• States cannot declare bankruptcy under federal law
  • States are required to balance their budgets
  • Nearly all states face a massive revenue shortfall in 2020

Congress just passed a $484 billion stimulus bill, and the conversation is now focused on what wasn't in it – financial aid for states and local governments. Senate Majority Leader Mitch McConnell kicked off a tense debate on Wednesday after suggesting states should be allowed to "use the bankruptcy route" like cities do. In an interview with conservative radio host Hugh Hewitt, he said additional assistance would need to be thoroughly evaluated and blamed generous pension programs. "There’s not going to be any desire on the Republican side to bail out state pensions by borrowing money from future generations," he said, and referred to this as "stopping blue state bailouts" on his website.

As can be expected, this spurred some angry responses, especially from the New York Governor Andrew Cuomo, whose state, a net contributor to the federal budget, has seen more confirmed cases than any single country outside the U.S. Fighting a pandemic is an expensive business, especially amidst supply shortages, but compounding the financial crunch is tax revenues plunging as unemployment soars. New York's top budget official has said the outbreak could cost the state as much as $15 billion in revenue.

Almost all U.S. states are legally required to balance their budgets, which means they will be forced to cut spending on vital services and possibly slow the economic recovery.

The National Governors Association has asked Congress for $500 billion in direct aid after receiving $150 billion in the $2.1 trillion CARES Act. They are also asking for flexibility to use funds received not just on COVID-19 related expenses, as was stipulated in the third stimulus package. 

The Center on Budget and Policy Priorities projects states' shortfall could be over $500 billion and concentrated in fiscal year 2021, which begins in October.

State budget
Source: Center on Budget and Policy Priorities.

3 Things Needed Before States Can Declare Bankruptcy

Bankruptcy in the U.S. is governed by federal law and handled in federal courts. States are not allowed to declare it as per the U.S. Bankruptcy Code. Changes to the bankruptcy code would require Congress to pass legislation. It was recently tweaked with the CARES Act to provide relief to businesses and individuals. However, changing the rules for states to go through Chapter 9 proceedings would be an extremely difficult challenge for Republicans concerned about the national debt ballooning.

States declaring bankruptcy would also go against the U.S. constitution, said the Council of State Governments. According to the contracts clause (Article 1 Section 10) states are barred from "impairing the obligation of contracts." The U.S Supreme Court in 1977 interpreted this as "a state cannot refuse to meet its legitimate financial obligations simply because it would prefer to spend the money to promote the public good rather than the private welfare of its creditors.""Thus, even if Congress were to pass a law allowing states to declare bankruptcy, such an action would likely face a contracts clause challenge," said Heather Poole, an analyst at the Office of Legislative Research, Connecticut General Assembly.

But there's a third key requirement. States have sovereign rights and would have to consent to participate. Even if they agreed, it wouldn't work, according to Bruce Markell, a Northwestern University law professor and former U.S. bankruptcy judge. He told Bloomberg Law, that because a state is sovereign, you can't have a federal oversight board overseeing the restructuring. "How can you have independent review of government financial decisions?" asked Markell. "It’s all political—where do you raise taxes or force concessions by creditor blocks, consisting primarily of bond holders, pension plans, and labor contracts?"