budgets during economic crisis, income inequality worsens

 
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June 12, 2020

States that slash spending to make it through an economic crisis can end up worsening income inequality — the gap separating incomes of top and bottom earners — for years, finds new research in State Politics & Policy Quarterly.

Americans today are dealing with a sudden and deep recession brought on by the coronavirus pandemic. With tens of millions of jobs gone or waylaid since the U.S. economy shut down in March, and anticipated tax revenues dried up, state leaders face tough budget decisions. Ohio Gov. Mike DeWine in May announced spending cuts of $775 million, with the biggest chunks coming from education and Medicaid. DeWine has said he won’t raise taxes. Meanwhile, California has borrowed almost $350 billion from the federal government for unemployment insurance and also plans to cut education spending. U.S. Senate Majority Leader Mitch McConnell in April suggested states should file for bankruptcy, but that would take a change in federal law, which does not allow states to go bankrupt.

States that cut budgets and reduce revenue through measures like tax cuts tend to have even worse income inequality in the long run, the new research finds, meaning fiscal choices states make during the coronavirus recession could exacerbate income inequality for years.

“Most states have to have a balanced budget,” says William Franko, an associate political science professor at West Virginia University, who wrote the paper. “The federal government, at the same time, is putting more policy burdens on the states. When we hit a severe recession like this, it’s not sustainable for states to maintain their spending and programs.”

The National Conference of State Legislatures, an organization representing state legislatures, provides a real-time, searchable database of fiscal and other laws states have passed in response to the pandemic.

A smaller sliver

Franko examined state-level income and spending data covering 1987 to 2012. There were three recessions during that period lasting at least eight months each. The National Association of State Budget Officers does a yearly survey of state fiscal health, including on spending and tax changes made after a state’s budget was passed. Franko used data from the survey to capture how states adjusted their budgets following economic shocks, like recessions. He explains that he wanted to focus on distinct budget and policy shifts in response to fiscal crises — rather than on existing policies that went to work when the economy took a dive.

Franko also used state income inequality data that U.S. Census Bureau economist John Voorheis compiled. The data measures income inequality as a ratio of the earnings of the top 20% of wage earners in a state to the earnings of the bottom 20%. The average ratio across states during the study period was five — meaning, on average, the top fifth of earners brought home five times more than the lowest fifth. Put another way, someone in the top fifth of earners in an average state would likely earn about $100,000 a year, while someone in the lowest fifth would likely earn about $20,000 a year.

The upshot is that when states cut budgets during downturns, their inequality ratio rises. For example, Franko demonstrates that a state with an inequality ratio of about five that suddenly cut its budget by 4% would expect to see its ratio bump 6.2%. That average state could see its top earners go from making five times its lowest earners, to 5.3 times, post-budget cuts.

Franko also finds that budget cuts are associated with the lowest fifth of earners having less income share. Think of the income a state’s residents earn as an apple pie. After budget cuts, there’s a smaller sliver that the lowest fifth of wage earners contributes to the whole pie. That’s income share.

What’s more, unexpected budget cuts are associated with persistent inequality across the years studied. States that favored revenue increases, however, decreased the income share for the top fifth of earners, in part because states trying to increase revenue may pursue policies like higher taxes for high earners.

“When you put the two together — cutting back on revenue and on spending at the same time — this is where you see a large increase in inequality,” Franko says.

Nasty weather

Every state has a rainy day fund set aside to close budget shortfalls. Vermont is the only state without a balanced budget requirement, though the state’s departments and agencies can’t spend more than authorized. Balanced budget rules can vary widely by state.

States had a total of $72 billion in rainy day funds as of October 2019, representing 7.6% of general spending, according to NASBO’s most recent Fiscal Survey of States. That’s up from 4.7% before the Great Recession that began in December 2007, meaning states were better prepared this time around to absorb budget shocks.

But those rainy day funds — also called “reserve funds” or “budget stabilization funds” — are still not enough to make up for budget losses during a moderate or severe economic downturn, according to the Congressional Research Service. Some states, like Illinois and Kansas, had almost nothing in reserve funds before the coronavirus recession. And local governments rarely have rainy day funds, the CRS reports.

Recent federal legislation has directed $150 billion to help state and local governments, including extra financial support for Medicaid and food assistance programs. Earlier this year, the U.S. Department of the Treasury created a $500 billion short-term lending program for states and large local governments. But the newly created Congressional Oversight Commission found in mid-May that the Treasury Department had, so far, disbursed a small fraction of those funds.

Still, rainy day funds and hundreds of billions of dollars in new federal government aid likely won’t add up to enough to avoid austere budget measures that could exacerbate inequality, Franko says.

One potential solution he suggests: federal legislation that would automatically kick-start federal dollars during recessions, as state demand spikes for health care, unemployment benefits and other assistance.

“States can’t do it on their own,” he says. “There needs to be some better long-term thinking about the programs that we have in place that are meant to help people during economic recessions and what the states, in combination with federal government, are going to do.”

Check out our other coronavirus-related resources, including tips on covering biomedical research preprints and a roundup of research that looks at how infectious disease outbreaks affect people’s mental health. Also, don’t miss our features on rural broadband and alternative financial services in the time of coronavirus.

 

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