Beyond Bulls & Bears

Fixed Income

COVID 19 Disrupts Municipalities—Will Taxing Millionaires Accelerate Outmigration?

Apart from some high-profile downgrades, the muni credit markets finished 2020 buoyed by breakthrough vaccines and signs that state and local tax collections were better than anticipated. That said, many governors still face tough choices when it comes to budget
shortfalls: they must either raise revenues, cut spending, or both. Our Director of Municipal Bonds, Ben Barber, and Director of Municipal Bond Research, Jennifer Johnston, explain why tax revenues have rallied unexpectedly for California, and explore if working remotely will accelerate outmigration from New York City.

For even more detail and analysis on this topic, download the team’s .pdf

New York Governor Andrew Cuomo didn’t mince words last April. In the wake of budget shortfalls triggered by COVID-19, Cuomo promised to cut state spending by $8.2 billion. It wasn’t an idle threat. Lawmakers in the Albany capital gave Cuomo unilateral authority to make broad cuts based on projected revenue shortfalls. Because raising taxes was off the table, the only way to avoid spending cuts was either direct federal aid to replace lost revenues, or if revenues turned out better than forecast.1 Fast-forward to January 2021, and Cuomo is now contemplating an approach New Jersey recently adopted: raising taxes.

Progressive Tax Increases

Back in September, New Jersey Governor Phil Murphy convinced state lawmakers to implement a progressive tax increase on residents earning $1 million or more. By raising the state’s top marginal rate from 8.97% to 10.75%, New Jersey now has one of the highest personal income tax rates, trailing just California (13.3%) and Hawaii (11%). That tax hike, however, wasn’t enough to hold off a credit downgrade in early November, due to the state’s hefty structural deficit. Following the downgrade, New Jersey issued an emergency $4 billion COVID-19 bond to help close the state’s budget gap. Driven partly by scant tax-free muni supplies, New Jersey’s one-of-a-kind bond was nearly 10 times oversubscribed. Given low rates, many issuers could refinance tax-exempt bonds with taxable munis and still achieve lower yield—doubling taxable muni issuance to $140 billion in 2020.2

Would raising New York’s top income tax rate solve Cuomo’s budget shortfall? Let’s start by reviewing California’s progressive tax structure to see how the Golden State weathered the COVID-19 storm last year.

Sunny California

Amid frustrations over a slow vaccine rollout, Governor Gavin Newsom delivered some welcome budget news in early January 2021: California had an unexpected $15 billion surplus. Back in June 2020, state lawmakers were bracing for much worse. After passing a skinnier budget that included funding cuts and payment delays, Newsom’s finance team projected a future $8.7 billion deficit if COVID-19 infections forced more lockdowns.3 So how do we explain the $23.7 billion spread between the anticipated deficit and California’s surprise surplus? One answer lies in the stark K-shaped recovery that has disproportionally benefited America’s wealthiest.

For employees in high-wage industries like finance and information management, technolo­gies like Zoom and Microsoft Teams meant they kept working safely from home through the pandemic without skipping a beat. With the combo of high-income work flexibility and California’s progressive income tax structure—the Golden State relies on the rich more than most other states—California ended up receiving more income-tax withholdings during the last nine months of 2020 compared with all of 2019.4

Just as Zoom-like technology buttressed revenues from high-income workers, so too have online retailers stabilized state revenues from sales taxes. Although COVID-19 closed revenue generators like Disneyland, millions of home-bound families helped pick up the slack by shopping online. In a stroke of great timing, Newsom had recently signed a new internet law in April 2019 requiring online marketplaces like Amazon to collect California sales taxes.

The COVID-19 Wealth Gap

If California’s top earners got through 2020 relatively unscathed financially, it’s quite a different picture at the other end of the economic spectrum. Because COVID-19 continues to hammer lower-income workers in service sectors like hospitality, employment among the bottom quartile of American earners—those making less than $27,000 a year—remains 22.5% below January 2020 levels. For Americans making above $60,000, unemployment has largely dissipated.

Pouring through Newsom’s new budget, it’s clear the governor recognizes some California residents are suffering disproportionally under COVID-19. With remote learning, low-income schoolchildren are failing in record numbers. Many working-class families are trapped by high unemployment rates and face possible eviction. Rather than wait till summer when Sacramento lawmakers typically reconcile budget disagreements, Newsom is asking for an immediate $5 billion to reopen schools by spring, aid struggling businesses and distribute $600 cash payments to low-income families. At this early stage of the budget process, making a granular credit assessment of Newsom’s spending priorities is premature. Quite a lot can change for the better between now and July 1, when California’s next fiscal year starts.

For example, if elements of President Joe Biden’s COVID-19 relief plan get through Congress, it could eliminate the need for Newsom’s direct COVID-19 payments, freeing up $2.4 billion that California can use for other long-term priorities. But there are also wildcards to consider. Infectious disease experts fear the more lethal and infectious B.1.1.7 variant of COVID-19 could be “a perfect storm” that re-scrambles California’s budget priorities.5 On a brighter note, by summer, the COVID-19 vaccine program could jumpstart service sectors like hospitality. If so, low-income workers could experience the same upward trajectory higher wage earners did last year.

Newsom has $34 billion beyond what he needs to balance California’s budget, of which $22 billion is going back into rainy-day reserves. The main reason to do this, he’s told reporters, is the current surplus could be fleeting. We agree. But what Newsom doesn’t reveal is that he’s legally obligated to replenish California’s reserves. And in fact, he’s only adhering to the bare minimum of what the state constitution stipulates. Given the uncertainties around the vaccine rollout and the potential economic catastrophe from the B.1.1.7 variant, we would prefer to see the state government transfer even more surplus into emergency reserves. From a credit perspective, such a move would reflect a more sustainable budget mindset given looming COVID-19 uncertainties. It’s a prudent approach that former Governor Jerry Brown deployed quite often, and to great effect.

Outmigration Accelerates

Just as COVID-19 propelled the Federal Reserve to lower interest rates, the pandemic is forcing governors and mayors to grapple with the outmigration of taxpayers from some cities and states. In an ominous sign for the high-flying San Francisco Bay Area economy, the region recently saw negative net migration for the first time in over a decade.6

As municipal bond investors, demographics and migration trends (such as tax flight) have always been part of our forward-looking credit analysis. Because COVID-19 has the potential to accelerate outmigration—we’ll get a sharper picture after last year’s income tax filings—we plan to release an analysis of state and city outmigration in the spring. As a preview, we believe the Bay Area economy can remain a powerful economic magnet, attracting and retaining large clusters of high-growth knowledge industries. Doing so, however, requires adapting to new realities, such as office activities being redistributed between other California cities and other states. One of the Bay Area’s biggest hurdles is overcoming the chronic failure to build enough new housing at moderate prices.

Life in the Big Apple

If bond investors left Newsom’s budget meeting with some optimism, some had whiplash listening to Andrew Cuomo’s 2022 budget proposal eleven days later. Instead of a surprise surplus, Cuomo pointed to a $15 billion deficit and issued a stern ultimatum: if the US Congress fails to give New York a direct aid package equaling $15 billion exactly, deep spending cuts and a new wealth tax will ensue. With the state legislature set to present its own budget proposal in the coming weeks, the prospect of raising taxes on the rich will be a lightning rod issue. Many of New York City’s wealthiest families already work remotely, either from second homes outside the city or from different states like Florida.

The wealth tax is generating a lot of heat, in part because Cuomo has long been a staunch opponent of taxing New York’s wealthiest any higher. Currently, the top 2% of the state’s highest earners pay roughly half of New York’s income taxes.7 Hiking taxes might give families who recently left Manhattan another reason not to come back, and potentially kick-start deep structural (i.e., permanent) spending reforms. That said, it is important to recognize this tax applies to roughly 4,400 tax filers and only for the next three tax years. What’s more, by pre-paying all three years of the surcharge in advance, taxpayers would be fully reimbursed.

The highest surcharge of 2% applies to a tiny sliver of New Yorkers making over $100 million annually. By using progressive tax tiers, families earning between $5 and $10 million would only see a 0.5% tax increase. All combined, the high-income surcharge for the 2021 tax year would generate $1.5 billion of new revenues, tapering down to $1.4 billion and $1.2 billion in the 2022 and 2023 tax years.8 For residents willing to prepay their 2022 and 2023 surcharges when they file their 2021 taxes, they would be fully reimbursed via tax deductions during the 2024 and 2025 tax years.

At this stage, it’s unclear if New York will pass a new high-income tax into law in March. But there is another certainty: the pandemic has shifted how Americans view working remotely and the benefits of flexible mobility. This could accelerate outmigration for cities like the Big Apple.

Trying to predict how pronounced outmigration might eventually become is tricky. While 2020 certainly gave wealthy families ample reasons to leave urban centers, the unique social and cultural institutions that New York City offers will likely pull some families back, as will premier schools for parents grooming their children for ivy-league colleges. We’ll be monitoring the situation closely, as will Andrew Cuomo.

For all the hand-wringing over tax flight, urban policy experts have identified an equally destructive phenomenon crippling dynamic “superstar cities” like New York City: sky-high housing prices and overburdened infrastructure.9 Blessed with above-average per capita gross domestic product driven by knowledge clusters in finance (New York) and high tech (San Francisco), these cities are victims of their own success as demand has vastly outstripped housing supply. Despite offering higher incomes, these cities will continue growing more slowly and even shrink unless they do two things: build higher-density affordable housing, and fund modern infrastructure that enables car-free access (walking, e-bike, subway, bus) to jobs, friends and family, and basic services.

An intriguing trend picking up steam in New York City is the Yes-In-My-Back Yard (YIMBY) movement that aims to build high-density affordable housing in expensive neighborhoods like SoHo and Gowanus in Brooklyn. As a grass-roots movement comprised of highly educated, well-paid millennials, the main roadblocks include byzantine zoning laws and fierce opposi­tion from New York’s wealthiest residents who don’t like change.

Bond Market (Over)Reactions

In the wake of the K-shaped COVID-19 recovery, a catastrophic-looking economic downturn has turned out better than expected for some state and local governments. Because bond markets often overreact to five-alarm headlines, our credit analysts sometimes spot good muni opportunities even in states we’ve been critical towards. That window of opportunity opened early last year for Illinois, a state that we believe has chronically short-changed its budgets. A similar opportunity happened for New York last October, when fears of urban outmigration dislocated spreads and performance from its underlying credit fundamentals.

Looking ahead, we expect more windows will open, given uncertainties over the vaccine program and prospects of more lethal COVID-19 variants. For us, navigating muni bond markets during 2021 will require a closer look at the scope of Biden’s COVID-19 relief package, along with his build-back-better infrastructure program which could be $2 trillion in size. Tax flight and outmigration remain volatile and hard to predict, requiring deeper analysis over the months to come.

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All investments involve risks, including possible loss of principal. Because municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices gener­ally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the portfolio’s value may decline. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.

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1. Source: Williams, Z. “Cuomo warns of $8.2 billion in cuts to localities,” City & State, April 26, 2020.

2. Source: Moran, D. “Muni Set for Seventh Straight Year of Gains Amid Record Supply,” Bloomberg, December 30, 2020.

3. Source: Bollag, S. “California lawmakers approve budget that delays pain, hopes for future federal funds,” The Sacramento Bee, June 27, 2020.

4. Source: Yamamura, K. “California expects record revenues in stunning Covid budget reversal,” Politico, January 8, 2021.

5. Source: Wingrove, J. Cook, N. “Biden Team Fears Virus Surge Imperils Pledge to Curb Pandemic,” Bloomberg, January 20, 2021.

6. Source: “In Ominous Sign, Net Migration to Bay Area Turns Negative; First Time in a Decade,” Bay Area Council 75, April 19, 2019.

7. Source: Ferre-Sadurni, L. McKinley, J. “Tax the Ultrarich? Cuomo Resists, Even With a $14 Billion Budget Gap,” The New York Times, September, 7, 2020.

8. Source: Cuomo, A. Mujica, R. “FY 2022 Executive Budget Briefing Book,” January 19, 2021.

9. Source: Renn, A. “Scaling Up: How Superstar Cities Can Grow to New Heights,” Manhattan Institute, January 2020.

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