Local Revenue Impacts
This kind of deep and relatively short-to-medium length recession is rare and places a number of unique pressures on local government revenue streams.
The usual time lag between the taxable event (e.g., retail sales), collection of taxes by the state, and distribution of tax revenues to the local government will provide some needed immediate-term relief to local governments, as March and April revenues are based on activities in prior months.
On the same note, even if a strong economic recovery begins as early as the third quarter of 2020, local governments will be feeling the revenue pressure in those same months.
As a result, we expect to see a larger drop in revenues in the third quarter of 2020 than in the second quarter.
On a fiscal year basis, then, FY2020 revenue growth will weather the storm to some extent. A significant portion of the year’s collections are already on hand, and economic impacts over the final few months of the fiscal year will not entirely show up in reduced collections until the next fiscal year.
With that in mind, we expect the first three to six months of FY2021 to be particularly challenging for local governments. The second half of FY2021 should provide needed relief, but we would not anticipate positive revenue growth in FY2021 relative to FY2020.
One of the most important revenue streams for local governments are sales taxes, both in terms of shared revenues from the state general sales tax and also from local option sales taxes.
This is where we will see the most significant negative revenue impacts from the shutdown of a wide array of economic activity in the effort to slow the spread of the virus, including government action and the individual actions of business and people. While consumers will shift some of their consumption away from impacted sectors like restaurants and brick and mortar retail stores towards grocery stores and online shopping, the net impact on sales tax collections will certainly be negative.
Fortunately, the negative impact from fewer sales of big-ticket items like home appliances and automobiles will likely be made up as many of those purchases will take place at a later time.
This pent-up demand will provide a welcome boost to collections at some point in FY2021 or FY2022, but some of the foregone taxable sales activity will never be made up.
It is important to recognize that sales to businesses (rather than consumers) represent a significant portion of local sales tax bases, and those sales will also suffer from the slowdown or shutdown of economic activity in response to the virus. As with business-to-consumer sales, some of the foregone business-to-business activity will eventually be made up while others will be lost forever.
Local governments that are more dependent on tourism will see even sharper declines in sales tax collections, driven by the absence of the tourists themselves as well as the income they provide for that locality’s residents.
The story should not be nearly as bleak for the other major component of local revenues: the property tax. There will be two possible sources of downward pressure on property tax collections. First, if the economic recession causes a longer-lasting reduction in property sales, this could place downward pressure on sale prices and thus property values, which could then reduce property tax collections unless the tax rate is increased.
This is likely to be more important story line when it comes to commercial rather than residential property since commercial property was already under stress. The expected depth of the recession could certainly place short-term pressures on property transactions, but the short duration should bring needed recovery in FY2021 or FY2022.
The second source of downward pressure is perhaps more meaningful for local governments in the immediate future: impacts on compliance and the timing of property tax payments.
To be sure, a significant portion of FY2020 property taxes have already been collected. The question remains as to whether the remaining portion will be paid in full and on a timely basis. This could create significant cash flow problems for local governments who need to pay their own bills but will likely have a sincere interest in working with their residents to ease the local economic burden created by the virus. Liquidity-constrained businesses and households may have problems meeting their property tax liabilities in FY2021.
Other Revenue Sources and Issues
Many local governments depend on revenues from gasoline and motor fuel taxes. On one hand, the sharp reduction in consumer mobility as a result of social distancing and Safer-at-Home guidelines will certainly lead to reduced revenues from gasoline taxes.
This could be muted somewhat if residents make greater use of food delivery options from their favorite restaurants. On the other hand, to the extent that residents become more likely to shop locally for groceries and other necessities and also more likely to shop online for needed items, delivery truck traffic will increase and provide needed relief in the form of motor fuel tax collections that do not fall as much.
The depth of the COVID-19 recession has created sharp drops in activity for a large segment of the economy.
The most significant impacts thus far involve hotels, restaurants, bars, tourism, and other hospitality services and to a slightly lesser extent retail trades and the manufacturing sectors. These industries will have a very difficult time making their regular tax payments, so it is feasible to expect some of them to seek discretion from local governments in order to allow later or reduced payments.
Indeed, one of the first revenue-related responses from the federal and state governments has been the extension of tax payment deadlines, most famously with the extension of the federal income tax deadline from the traditional April 15 to July 15 as well as a similar state-level extension of the Hall income tax and franchise and excise tax payments.
While these extensions provide important and needed cash flow benefits to taxpayers, these actions place considerable revenue strain on local governments that depend on shared revenues from higher levels of government. Several local government revenue streams are passed through the Tennessee Department of Revenue following state-level collection, and it remains to be seen whether the state will make efforts to keep those funds flowing even as collections slow significantly.
Assisting these possible efforts will be the massive federal stimulus efforts. The most recent CARES Act legislation includes a considerable amount of funding for state and local governments that are most heavily impacted by COVID-19.
Tennessee stands to receive approximately $2.6 billion from this pool of funds, which will certainly reduce some of the state and local revenue strain.
Local government officials are wise to consider the various pressures that will confront their primary revenue sources in the near term. Local tax collections will surely show signs of recession over the next few months, and will become very significant in the first few months of the next fiscal year.
State and federal actions will hopefully provide some needed support for local governments that see sharp drops in funding, such that they can continue to provide vital services in health care, safety, education, and other areas.
Fortunately, the negative economic impact of COVID-19 should begin to reverse course during calendar 2020 or early-2021 and allow local governments to get back on track thereafter. Our general expectation as of this writing is for negative revenue performance through FY2020 followed by flat revenues in FY2021 before resuming to trend.