• Coronavirus-related disruption has altered the stable path of economic growth projected at the January Consensus Revenue Estimating Conference. 
• Income and sales tax collections are particularly likely to experience significant reductions.
• The General Fund could face tough choices as a result of these financial challenges; the School Aid Fund may fare better, but could face revenue losses of its own.

In January, economists at the Consensus Revenue Estimating Conference (CREC) projected that the next recession was likely well over a year out. Their biggest concerns for uncertainty were with trade, international economic turbulence, and oil prices. A global pandemic, coupled with temporary shutdowns of large segments of the economy, wasn’t on anyone’s radar.

And then, faster than anyone expected, it was.

COVID-19 has destroyed a rosy fiscal forecast. Confined to our homes by a shelter-in-place order, economic realities have changed drastically for Michiganders. These disruptions will disrupt the budget. A recession is likely, say economists at the Research Seminar in Quantitative Economics at the University of Michigan (RSQE), with consequences lasting anywhere from a few months to several years. There is much uncertainty; no one can accurately predict how long the outbreak, and mitigation measures, will last. 

The current crisis will have significant ramifications for the state budget.

A Viral Disruption to State Revenue

Economic disruptions caused by COVID-19 will reduce revenue collection of many of the state’s primary revenue sources. One potential issue is that the next CREC is not until May; and there is a good chance we still won’t have a full picture by then. A few of the major revenue sources could see reductions, particularly if we experience a prolonged outbreak.

Let’s look at two of them now.

Income Taxes – Prior to the Governor’s shelter-in-place order, several industries were already temporarily shut down. Bars, theaters, dine-in restaurants, salons, and most entertainment-based locations were told to temporarily close. Numerous other stores did so voluntarily. Within the first three days of this, unemployment claims in Michigan increased 1500 percent. 

The depth of the crisis will determine the magnitude of the impact; as RSQE states, there is a lot of uncertainty with the projections right now. However, RSQE estimates that the annual unemployment rate for Michigan could increase, to anywhere from 5.8 to 8.8 percent. National projections see things getting much worse, with the International  Monetary Fund projecting a decline worse than the 2008 recession, though the rebound would likely be faster and stronger. Without a clear understanding of the economic impact, it is impossible to determine the magnitude of the effect on income tax collection.

Sales and Use Tax – With the large number of retail and dining closures, as well as the reduction in movement caused by the shelter-in-place order, sales and use tax collections are likely to decline significantly. And with unemployment spiking, many will be unable to purchase goods at the same rate they were prior. Based on a 2014 analysis from the Department of Treasury, general merchandise purchases only accounted for $600 million of the $9 billion in revenues; while food purchased for immediate consumption – i.e. restaurant meals –  accounted for more than $1 billion. The longer the outbreak drags on, the larger effect this will have on consumption, and state collections. The sharp decline in fuel prices will also reduce sales tax collections.

The causes of the current recession could affect retail sales to a larger extent than occurred during the 2008 recession. 

A State of Economic Turbulence

Disruption in state revenue collection will have varying degrees of impact on state funds. As most revenue streams are earmarked, the impact on state-funded programs will vary greatly. The state’s two largest accounts, the General Fund and School Aid Fund, will likely face different challenges.

General Fund – While there’s no good time for a recession, this is particularly poor timing for the state General Fund. While presenting the Fiscal Year (FY)2021 Executive Budget, Governor Whitmer outlined the coming fiscal pressures facing the General Fund, the state’s discretionary account. We previously outlined these, but that was when we were expecting continued economic growth. Add to that picture weakened income tax revenue (the General Fund’s primary funding source), $600 million allocation to roads, and costs of the Personal Property Tax exemptions and the Michigan Economic Growth Authority tax credits, and a General Fund struggling to be in balance will require one of two things – budget cuts or new funding, i.e., taxes. Given this crunch, there is the possibility that supplemental road funding may be cut to maintain other programs. (Yes, the damn road funding.)

Almost half of General Fund appropriations are for Health and Human Services programming (particularly Medicaid and other health care), which help fund health-care services expected to increase during and after the COVID-19 outbreak. Another 20 percent funds the Department of Corrections, which has not reduced usage and will require continued funding to maintain operations. Needless to say, the General Fund faces some of the largest risks in the current environment. 

School Aid Fund – With sales tax revenue likely to decline, the School Aid Fund will be squeezed as well;  73 percent of all sales tax revenue goes to the School Aid Fund. The good news is, the School Aid Fund receives funding from a variety of taxes and other sources. Some are likely to weather this economic climate fairly well, such as property taxes. Housing prices typically do not decline during a recession, and liquor and tobacco sales continue. Other sources may see declines, with casinos shut down (estimated to raise $121 million in FY2020), and a reduction of income tax revenue ($3 billion). Ultimately, the School Aid Fund revenue sources are likely to fare better than those of the General Fund, but there still are likely to be challenges. 

Budget Stabilization Fund – Popularly called the Rainy Day Fund, these dollars are reserved for times like this. And even though that account balance now stands at $1.1 billion, it’s unlikely to last long. Michigan had more savings in 2001 prior to the state’s economic troubles, and those were depleted in less than two years. If the situation improves quickly, it could be enough to stabilize the budget. If we enter a protracted economic downturn, the Budget Stabilization Fund could be depleted before revenue collection rebounds. 

What it all Means 

Monthly tax collection reports tell us the impact of the slowdown thus far, but shed little light on long-term projections. The May revenue conference will tell us more; revenue projections for the current and next two fiscal years will be adjusted downward substantially, but by how much, we don’t quite know. Armed with these updates, budget writers will be tasked with making sure the FY2020 remains in balance and crafting the upcoming FY2021 budget using the new figures.

The federal response could also change the calculus. The CARES act, which was signed into law on the 27th, would provide $150 billion to states for costs to fight the coronavirus that were not already in the state budget. Michigan’s share of the funding would be $3.87 billion. In addition, it would provide additional funding for medical supplies, hospitals, schools, and Medicaid to help ease the burden on states. However, as of right now this would not include aid to stabilize the General Fund budget.

With little room to spare in the General Fund budget, it will likely put policymakers in the position of figuring out how to balance the state budget for FY2020 on the fly, while balancing the General Fund in FY2021 in an already restrictive revenue environment. Nothing about today’s economic crisis was predictable several months ago. Yet today’s fiscal climate demonstrates one difficulty of building a state budget.