Clouds on the horizon: inflation, clawbacks, economic uncertainty

From the Beacon, May 2022

The Commonwealth’s record revenue growth over the past two years is certainly welcome news. The governor and lawmakers have used this multi-billion-dollar largess to propose record state budgets, bring the state’s rainy-day fund to highest-ever levels, and create a level of stability that was hard to imagine during the early stages of the pandemic.

One of the state’s impressive and much-appreciated investments is the ongoing commitment to fully fund the ambitious Student Opportunity Act within the original seven-year time span, even though that target was set before the pandemic disrupted all planning and whipsawed the state’s cash flows. This has been possible because state revenues are growing at well-above-inflation rates, and because state leaders have remained focused and passionate about closing educational resource disparities.

Yet the recent fiscal headlines mask a number of significant concerns that local and state leaders must attend to.

At the local level, municipal finances have not boomed. Cities and towns are trapped in an ever-tightening vise, squeezed on one side by revenues that have been reduced or stalled by the COVID economy, and on the other side by a growing demand to deliver essential services to their residents to respond to and recover from the public health emergency and its negative impacts on families and businesses.

Whether this fiscal vise grip tightens or loosens will depend on several factors that are beyond the control of local leaders. These factors — high inflation, federal clawbacks and an economic slowdown — are clouds on the horizon that must be carefully monitored.

High inflation would make Proposition 2½ unworkable
In the years leading up to the pandemic, cities and towns were able to achieve fiscal stability through a combination of sound management practices, cautious budgeting, predictable revenue sharing by the state, and generally favorable macroeconomic conditions that kept revenue growth at or above the rate of inflation.

Unfortunately, that formula for success has been upended by the spike in inflation and a slowdown in commercial and industrial growth. The only way that Proposition 2½ can be managed without forcing deep cuts in municipal services is in a low-inflation environment. In most years, inflation has hovered within the range of municipal revenue growth, at about 2.5% to 3.5%. From 1983 to 2022, the average U.S. inflation rate has been 2.73%, and the highest annual rate was 5.4% in 1990. This year’s 7.9% annualized inflation rate in the U.S. is not just high, it’s more than 40% higher than any other year during the Prop. 2½ era. If high inflation continues into the next budget cycle, communities will quickly drain their reserves and the 2.5% cap on local property taxes will create a deep and enduring fiscal crisis.

Few people seem to understand how vulnerable local governments are to macroeconomic conditions. The Federal Reserve Bank and U.S. economic policy must rein in inflation quickly. This is an imperative for the long-term fiscal stability and sustainability of our hometowns and the workability of Proposition 2½. A “soft landing” is essential, or else local and state finances will be hammered.

Short-term inflation is also a powerful reason for the state to increase revenue sharing so that Unrestricted General Government Aid grows by 7.3% in fiscal 2023, instead of the far-too-low 2.7% amount proposed in the governor’s budget. The higher amount would simply match the state’s budget-to-budget revenue growth and provide communities with a local aid increase to protect municipal services from the corrosive impacts of inflation in the coming months.

Growing attempts to claw back federal ARPA funding
Just one year ago, local and state leaders in Massachusetts and across the nation were giving a standing ovation to our federal lawmakers for the unprecedented investments provided by the American Rescue Plan Act. The law targeted direct aid to every city and town in the nation, creating a lifeline for vital programs, projects and initiatives to recover from the COVID crisis and rebuild local and state economies.

ARPA provided $130.2 billion to all municipalities and counties, and $195.3 billion to state governments. In Massachusetts, this translated into $3 billion for our cities and towns, $393 million for our still-functioning county governments, and $5.3 billion for the state. Local, state and county leaders have until December 2024 to obligate the funds, and until December 2026 to spend the grants.

With this federal commitment in hand, local and state leaders have been fully engaged in planning how to best use these invaluable ARPA funds, working under the assumption that they will have adequate time to plan, allocate, appropriate, distribute, commit and spend the funds. This is not a swift process. A huge portion of the funds will be directed to capital investments, which will require extensive time for procurement, negotiation and contracting. The deadline for completing all this work to obligate the funds is, on paper, Dec. 31, 2024.

However, the minority party on Capitol Hill has made it clear that their goal is to claw back unobligated state and local ARPA funds if they return to the majority. Indeed, their demand has been to use these already committed ARPA funds to pay for new federal spending measures. While these attempts have been blocked by the majority party in recent months, if the balance of power shifts in this fall’s elections, ARPA clawbacks will become a very real possibility.

The best way to protect our communities and state from losing hundreds of millions — or billions — of invaluable ARPA dollars is to move swiftly in the allocation process, and to make certain that the funds are obligated well in advance of December 2024. With $2.3 billion in state ARPA funds still awaiting appropriation, and formal legislative sessions scheduled to end on July 31, the state is facing a new and unforeseen deadline to act within the next 90 days.

Fortunately, Gov. Charlie Baker’s recently filed $3.5 billion economic development bill (see MMA coverage here) provides an excellent vehicle to finish the ARPA appropriations process in time to avoid the risk of clawbacks that could be triggered when the new Congress convenes in January. While it would be ideal for the state to have more time to decide where to focus ARPA investments, waiting beyond July 31 would create an enterprise risk that could jeopardize access to the full amount that Massachusetts is entitled to.

Because of the political uncertainty in Washington, D.C., it is becoming increasingly clear that municipal leaders should do their best to complete their planning and decision-making processes and move to obligate the funds as soon as practicable.

Recessions always hit local governments the hardest
The third threat visible on the horizon is the global economic uncertainty created by the pandemic, supply chain disruptions, spiking energy prices and inflation — all deeply exacerbated by Russia’s immoral war on Ukraine.

With last week’s news that the U.S. experienced a real decline in GDP during the last quarter, economists are concluding that the risk of a recession within the next 18 months has increased substantially.

We know from experience that every recession has created deeper and longer fiscal stress for municipalities than for states and the federal government. This is because the federal government can operate in deficit. Our state government, while needing to balance its budget, has far more tools at its disposal, including a $5.7 billion stabilization fund (massively higher than local rainy day funds), the power to raise taxes, and the ability to reduce spending. Cities and towns have very slim reserves and cannot raise taxes without state or voter permission. In addition, local government’s main revenue source, the property tax, lags for years after a recession due to the suspension of private investment in commercial or business growth.

While communities cannot insulate themselves from a recession, they can benefit from fiscal and economic tools that their partners at the state and federal levels can provide. For example, using today’s state revenue surplus to shore up municipal aid to match inflation, and using the state’s stabilization fund to protect education and local aid if a recession comes, would help enormously. Federally, guaranteeing 100% of ARPA funds would advance projects to deliver core services, employ thousands of private sector workers, build lifelines for teetering businesses and vulnerable residents, and create stronger local economies as a base to build on.

Inflation, clawbacks, recession — that’s a lot to worry about!

The good news is that local officials, state leaders, and our federal lawmakers here in Massachusetts can lean in and work together to manage these risks.

That’s the only way to guard against the coming hazards.