States should save their surpluses, not spend them

It's one of the few silver linings of the pandemic: State governments are awash in money. Many are spending it - on education, construction projects and tax cuts. They would be better off saving it for a rainy day.

There are two obvious rejoinders to this recommendation, both of which can be best expressed as questions. First: Isn't it more fiscally responsible to use the money for long-term needs and short-term tax relief? And second: You mean it's not raining now?

Both questions have the same answer: These are not normal times. That means the fiscally prudent course - Maryland Gov. Larry Hogan's plans for the state's historic windfall, for example, include a mix of long-term spending on infrastructure and short-term tax relief - is not necessarily the wisest course.

And what feels like rain to many consumers - inflation at its highest in almost four decades, and a stubbornly persistent pandemic - looks a lot different from a budgetary perspective.

The current state budget surpluses are driven by several factors. First, the pandemic caused a shift in spending patterns, from services to goods. Most state sales taxes focus on goods, so this shift caused a tremendous expansion in the relative sales tax base.

It's highly unlikely that this shift will be permanent. A simple rebalancing of consumption spending will produce major losses in state revenue. There is a chance, however, of overshooting. For example, spending on dental services was down more than 20% in 2020, the last year for which there is data. When the pandemic lifts completely, there will be a backlog of teeth waiting to be pulled.

Other services, from personal trainers to accountants, could see a surge in spending as consumers make up for all the things they put off during Covid. If and when this happens, states will face even sharper shortfalls in revenue.

A second concern is inflation. Europe experienced much of the same shift in consumption patterns as the U.S. But the trajectory of consumption spending in Europe is in line with what it was before the pandemic. In the U.S., it has accelerated at a record pace. So while Europe's inflation seems to reflect mostly transitory issues, the U.S.'s appears deeper.

That acceleration in spending and the associated rise in inflation are direct consequences of the U.S. government's much larger expenditure of pandemic relief. In one way or another, those trends have to correct themselves.

If nothing else, continued inflation will lead the Federal Reserve to raise interest rates. Some analysts are expecting as many as seven rate hikes this year. In that case, consumer spending could be cut sharply as the economy experiences a mini-recession similar to the one it went through in 2015-2016 - and states could see a precipitous drop in revenue.

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Under a more fortunate scenario, there would be fewer rate increases and a more gradual decline in overall consumer spending. There are reasons to believe that might yet come to pass: Even with record levels of consumption, Americans were not able to spend all of the relief money the government doled out over the past two years.

Savings rates hit record levels, although they began to drop sharply at the end of 2021 and they should get back to normal sometime this year. When that happens, consumers may feel more hesitant about big purchases.

Under this scenario, the hit to states' finances would be less severe. Yet it's still hard to argue that now isn't a good time for states to make deposits into their rainy day funds. Their residents' cash position is almost certainly going to decline in the near future.

So it makes sense for states to take this opportunity to improve theirs.

(COMMENT, BELOW)

Smith is a former assistant professor of economics at the University of North Carolina's school of government and founder of the blog Modeled Behavior.

Previously:
• 12/30/21: The RINO who would rescue Biden's agenda
• 07/22/21: Hey Biden, Trump could be your best vaccine friend
• 11/14/19: Trump's economy complicates Dems' message
• 11/07/19: Trump, economically, has helped minorities most
• 08/27/19: Corporations can shun shareholders, but not profits
• 06/21/19: Wealth Isn't the Problem
• 03/04/19: Warren is right that it's in the national interest to ease the burden on parents. But here's how to do it
• 01/31/19: What if the 'rich' aren't quite who the Dems think they are?