After having left it out of the last COVID-19 response bill, Congress is considering a new package of aid to states and cities. Speaker of the House Nancy Pelosi (D-CA) is seeking $1 trillion in new aid to states and cities. Republicans are skeptical, arguing that Congress should not aid states that came into the crisis in bad fiscal shape. Senate Majority Leader Mitch McConnell (R-KY) came out against any new aid, suggesting instead that states be given the power to file for bankruptcy. He has since suggested that he was open to a state and local aid package, but with some conditions. President Trump said that if state aid were included in a relief package, “we’re going to have to get something for it.” 

States and localities are in desperate need of aid, their budgets having been decimated by the pandemic and the economic collapse. Forcing them to make (more) severe layoffs, spending cuts, and tax increases would be a macroeconomic disaster and a social one–leaving more unemployed people during a harsh recession and more people without quality government services in their time of greatest need.

The positions taken by McConnell and Pelosi suggest that providing aid, but putting some conditions on it, might be a deal that both sides could agree on (although it is possible that McConnell may want unrelated legal changes). 

But what conditions on state and local aid can and should be included? Any conditions should address the underlying reasons why some states came into the crisis in bad fiscal shape–problems in state politics and budgeting practices–without getting in the way of getting aid to states quickly. 

Below I suggest three reasonable, limited conditions that would address concerns about state fiscal weakness while not getting in the way of aid needed during this crisis.  

Why Do States Need Aid?

As many analysts have discussed, both here and elsewhere, state budgets are wildly pro-cyclical. Because states cannot print money and don’t have effectively unlimited borrowing capacity like the federal government, there are natural limits on how much they can borrow during recessions. Further, state constitutions include balanced budget requirements and debt limits that create legal barriers to running deficits.  

As a result, when times are good, states can and do spend or cut taxes. But in recessions, they have to cut back, reducing services and raising taxes. This is macroeconomically perverse, as it worsens recessions. And it is cruel because we rely on states to share in the funding of many crucial social safety net programs, like Medicaid and Temporary Aid for Needy Families, which end up experiencing cuts just when people need them the most.

The COVID-19 crisis has been particularly brutal for state and local budgets. Not only are income and capital gains taxes down, normally reliable sales tax revenue is also declining as people stay at home, while the most active parts of the economy–professional services–are not included in the sales tax base. Other reliable revenue sources, like farebox revenue for transit agencies and the money public hospitals get from elective surgeries, have also cratered. On top of this, the pandemic has increased costs, both for direct public health spending and in other areas, with public transit unable to run at normal capacity and state universities shuttered.

The result is a huge world of hurt for state and local budgets. The CARES Act included $150 billion for states and cities, plus money for transit agencies, schools and hospitals. State rainy day funds were better funded coming into the crisis than they had been in the past (although some states had almost nothing saved). The Federal Reserve stands ready to loan up to $500 billion by buying short-term bonds–but those are loans not grants. Bond markets are already treating Illinois like its debt should be considered junk.

Even so, the damage to state and local budgets is much much bigger than all of this. Failure to provide aid will lead to lots of layoffs (which we are already seeing), rising tax rates, and major macroeconomic harm.  

Would Giving States and Cities Money Be a “Bailout”?

Not really. As long as the aid goes to all states roughly equal to population or in proportion to COVID-19 cases, it isn’t what we’d traditionally consider a bailout. Instead, the federal government is spending money and delegating decision-making to the state governments. If a state is still in fine fiscal shape, it can use the money for new purposes, new spending, or tax cuts or savings–that is, if Congress lets it. The CARES Act included unfortunate conditions that money be spent on problems necessitated by the crisis and before December 2020, and on things not previously budgeted for. 

If the aid were targeted at places in poor fiscal condition, or allocated on the basis of debt, we’d need to have a very different discussion. When Illinois’s state senate president asked Congress for $40 billion in aid specifically to pay for its pension debt and other woes, he was asking for a bailout. When Congress adopted Alexander Hamilton’s plan to assume state debts, that was a bailout. What Congress gave to D.C. in 1995 was a bailout–albeit one with substantial conditions.   

Bailouts raise questions about moral hazard and inter-state equality. As Jonathan Rodden argues, if one state got a bailout, other states might think they should be similarly irresponsible, believing there would be no consequences. Donor states might reasonably be angry about funding other states’ profligacy. Granting bailouts regularly, as Rodden shows, would necessitate a much heavier federal hand in state budgeting practices, lest the U.S. replicate the types of financial crises created by too much provincial spending we saw in Brazil and Argentina in the 1990s.

But that’s not what anyone in Congress is talking about, at least yet.

Should Aid Be Offered Without Conditions?

Probably not. Some states genuinely have been fiscal basket cases for quite a while. You can see how indebted many states, counties, cities, and school districts are in this great piece by Alicia Munnell and Jean-Pierre Aubry. For states like Illinois and New Jersey, and for cities like Chicago, it’s ugly. Many states and cities have been able to hide how bad their budget condition is, and to avoid state law limits on budgets and debt, behind clever accounting and other tricks.  

Congress could pass some new rules to address some of these long-run budget problems without getting in the way of the central goals of a state and local aid bill. This could save the economy from collapse, and fund necessary public health interventions. 

 What Conditions Would Be Reasonable?

In order to answer that question, it is important to ask why some states–Illinois, Kentucky, Louisiana, Connecticut, and New Jersey among others–came into the crisis in such a troubled state. 

Federalism theory suggests that states should not get into massive fiscal trouble for a few reasons. State politicians are theoretically accountable to voters in elections “closer to the people”; state fiscal constitutions constrain spending and debt; and officials’ fear of “exit,” by either mobile residents packing their bags or investors refusing to buy bonds. But many of these mechanisms are pretty broken. State legislative elections turn almost entirely on national partisanship, reducing accountability. Resident exit is constrained by unfortunate policy decisions, like excessive zoning and occupational licensing rules in high demand jurisdictions, and economic changes that have reduced interstate mobility.  

This leaves state budgets unprotected against claims on the public fisc by intense policy demanders and politicians’ short-term desires to avoid doing unpopular things. In the next aid bill, Congress could tie aid to changes that seek to make legal, financial market, and political mechanisms more effective in checking state largess. 

  1. Require Changes in Budgeting Practices 

States and cities are required to balance their budgets, but the methods they use for accounting for expenses in their budgets allow them to hide all sorts of secret forms of debt.  

Most states and cities use “cash” accounting in their budgets, simply looking at whether the state spends the same amount as it collects. But this allows them to book positive revenues for policies that are actually revenue losers and to hide today’s spending. For instance, when Arizona sold its state capitol (while promising to pay rent and buy it back after a number of years) it could claim to balance its budget and not issue debt–even though it was, for all intents and purposes, borrowing money. Pensions are accounted for when the money goes out the door, not when the pension is promised or when it vests.  

In contrast, following its budget crisis, New York State required New York City to follow Generally Accepted Accounting Principles when budgeting that rely on “modified accrual” accounting.  Virginia has done the same thing for its budget. This requires states and cities to book expenses when they are incurred, rather than when the cash changes hands. States use accrual accounting when preparing their annual accounting statements (which are backward-looking), but don’t do it when setting their budgets

 The Volcker Alliance put together a nice compendium of budgeting practices that limit the ability of states to hide incurred expenses.  In particular, bans on treating debt-like instruments as revenue would be useful.  Policies like Chicago’s sale of 75 years of parking meter revenue for a one-time infusion of cash should not be allowed to balance budgets.  States have traditionally used excessively aggressive and economically-strange discount-rate assumptions for pensions, given that paying them is constitutionally required.  

Congress could condition aid money on adopting new accounting practices when setting their budgets, giving states a few years to implement them, so as not to require cuts during this crisis. A reasonable step would be a requirement that by 2024, states adopt budgeting practices in line with the general principles of accrual accounting. Given that a one-time shot of aid will not give the federal government much leverage to insist on a structural change like this, perhaps Congress could pass a law requiring states make changes in their budget process in order for their municipal bonds to be tax-exempt.  

Notably, doing so would not only improve the power of legal limits on excessive debt taking–it would make state politics work better. It is too much to ask voters, or even informed observers, to track complex financial transactions. To the extent that state voters (and probably more importantly, journalists and politicians in the opposition) can see the costs being imposed, they will have a greater capacity to hold politicians accountable. 

  1. Repeal the Tower Amendment

When states and cities issue bonds, they are not required to make the same kinds of disclosures as other sellers of securities.  Under the “Tower Amendment,” the SEC is barred from requiring issuers to disclose information prior to selling municipal bonds.  The SEC does indirectly regulate disclosures through regulations on underwriters, but “quality, consistency and timeliness” of disclosures have long been criticized by investors.

The justification for the Tower Amendment is that states and cities rarely default, so making them bear compliance costs is unnecessary.  In a world where states and cities have to borrow from the Federal Reserve to stay afloat, and where Congress is offering huge amounts of aid, this makes less sense. 

Requiring disclosure will help the bond market encourage states and cities to budget more responsibly.  But it will not only help capital markets discipline governments, it can be leveraged to make politics work better.  More disclosures would give reporters and political opponents more capacity to look under the hood of local budgeting practices.   

  1. Help States Develop Rainy Day Funds

Outside of regular federal aid, the only real answer to the problem of pro-cyclical state fiscal policy is for states to save money in good times.  If states save money in good times, they could engage in counter-cyclical spending in bad times, without running into the practical and legal limits on deficit spending.

Rainy day funds are the mechanism through which states save.  While such funds were in better shape than they had been in recent years coming into the crisis, many states were without much in the way of reserves.  States should save, but it is hard to get politicians and voters–who were facing lots of real needs even in 2019–to put money away when they could spend it on new roads, better schools, or lower taxes.

Brian Galle and Kirk Stark argue that states will never save enough without federal help.  They suggest that the Federal Government subsidize rainy day funds, providing matching money.  But drawing on Richard Thaler’s work in the context of individuals, they suggest states could be induced to “save more tomorrow,” locking in future savings policies in future periods rather than doing it all today.  The feds could also be given control over when rainy day fund money can be accessed, stopping premature raids on the money.  (Amazingly, Connecticut was considering raiding its rainy day fund months before the COVID crisis, because politicians did not want to impose new tolls). Galle has a similar type of proposal for reforming unemployment insurance.  

This blast of federal aid could be used to get states to opt into a “Save More Tomorrow” program, getting them to save more when the economy improves,  thus blunting the negative effects on state budgets of the next recession. 

What About State Bankruptcy?

McConnell proposed state bankruptcy as an alternative to state aid–a position he has somewhat backed off of.  McConnell’s statements were seized upon by a whole host of critics, who lambasted the proposal.   

But the idea of state bankruptcy developed by David Skeel) has been wildly misunderstood, both seemingly by McConnell and by its numerous critics.  Although it would not be particularly useful as a response to this particular crisis,  it is not a bad idea. 

To start, critics and supporters alike seem to think that states need bankruptcy in order to default. They don’t. States, possessing sovereign immunity, can default just as sovereign nations can.  Additionally, even more than sovereign nations, they are protected against creditor lawsuits.  Many states have in fact defaulted.  Eight did so in the 1840s, and a group of Southern states grossly repudiated Reconstruction-Era debtsArkansas defaulted in 1933. (The state has in fact defaulted three times, making it the Argentina of the U.S.). If states don’t want to pay creditors, they do not need to wait for the federal government to create a legal regime ( i.e. bankruptcy) for them to do so.

Further, bankruptcy could not be imposed upon states.  To justify Chapter 9  (which governs bankruptcy for municipalities) the Supreme Court relied heavily on the fact of state approval.  Cities cannot file for bankruptcy without specific authorization from state legislatures.  There is no way it would be constitutional for Congress or creditors to make states file. It would need to be the state’s choice.  Further, in municipal bankruptcy on which state bankruptcy would be modeled, cities (and not creditors) design their “plans of adjustment” or proposals to exit bankruptcy.  There are questions about whether state bankruptcy might still be unconstitutional even with state authorization (this is doubtful, for what it’s worth), but there is no doubt that states could not be forced to file.  

As a result, a law authorizing bankruptcy for states would not be an imposition on them.  It would be a new power granted to them.  One might ask,  as Vincent Buccola has, whether any state would file, even if given the power.  After all, doing so would reduce a defaulting state’s freedom to pay some creditors and not others, as it would impose the rules of bankruptcy on them.  One can imagine situations in which a state would use it.  They might seek to avoid political claims from groups of different types of creditors.  Or they might use bankruptcy as a way to avoid hounding from the federal government on behalf of creditors, as we saw in Arkansas in 1933.  Regardless, it could not be imposed on them.     

What follows from this is that the horror stories critics tell about the idea of state bankruptcy don’t make a lot of sense.  People say that it is targeted at state public pensions.  But in most municipal bankruptcies, bondholders see smaller recoveries than pensioners because the plans of adjustment are written by the city (and courts have signed off on this).  Further, writing down debt of all kinds frees up fiscal space to provide services to residents. Critics also suggest that adding a state bankruptcy code would cause havoc in the bond market. But as states can already default, it should not shake the market too much.

But all of that said, state bankruptcy is not much of a response to this crisis. To start off, it’s not clear that any state is insolvent. States have lots of tools for cutting spending, most notably cutting aid to cities and school districts (which may make those local governments insolvent, but that’s another issue) or raising taxes. They can also further underfund their pensions. 

Perhaps more importantly, the Federal Reserve stands ready to make short-term loans to states and bigger cities and counties–meaning there isn’t likely to be any short-term financing problem that forces any of these governments into insolvency for a while (although the news from Illinois is pretty scary).

The real question today is whether states will cut spending and raise taxes or whether they will get money from the feds–either in grants or loans.  If state bankruptcy solves some problems (and it likely will), it may be useful at some point down the line, not immediately, when a state is genuinely insolvent and short-term financing is withdrawn. Designing a well-functioning state bankruptcy regime would be a complicated endeavor. Attempting to create such a law in a rushed aid package–without hearings, without committee reports, without Congress even really being able to meet–would be extremely difficult.

But there are things we can do now that would address Republican concerns about irresponsible state budgets without stopping money from getting to states today. We should do them.

David Schleicher is a senior fellow at the Niskanen Center, a Professor of Law at Yale Law School, and an expert in election law, land use, local government law, state and local finance, municipal bankruptcy, urban development, transportation, and local regulation of the sharing economy. His work has been published widely in academic journals, including the Yale Law Journal and the University of Chicago Law Review, as well as in outlets like The Atlantic and Slate.