Big city mayors and Democratic state governors had been counting on a “blue sweep” of national offices to help get them out of some very deep budget and pension funding holes. They also dreamt of green transport, more help with healthcare . . . the list was long.
Now there is the grim winter reality of a surviving Senate Republican majority, led by Democratic bugaboo Mitch McConnell, which keeps its veto on all that progressive spending and redistributive taxation. Before the elections, House Speaker Nancy Pelosi and her allies were demanding a multitrillion-dollar package of federal payments to the states to help maintain employment and services.
As one of Ms Pelosi’s colleagues, Ayanna Pressley, wrote in a letter to the Treasury and the Federal Reserve, the states and local governments “have been hit hard by Covid-19, creating an estimated budget shortfall of as much as $650bn over the next two fiscal years . . . the solvency of our nation’s states and cities is a matter of racial justice”.
Amount of bond issues that US state and local governments have outstanding
The Democrats had also prepared an ambitious climate-sensitive energy transition plan and expansion of support for healthcare. Much would have been paid for by taxes on the rich, slightly offset by the resurrection of the Trump-revoked “Salt” credits, which allow for state and local taxes to be deducted from federal tax bills. Salt limitation has cost high tax states such as New York and California billions of dollars in revenue from relocating rich residents.
While many of the progressive Democrats believe they would be better presidents than Joe Biden, they may not yet have fully appreciated his potential ability to work out compromises with Mr McConnell. Mr McConnell and Mr Biden have known each other for decades and are actually “friends” in the practical and transactional Washington sense. They are already sending horse-trader signals to each other.
For example, a day after the November election, Mr McConnell let it be known that “it’s a possibility” that he and his Republican colleagues could come up with aid for the states and cities. He knows his home state of Kentucky has one of the country’s worst pension-funding records, which, given a recession and ever-stricter accounting rules for unfunded liabilities, could lead to lay-offs or service cuts for his own voters. More funding for states’ Covid-19 response is on offer.
And while full Salt tax relief for the high-tax states such as New York, California, New Jersey and Illinois is not on, there are a few programmes that will get funding votes from Senate Republicans. For example, more direct subsidies for the development and production of batteries for electric vehicles and utilities can be part of the package, along with carbon capture technology.
While the full range of Democratic-proposed tax increases on the rich will not get through the Senate, some increases in corporate taxes are inevitable.
Of course Mr McConnell’s friends can offset some of those burdens with the green credits, and the increased taxation of corporations and financial companies will help create more demand for state and local bonds.
US state and local governments have more than $4.2tn of bond issues outstanding, from more than 16,000 separate entities. In the past year, most of those issues have been bonds with taxable interest, which have been used to pre-pay or buy back higher interest older bonds whose coupons are not subject to state and local taxes.
The higher tax rates for corporations and some individuals that a Biden Administration and Congress will pass will increase the demand for tax-exempt issues from the states and localities, which should ease the funding burdens worsened by Covid and recession.
The pressure on the states and cities will worsen with any bear market, particularly one that forces valuation cuts in private equity assets. Those would require higher immediate contributions to pension and health benefit funds at the worst possible time.
For all the attention given to politics at the federal level, the budget squeeze over the next four to six years could be much more dramatic at the state and local level. Growing, high investment grade states such as North Carolina, Texas, Utah and Virginia will do quite well, and their bond prices will reflect that.
New York, New Jersey, and Illinois face successive downgrades, and some of those issuers could even become wards of the Fed. They can ask Argentines what it’s like to depend on Calvinist central bankers.