COVID-19 economic impact could threaten state and school district budgets

COVID-19 economic impact could threaten state and school district budgets

As school leaders work to maintain some level of instruction and other support for children with school buildings closed until the end of May, there are growing concerns that the economic fall-out from the COVID pandemic could undermine the state budget, which provides about two-thirds of total school funding.

The COVID crisis has not affected state revenues yet. State general fund receipts for March were down just 1.6 percent for the month, and revenues for the year remain about $175 million higher than projected in November. Even without the extra revenues, the budget adopted by the Kansas Legislature is projected to have an ending balance of $927 million at the end of the current fiscal year on June 30 and $731 million next year.

But when the official Consensus Revenue Estimating Group meets April 20, it is widely expected to lower revenue estimates, as many economists say the current Coronavirus pandemic could have an impact equal to or worse than the Great Recession of 2008 and 2009.

State revenues depend mostly on income and sales taxes. The waves of layoffs and reductions in working hours required by closure of “non-essential” business activities mean wage income will be reduced, and the worst drop in the stock market since 2008 means lower capital gains. Those with lost income will have less money to spend and those maintaining their incomes will have less opportunity to shop, reducing sales and therefore sales tax revenues.

Even more than the immediate impact, these effects could cascade through the economy by causing individuals and businesses to cut back on spending, hiring and expansion. Further, the loss of tax revenue could mean cuts in funding for public programs, leading to even more unemployment and reducing public purchases from the private sector.

Looking back at 2008

The Great Recession brought on by the 2008 financial crisis had the most negative impact on the Kansas economy since the Great Depression of the 1930’s. For the first time since at least 1975, Kansas personal income (the total annual income of all state residents from all sources – wages, farm and business income, government payments) actually declined by 3.4 percent, from $114.4 billion in 2008 to $110.5 billion in 2009.

Chart 1: The financial crisis of 2008 led to the largest cut in Kansas personal income in at least half a century, but the economy recovered relatively quickly.

The calendar year for personal income ends in December, while the state’s fiscal year ends June 30, creating a lag. State general fund receipts dropped $106 million or 1.8%, from 2008 to 2009, but then plunged $504 million in 2010, for a two-year decline of almost 11 percent – three times the reduction in state personal income.

Because the state had a general fund ending balance of $526 million, or 8.6 percent, in 2008, state programs were not immediately reduced; in fact, SGF expenditures actually increased by $62 million in 2009, the final year of a three-year phase-in of school funding in response to the Montoy school finance lawsuit. But spending down balances provides only “one time” funding; it can’t be spent the following year. In 2010, SGF spending would drop $895 million, or 14.5 percent.

Of that $895 million, about half, $437 million, was K-12 state aid. The impact was blunted somewhat by about $476 million in special federal aid spread over 2010 and 2011. But total school funding dropped by over $100 million from FY 2009 to 2011, and school district general funds, local option budgets and special education state aid dropped by nearly $200 million – almost five percent – from 2009 to 2010.

By 2011, the state economy was recovering. Kansas personal income increased 8.5 percent in 2011 and 6.2 percent in 2012. State general fund receipts increased 13.3 percent in 2011 and 9.0 percent in 2012. SGF expenditures increased 7.5 percent in 2011 and 7.6 percent in 2012, and the SGF ending balance increased from essentially zero in 2010 to over $700 million, or 11.6 percent, in 2013.

Those trends suggested the Kansas economy and state budget were returning to normal. But in 2012, Republicans in the Legislature, pushed by Governor Sam Brownback, approved deep cuts in the state income tax, especially for small business. Brownback said the reason for the cuts was to stimulate the economy.

The resulting reduction in state income tax revenue was higher than projected, a higher state sales brought in less revenue than expected, and Kansas personal income growth dropped below 3 percent per year from 2013 to 2017, when the tax cuts were largely repealed, ranking Kansas among the slowest growing states in the nation. Ending balances again dropped to near zero, state support for education trailed inflation and most other states, payments to the state retirement system were delayed and hundreds of millions of sales tax dollars dedicated to the state highway fund were shifted to the state general fund.

Chart 2: The 2008 crisis led to a sharp decline in state general fund revenues, followed by cuts in SFG spending. That was followed by reductions due to income tax cuts, which were largely reversed in 2018. Adjusted for inflation, the state general fund has only recently returned to 2008 levels.

The income tax repeal and changes in the federal tax code have boosted state revenues, and Kansas personal income grew an average of over 4 percent annually in 2018 and 2019, which allowed the state to begin a six-year school funding plan from 2018 through 2023.

It is unknown whether the impact of the Coronavirus will be as bad, or worse, than 2008. Some believe the economy might quickly “snap back” if social distancing is eased or ended relatively quickly and people can return to work and consumer spending resumes. Others worry that if the health issues persist, many jobs will be lost permanently.

Impact of state funding changes on education

Changes in the state general fund almost always have a major impact on K-12 funding. In fact, since the mid-1990’s when the current school funding system was adopted, about 50 percent of SGF expenditures every year have gone to K-12 state aid.

Chart 3: Despite increases and decreases in the Kansas state general fund, about 50% of expenditures have gone to K-12 state aid each year since the mid-1990’s, when the state took over a larger share of school funding.

The budget for current year (2020) provides about $7.8 billion in SGF spending. Of that amount, K-12 state aid is just under $4 billion, or 51 percent. Higher education and programs like the state library and historical society receive about $850 million, or 11 percent. Human services, including state hospitals and other medical assistance programs, receives over $2 billion, about 26 percent of the total. Over $1.3 billion is human services caseloads, which are mostly matching dollars required for federal programs that can’t be reduced without losing federal aid. In fact, human services costs usually rise during economic downturns. The remaining 12 percent includes public safety, agriculture and natural resources and general government functions.

If SGF spending is reduced and K-12 funding and human service caseloads are not, other programs would face deeper cuts than an “across the board” reduction.

Of the roughly $4 billion in general state aid school districts receive, nearly $2.3 billion is general state aid. Most of the rest is in three major programs, each around $500 million: Kansas Public Employee Retirement System contributions for employee pensions; state aid for local option budgets; and special education state aid.

School districts also receive aid that does not go through the state general fund. This includes the 20-mill statewide levy, which goes to the state and is distributed back to school districts but not through the general fund, and capital improvement (bond and interest) state aid, which is automatically transferred before going into the general fund.

Districts also receive about $1.8 billion in local revenues, mostly local property taxes but also student fees and any other local revenue. These funds could also be reduced due to higher tax delinquency rates and fewer families able or willing to pay fees. Significantly more students are likely to quality for free meals.

Finally, districts receive about 8 percent of their total revenues from the federal government. This will increase temporarily because Congress has approved additional federal aid to help schools deal with pandemic.

The education funding cuts passed by the Legislature were almost entirely in state foundation aid, which reduced school district general fund budgets. The general fund, along with the LOB, is where most salaries and general operating costs for educational programs are paid.

School finance and Kansas Supreme Court Review

In 2009, the state was completing a three-year phase in of additional school funding to settle the Montoy decision by the Kansas Supreme Court. The Court dismissed the case after the Legislature passed the three-year plan in 2006. That plan was based on a Legislative Post Audit cost study of providing state education outcomes and was presumed constitutional by the Supreme Court.

When the Legislature began reducing base state aid per pupil, froze local option budget state aid and eliminated capital outlay state aid, plaintiff school districts filed the Gannon case, which had to “start over” at the district court level and work its way up to the Supreme Court on appeal.

However, when the Supreme Court approved a final settlement in the Gannon school finance case last summer, the court retained jurisdiction for the phase-in period through 2023. That means if the Legislature reduced K-12 funding or fails to provide the agreed-upon base increases through 2023, the plaintiffs can immediately ask the Court to intervene.

In resolving the Gannon case, the state agreed to two broad principles. First, the local option budget and capital outlay state aid formulas would be fully funded and provide “equalization” at previous higher levels. Second, base state aid would be increased until it reached approximately the inflation-adjusted level of 2009, the last time the system was presumed constitutionally adequate.

Chart 4: The Kansas Supreme Court approved by plan passed by the Legislature to restore school operating funds to inflation-adjusted 2009 levels by 2023. General fund, local option budget and special education funding remained well below adjusted 2009 funding in 2019.

Any significant reduction in school funding would also certainly impact base state aid or equalization programs for this simple reason: that is where most of the funding goes.

The one major exception is KPERS contributions, which are payments for future obligations. They can be deferred – and were several times during the budget problems of the mid-2010’s – but that adds to unfunded liability of the system. Cutting contributions now means more money will need to be added later. That is the reason KPERS contributions for school employees have increased from about 2 percent of total school spending in the 1990’s to over 7 percent now. Furthermore, the KPERS system relies on a 7.75 percent return on investment to meet its future obligations. The collapse of the stock market during the COVID crisis could mean it will take even higher contributions to pay future benefits.

What happens next?

It is impossible to know what impact the current COVID crisis will have on the state’s economy, budget and school funding. But in the short term, it won’t be good. Governor Laura Kelly expects to “take a huge hit in our revenues,” if for no other reason than extending the date to pay income tax to July, which means people can pay what they already owe later. But those payments will eventually be made. The real impact will be the lost revenue from reduced wages, lower income and fewer sales.

The Legislature has approved school funding for the remainder of the current year (Fiscal Year 2020) and next year (FY 2021), along with other state programs. The issue whether tax receipts drop so much that that there is not enough revenue to pay for that budget.

The April 20 consensus revenue estimate will give an early look as to what might happen. The Legislators could use that estimate to make further adjustments in next year’s budget (Fiscal Year 2021) if they return for the traditional “veto session” session in late April and pass an Omnibus appropriations bill, but it is unclear if that will happen. Or, they could wait until next session, beginning in January 2021, following a general election, another consensus revenue estimate in November, and the Governor’s budget proposals for Fiscal Years 2021 and 2022.

If revenues fall dramatically, the state can first spend down the currently projected ending balance of almost $1 billion. Next, the Governor has authority to order cuts in spending, called “allotments”, to avoid a deficit in the SGF. But approved spending in 2021 and 2022 is already higher than projected revenues, so spending down balances would still leave a “structural deficit.”

Kansas will receive additional federal funds for K-12 and postsecondary education. It is possible that additional state and local revenue placement could be included in future federal aid bills.

As noted, it is possible that the U.S. and state economy could “snap back” if social distancing ends quickly and jobs are available to which people may return. There could be pent up consumer demand that would quickly stimulate business activity.

But a less optimistic situation could require some combination of the following: raising taxes in a recession; again deferring KPERS payments; increasing reliance on highway fund transfers; deep cuts in higher education, social services and public safety programs to avoid affecting K-12 education; or cutting K-12 state aid and a possible confrontation with the Supreme Court. Would the Court look differently at a budget shaped by pandemic and recession, rather than tax cuts?