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date: 22 June 2018

The Fiscal Implications of Managing Natural Disasters for National and Subnational Governments

Summary and Keywords

Natural disasters cause massive social disruptions and can lead to tremendous economic and human losses. Given their uncertain and destructive nature, disasters invariably induce significant governmental responses and typically pose severe financial challenges for jurisdictions across all levels of government. From a public finance perspective, disasters cause governments to incur additional spending on various emergency management activities, and by disrupting normal business activities they also affect tax base robustness and cause revenue losses. The question is: How significant are these fiscal effects and how do they affect hazards governance more generally? Understanding the fiscal implications of natural disasters is essential to evaluating the size of the economic costs of disasters as well as forecasting governments’ financial exposure to future shocks. Furthermore, how disaster costs are shared among different levels of government is another important question concerning the intergovernmental dynamics of disaster management.

In the U.S. federal system, the direct fiscal costs of natural disasters (i.e., increased government expenditures due to disaster shocks) are largely borne by the federal government. It is estimated that Hurricane Katrina cost the federal government approximately $120 billion while Hurricane Sandy cost $60 billion. Even in the years without large-scale disaster events, federal disaster spending is between $2 billion and $6 billion annually. Under the Stafford Act, the federal government plays a critical role in funding disaster-related programs (e.g., direct relief, mitigation grants, and subsidized insurance programs) and redistributing the actual costs of natural hazards, meaning that a considerable portion of the local disaster burden is shifted to all U.S. taxpayers. This raises a set of issues concerning the equity and efficiency of the U.S. disaster policy framework.

Managing disasters involves multiphased activities to mitigate, prepare for, respond to, and recover from disaster shocks. There is a common belief that the federal government inappropriately spends far more on ex post disaster response, relief, and recovery than what it spends on ex ante mitigation and preparedness, often driven by political motivations (e.g., meeting voters’ preferences for postdisaster aid) and the current budget rules. As pointed out by many others, federal disaster relief and assistance distort the subnational incentive to invest in local disaster prevention and mitigation efforts. Furthermore, given the mounting evidence on the cost-effectiveness of disaster mitigation programs in reducing future disaster damages, the current practice of focusing resources on postdisaster assistance means substantial public welfare losses. In recent years there has been a call for the federal government to shift its disaster policy emphasis toward mitigation and preparedness and also to facilitate local efforts on mitigation. To achieve the goal requires a comprehensive reform in government budgeting for emergency management.

Keywords: natural disasters, public finance, emergency management, preparedness, mitigation, response, recovery, budgeting, intergovernmental relations, federalism

Introduction

Natural disasters are low-probability, high-consequence events that can result in significant human losses and economic shocks. In 2016 alone, more than 300 natural disasters occurred worldwide, affecting 411 million people in 102 countries and causing about 7,000 deaths and $100 billion in direct damage, according to the statistics compiled by the Centre for Research on the Epidemiology of Disasters (CRED, 2016). Disaster-induced economic damage has been increasing in the past few decades and will likely continue growing because of urban development, population growth, and ecosystem alteration (Intergovernmental Panel on Climate Change (IPCC), 2012). Moreover, climate change is expected to increase the frequency, intensity, duration, and spatial extent of extreme weather events (e.g., heat waves, hurricanes, floods, droughts, and winter storms), which constituted 90% of the major disasters recorded worldwide between 1995 and 2015 (IPCC, 2012; CRED, 2016). The disaster impacts are unevenly distributed across the world. While developed countries generally have stronger capacities and more resources to deal with disasters than developing countries, they are highly susceptible to the economic losses from natural hazards. For example, since 1980 the United States has sustained more than 200 significant weather and climate disasters, of which the total costs exceeded $1.2 trillion, according to the National Oceanic and Atmospheric Administration (NOAA).1

Due to their destructive nature, natural disasters often necessitate government response and interventions when they strike. As noted in Schneider (1995, p. 9), “When a natural disaster occurs, few people stop to ask whether the government should intervene. Instead, citizens tend automatically to view the situation as a serious public problem requiring immediate governmental action.” While governments are in a natural position to respond to emergencies and protect their citizens, relatively little attention has been paid to the fiscal burden disasters may place on governments. Natural disasters often induce governmental expenditures on emergency response, disaster relief, reconstruction, and recovery efforts, which may lead to overspending or budget reallocation. Moreover, disasters inflict direct damage to properties and assets and could also disrupt business activities and economic production. The disaster-induced macroeconomic impact may further affect tax base robustness and cause fluctuations in government revenues.

The fiscal implications of natural disasters, on the expenditure and revenue sides, have been explored only in a limited number of studies. Nonetheless, such estimates are essential for a government to assess and forecast its financial exposure to natural hazards, and if necessary, to budget for disaster reserves (Cavallo & Noy, 2011). They are also useful in enabling better cost–benefit evaluation of various disaster-related programs such as predisaster mitigation and postdisaster response and assistance (Noy & Nualsri, 2011). More importantly, this article argues that understanding the link between natural disasters and public finance should go beyond the ex post disasters’ impact on government finance and also consider the implications of fiscal institutions and policy structures for a society’s capacity to protect against natural disasters. Specifically, how governments allocate their resources to different disaster management functions and how cost-effective their programs are would influence their long-term disaster risks and related fiscal burden.

While natural disasters are mostly localized incidents, their impact may expand across all levels of government. In particular, large-scale disasters that exceed the coping capacity of local governments often trigger intervention and assistance from the national government or even from the international community. Under such circumstances, the financial burden is lessened in the disaster-stricken jurisdiction and, at the same time, partially shifted to the rest of society. How a nation’s fiscal regime and intergovernmental relations influence the distribution of disaster costs and subnational disaster management behaviors are important questions to consider when examining the financial implications of disasters and disaster policy.

The remainder of this article proceeds as follows. The section, “Natural Disaster and Public Finance: An Overview of the Issues,” provides an overview of the conceptual issues surrounding natural disasters and public finance, with a particular focus on the mechanisms through which disasters affect government finance and how governments can use their resources and policy tools to reduce disaster impacts. We also discuss the measurement of fiscal costs of natural disasters and review the empirical literature concerning disaster-induced fiscal impacts based on cross-country studies. The section “Fiscal Implications of Disaster Management in the U.S. Federal System” focuses more specifically on the U.S. context by discussing the federal disaster policy and its implications for disaster risk reduction and disaster financing at the subnational governments level. The section “Conclusion” provides a brief discussion of the overarching issue and directions for future research.

Natural Disasters and Public Finance: An Overview of the Issues

Despite the critical role of government in dealing with disasters, scholars have devoted modest attention to the financial aspects of disaster management. The literature on this subject not only lacks theoretical coherence but also insufficient empirical evidence. To elucidate the fiscal implication of disasters, it is necessary to first identify the conceptual boundary of this notion and relevant questions for consideration. Importantly, we should recognize that natural disasters and public finance can influence each other and are thus intertwined in many different ways. While natural disasters are triggered by external shocks within the physical system, their financial impact depends on the magnitude of disaster losses and also on how a government reacts to the shock. The government’s response, to a large extent, is determined by its disaster policy, emergency management system, financial conditions, and fiscal structure. Natural disasters can affect a jurisdiction’s public finances through multiple channels, which are discussed in more detail next. Meanwhile, if we take on a dynamic perspective and consider the recurrent nature of most natural hazards in the long term, the fiscal implication should not be confined to the ex post cost of a single disaster incident, but also concerns how the government allocates its sources to respond to and mitigate disaster risks on behalf of a society.

Mechanisms for Postdisaster Impacts on Public Finance

As suggested in the prior research, natural disasters can influence a government’s financial conditions by affecting its expenditures and revenues (Benson & Clay, 2004; Mahul & Signer, 2014).2 On the revenue side, many scholars note that a government may see a decline in its tax revenues following a disaster because, by causing property and capital damage and disrupting business activities, natural disasters can lower outputs, incomes, and employment in the affected area and thereby dampen the local tax bases. Therefore, the loss of tax revenues due to the disaster-induced macroeconomic dynamics constitutes part of the fiscal cost borne by the government. For example, a World Bank report estimates that the 2011 floods in Thailand reduced the total government revenues by 3.6% and 2.8% in 2011 and 2012, respectively (World Bank & Government of Thailand, 2012).

Nonetheless, the prediction on the disaster shock to tax revenues could be complicated for at least three reasons. First, the disaster economics literature has not yet reached a consensus on whether natural disasters cause a negative economic impact overall (e.g., on productivity and economic growth).3 In particular, some argue that disasters may potentially generate a positive effect on the local economy because they provide an opportunity to update capital stocks and adopt new technologies that enhance productivity (Schumpeter, 1942; Skidmore & Toya, 2002; Cuaresma et al., 2008). However, the idea that natural disasters act as a “creative destruction” has always been subject to debate (Kousky, 2014).

In the short run, postdisaster reconstruction may trigger the demand for replacing destroyed capital as well as increased outputs in some sectors of the economy. For example, in a study of 26 countries between 1960 and 1979, Albala-Bertrand (1993) found that natural disasters led to an increased growth rate of construction outputs. Baade et al. (2007) showed that the taxable sales in Miami, Florida increased and remained high for more than one year following the immediate drop after Hurricane Andrew. Their finding thus suggests a potentially positive effect of disasters on local tax bases. At the same time, natural disasters may lead to various behavioral changes in the affected populations, such as migration, which would indirectly influence the tax base. For example, Strobl (2011) found that hurricanes caused a significant and negative effect on the economic growth of U.S. counties, which was partially driven by outmigration of higher-income households after hurricanes. This finding suggests that disaster-induced relocation and demographic changes can have important implications for the source of government revenues. Overall, considering the various mechanisms behind disasters’ economic impacts as well as the mixed empirical evidence (e.g., Skidmore & Toya, 2002; Raddatz, 2007; Noy, 2009; Hochrainer, 2009; Strobl, 2011; Felbermayr & Groschl, 2014), the net effect of natural disasters on tax bases and tax revenues, particularly through the macroeconomic dynamics, is conceptually ambiguous (either positive or negative).

Second, the extent to which natural disasters influence tax revenues is also influenced by the tax structure in disaster-affected jurisdictions (e.g., the composition of income taxes, sales taxes, or property taxes). Depending on the tax type, disasters may exert differential impacts on these revenue sources. For instance, in a study of Mobile, Alabama, Chang (1983) noted that natural disasters would severely affect the municipal finance unless sales tax is a major revenue source. This argument seems consistent with the finding in Baade et al. (2007) that disasters can trigger a bump in taxable sales and sales tax revenues. Friesema et al. (1979), however, suggested that natural disasters would lower the property tax bases, thereby causing a negative impact on local tax revenues.

Third, examining disasters’ impact on tax revenue should also account for whether and how a government adjusts its taxation policy in response to a shock. It is possible that the government would provide tax reductions or relief to disaster victims to cover some of their losses. For example, the U.S. Congress enacted the National Disaster Relief Act in 2008, which provided a broad package of tax reliefs to victims affected by federally declared disasters in 2008 and 2009. However, it is also possible that, under certain circumstances, a government may have to increase taxation to cover its own disaster-related spending. Finally, to sum up, how natural disasters affect the collection of tax revenues could depend on their direct economic impact (e.g., incomes, outputs, employment, and population), a jurisdiction’s tax structure, and possible adjustment of tax policy in the aftermath of a disaster incident.

Regarding public expenditures, the occurrence of a natural disaster often requires a government to commit resources to cleaning up the site, removing debris, and repairing and rebuilding public infrastructures. To the extent that disasters cause human and economic losses, governments are sometimes responsible for providing relief aid to disaster victims and assisting their postdisaster recovery, which would impose continuing pressure on government finance. All these disaster-induced expenditures also constitute the fiscal costs borne by the government. For example, the U.S. federal government provided roughly $120 billion for the 2005 and 2008 Gulf Coast hurricane seasons and $50 billion for the recovery after Hurricane Sandy through supplemental appropriations (Lindsay & Murray, 2014). The 1999 Marmara/Izmit earthquake in Turkey cost the Turkish government at least $2.4 billion (2010 US dollars), with most of the direct cost incurred from reconstruction and repair of damaged properties (World Bank, 1999). In Mexico, natural disasters cost the national government nearly $1.5 billion (in 2011 US dollar) annually in rebuilding damaged public infrastructures between 1999 and 2011 (Government of Mexico & World Bank, 2012).

In general, the extent to which disasters influence public expenditures depends on the magnitude of disaster damage as well as the government’s role in disaster management. While a disaster occurs and induces additional spending to support relief and rehabilitation efforts, it remains a question whether natural disasters would ultimately increase total government expenditures or trigger reallocation of budgetary resources that involves cutting other programs’ funding (or both). If the total expenditure increases significantly following a disaster, it might lead to budgetary deficits and government indebtedness. Moreover, this problem can become even worse if the disaster shock simultaneously causes a loss of tax revenues. If a government has to engage in borrowing to cover its excessive expenditure, it would have to bear additional borrowing cost. If a government chooses to reallocate its budgetary resources and divert funding from other programs (e.g., by reducing provision of public service or abandoning or postponing other planned projects), these measures would help curb the increase in total expenditure post disasters but then incur an opportunity cost (Benson & Clay, 2004).

Dynamic Fiscal Implications of Integrated Disaster Management

By far, most of the current discussion regarding the fiscal implication of natural disasters has focused on the ex post disaster impact on government spending and revenues. This approach assumes that governments are largely reactive to disasters and ignores the dynamic interdependency between public finance and disasters. A better understanding of disaster-related financial implications and governance would benefit from combining different strands of literature on disaster management and social vulnerability to natural hazards. Specifically, the modern approach of disaster management is no longer confined to responding to individual disaster events after they occur. If managing disaster risks is part of regular government functions, the fiscal implication should encompass the allocation of government resources to a set of activities dedicated to mitigating against, preparing for, responding to, and recovering from natural disasters. Therefore, the multiphase management approach requires a certain amount of public funding used to support proactive mitigation and preparedness before a disaster strikes. Figure 1 describes the four different phases of modern emergency management, based on the discussion in Donahue and Joyce (2001).

The Fiscal Implications of Managing Natural Disasters for National and Subnational GovernmentsClick to view larger

Figure 1. Four phases of disaster and emergency management.

Including predisaster government spending (on preparedness and mitigation activities) is important in the context of integrated disaster management. This issue is particularly relevant for hazard-prone regions where natural hazards happen more frequently, and investment in prevention and mitigation measures would deliver greater benefits in the form of avoided disaster losses.4 A fundamental question arising from this discussion is to which extent natural disasters can be mitigated or what factors influence the actual disaster damage. It has been widely accepted that the social impacts of natural disasters are determined by the physical magnitude of the external shock (or hazard event) that triggers a disaster as well as social vulnerability to natural hazards. The latter reflects a community’s exposure and sensitivity to potential disaster losses (including its capacity to undertake adequate risk mitigation strategies), which inherently depend on the community’s socioeconomic and demographic characteristics (Cutter et al., 2003).

The notion of social vulnerability resonates with a small, yet growing body of empirical literature that examines the determinants of disaster damage. This line of research, mostly based on cross-country analyses, has commonly identified economic development and institutional quality as two factors that influence disaster damage (e.g., Anbarci et al., 2005; Kahn, 2005; Rashky, 2008; Keefer et al., 2011; Ferreira et al., 2013; Escaleras & Register, 2016).5 The argument is that countries with higher income and better institutions suffer less damage because they have more economic resources, better infrastructure and technologies, and more effective regulations and risk management measures to protect against natural disasters. These findings shed light on the role of governmental conditions and policies in disaster risk reduction.

Incorporating the literature on emergency management and social determinants of disaster damage provides valuable insights into the dynamic aspect of disaster-related financial implications. In particular, the more resilient a community is to external shocks, the less economic losses it would suffer, which implies fewer disturbances and a smaller financial burden placed on its government. The diagram in Figure 2 presents our conceptual framework with multiple channels through which a natural disaster impacts a local government and how its public finance functions could in turn affect disaster damage simultaneously and iteratively. We begin with a closed system with an internal feedback loop and then incorporate the potential impact of additional external aid from outside the local jurisdiction.

The Fiscal Implications of Managing Natural Disasters for National and Subnational GovernmentsClick to view larger

Figure 2. Conceptual framework on the fiscal implications of natural disaster management.

As shown in channel a, a disaster often results from the occurrence of an abnormal or infrequent natural hazard and can result in substantial losses (e.g., in human, physical, and financial capital), depending on the vulnerability and coping capacity of the affected communities (Benson & Clay, 2004).6 The disaster influences the local economy and further affects the local tax base and tax revenues (channel b). During and after a disaster event, the local government takes charge of organizing emergency responses, providing assistance to affected residents, and repairing local public infrastructures. These public expenditures would either directly or indirectly influence the disaster’s actual economic impact from a society’s perspective (channel c). For example, direct disaster relief compensates victims for some of their direct losses, such as property damage. The repair and rehabilitation of public facilities (e.g., transportation) may accelerate the postdisaster recovery, thereby helping bring local business activities back to normal conditions and stabilize their production. Also, because the government can use its resources and spending power to support ex ante preparedness and mitigation functions that enhance community resilience, such investment may reduce the first-order disaster impact on the society (channel d), which also implies less disturbance to local government finance. This feedback loop also suggests that the government should strategically prioritize and fund different functions of emergency management.

As noted, when a disaster overwhelms local governments, it is common for higher levels of government to respond and provide additional assistance.7 The external aid can relieve the financial burden borne by the local government and allow it to spend more on disaster response and recovery projects (channel e). Similarly, the postdisaster aid from other levels of government (e.g., relief aid offered to the affected individuals and households) could help mitigate the economic shocks triggered by disasters and help restore personal incomes, assets, and the local economy (channel f). The external aid can additionally influence the community’s social vulnerability or resilience to future hazard events, although the direction and size of such impact might be ambiguous, depending on the funding purpose (channel g). For instance, external aid targeting preparedness- or resilience-enhancement projects may lead to better protection against future disasters and less damage. However, external disaster aid may also create the moral hazard problem and reduce local incentive for taking costly precautionary measures (which are discussed in more detail in the U.S. context).

To sum up, our proposed conceptual model considers that disaster-induced fiscal disturbance is influenced by the magnitude of disaster losses and economic impact, as well as how a government adjusts its spending and taxation policy in response to the disaster, given its budget constraint, financial conditions, and fiscal institution. Our framework additionally incorporates a dynamic perspective to consider the integrated disaster management process and its implication (in particular, predisaster mitigation and preparedness investment) for disasters’ economic and fiscal impacts. This approach departs from the traditional focus on the fiscal consequence of natural disasters and focuses more broadly on the financial implication of disaster management. Finally, our model also incorporates the external aid and transfers from other levels of government to account for the intergovernmental dimension of disaster management—an important factor in determining the distribution of disaster cost across levels of government.

Fiscal Cost Versus Economic Cost of Natural Disasters

Several studies have attempted to estimate the fiscal costs of natural disasters in either single-country or cross-country settings (e.g., Noy & Nualsri, 2011; Deryugina, 2017; Miao et al., 2018). Given the complexity in the mechanisms behind the disaster’s impact on public finance, it is worthwhile to further discuss the measurement of these fiscal costs and how they are related to the economic costs of natural disasters. First, as natural disasters cause perturbation to the functioning of the economic system (Hallegatte, 2015), their economic cost at a societal level is theoretically the welfare changes resulting from these incidents (Kousky, 2014). The disaster literature often classifies the economic costs of a disaster into direct and indirect losses (e.g., Rose, 2004). The former measures the immediate impact generated during the disaster’s physical destruction process (e.g., damage to homes, assets, and infrastructures), whereas the latter (sometimes referred as the “higher-order” costs) includes the economic losses caused by a disaster’s destructive consequences (e.g., output losses or loss of incomes caused by the destroyed or damaged capital that was previously used as a means of production). Overall, the economic cost of a natural disaster can vary substantially depending on the scale and boundary of the analysis (e.g., households, communities, sectors, or nationwide).

The fiscal cost of natural disasters includes all the losses borne by a government due to disaster incidents (here we begin with the local government directly affected by disasters). Some of these costs are explicit, for example, additional government expenditure on emergency responses and disaster aid, while some other costs are more implicit, such as the loss of tax revenues. Depending on the mechanism by which these costs are incurred, the fiscal cost of natural disasters is associated with (or should be distinguished from) their economic cost in several ways. First, when a disaster shock triggers immediate government intervention and response, the increased spending on undertaking emergency measures (such as debris clean-up and infrastructural repair) adds to the disaster’s direct economic costs and fiscal costs (Kousky, 2014).

Given the possibility that a government’s disaster spending may squeeze its nondisaster spending under certain circumstances, such as the total spending limit, it is important to account for the opportunity cost of the internal adjustment of expenditures. If the disaster spending is diverted from government funds in other use, this action may not lead to overspending at the aggregate level, but it involves possible welfare losses because of the reduced provision of public services or abandonment of planned projects (Benson & Clay, 2004). Such losses should be included in the fiscal cost as well as the economic cost (indirect) of the disaster. In other cases, if the government has to raise additional revenues from taxation (or other sources of public revenues) to cover its postdisaster expenditures, this approach may help reduce the disaster’s fiscal cost for the government, but at the same time may cause welfare losses at the societal level (depending on how much distortion the tax introduces). If the excessive spending is covered by borrowing, the government then has to bear additional borrowing costs such as interest payments, which are also part of the fiscal and economic cost of the disaster.

Second, it is important to note that, depending on the funding purpose, some of the government postdisaster expenditures can affect the economic cost borne by private agents. For example, the disaster relief and aid payments a government distributes to disaster victims reduce the private losses (e.g., loss of properties and assets) sustained by these individuals and households. Notably, these payments do not add to the total economic costs of a disaster from the perspective of society because they are indeed a transfer of the disaster losses from those directly affected to the government, or to a broader base of taxpayers. Similarly, the potential revenue loss due to the macroeconomic shock triggered by a disaster is another transfer of the disaster’s economic cost. Moreover, as discussed, if the government spending that funds restoration of public infrastructure leads to faster economic recovery of the affected community, it also has the potential to lower the disaster’s economic cost in private sectors as well as at the society level.

Some scholars also point out that the occurrence of large-scale disasters may also likely increase a government’s nondisaster-related spending (e.g., on social safety net and social insurance programs) because more people become eligible for these benefits after experiencing a disaster (Deryugina, 2017). For example, those who lose their jobs after disasters might receive unemployment insurance benefits provided by the government. The disaster-induced government payments through welfare programs should also be included as part of the total fiscal costs, but they are still a transfer within the society and do not add to the total economic cost of the disaster.

Finally, it is important to account for the flow of intergovernmental aid and recognize that the size of a disaster-induced fiscal burden may vary by the levels of government. A local government receives a significant inflow of disaster aid can spend more but bears a lower cost because part of the disaster’s fiscal costs is shifted to the other levels of government that provide the aid. While such aid (such as disaster relief provided to victims) should not add to the total economic cost, it has redistributional implications within a nation. Similarly, if the intergovernmental disaster aid is effective in accelerating the local economic recovery, it then may also reduce the economic cost of the disaster as compared to what it would have been without the aid.

Research on the Fiscal Consequences of Natural Disasters: Cross-Country Evidence

Despite the vast literature on the short- and long-run economic impacts of natural disasters, far fewer studies have empirically examined the fiscal impact of disasters, and almost all are cross-country studies using aggregate national fiscal accounts. For example, Melecky and Raddatz (2011, 2014) estimate the impacts of natural disasters by types (geological, climatic, and other types of natural hazard) on government expenditures, revenues, and deficit based on a panel data set of 81 high- and middle-income countries over the 1975–2008 period. Using the panel vector autoregression (VAR) model, they found that on average, natural disasters, particularly climatic hazards, exert a negative impact on public finance by decreasing output and increasing budget deficits.8 This effect is particularly pronounced for lower-middle-income countries, where budget deficits tend to increase across different types of natural disasters. To further examine the heterogeneity of the fiscal impacts, they showed that countries with higher levels of financial development and higher insurance penetration suffer smaller real consequences from natural disasters, which suggests the role of a country’s financial development in withstanding disaster-induced fiscal shocks.

In another study, Lis and Nickel (2010) employed a country fixed effects model (which controls for unobserved time-invariant heterogeneity across countries) to estimate the budgetary impacts of large-scale extreme weather events (e.g., hurricanes and floods) using a panel data set of 138 countries between 1985 and 2007. Their research showed that the average estimated effect of extreme weather events on budget balance ranges between 0.23% and 1.4% of GDP. These findings are similar to those of Melecky and Raddatz (2011) in suggesting that developing countries experience much larger budgetary impacts compared to developed countries.

Noy and Nualsri (2011) examined the fiscal responses to large-scale natural disasters (measured by aggregate disaster damage from all hazards) using the quarterly data for a panel of 42 countries for the period of 1990 through 2005. Also employing the panel VAR model, their research suggests different patterns of fiscal responses in developed and developing countries. As for the former, they found that government spending increased right after a disaster while revenue dropped, resulting in increased outstanding debt (accumulating over 8% of GDP 18 months postdisaster). In contrast, they found that developing countries responded to disasters by decreasing spending and increasing revenues, which is characterized as the procyclical fiscal dynamics as opposed the countercyclical pattern in developed countries.

Finally, Ouattara and Strobl (2013) quantify the fiscal impact of hurricanes (measured by an index of a hurricane’s physical magnitude) on a panel of 18 Caribbean countries over the 1970 to 2006 period. Their study, also using the panel VAR methodology, showed hurricane strikes exerted a short-term positive effect on government spending, with an insignificant impact on other relevant variables including public investment, tax revenue, and debt. Their study suggests that hurricanes lead these governments to engage in short-term deficit financing to cover their additional expenditures.

Most of these empirical findings seem to suggest that natural disasters increase government expenditures and budget deficit, and such fiscal shocks could lead to more negative impacts in less developed countries with tighter budget constraint and less mature financial markets. It is also noteworthy that while these studies present the first few attempts to examine disaster-induced fiscal responses, they share some common problems. They generally do not account for international financial flows and, in particular, the humanitarian aid provided by international institutions to assist affected countries. Notably, several studies have recently examined the impact of natural disasters on the flows of international aid and remittances, suggesting their effect in buffering the negative shock of disasters (Yang, 2008; Cavallo & Noy, 2011; David, 2011; Hsiang & Jina, 2014). For example, Yang (2008) found that hurricanes led to significant increases in foreign aid to the affected developing countries. In addition, hurricanes also increased inflows of migrants’ remittances to the poorer countries and new lending from multilateral institutions to the richer nations.

Moreover, given their unit of analysis, these cross-country studies provide little information about the cost distribution of natural disasters among different levels of government within a country. Because part of the local disaster costs can be shifted to other levels of government and imposed on the taxpayers who are not affected, it is important to estimate the fiscal costs borne by local and national governments separately to assess its distributional implication. The intergovernmental disaster aid also raises additional questions related to the welfare changes in the affected region, how aid influences local incentives and practices for disaster management, and how efficiently local public officials use the aid to address their needs.

Moreover, as discussed, the fiscal implication of disaster management should also account for government investment in predisaster mitigation and preparedness measures and the effectiveness of various risk management strategies in reducing long-term disaster risks. To better understand these issues necessitates more in-depth examination of the influence of disaster policy, fiscal regime, and intergovernmental relations in more specific country settings. In the next section, we discuss the disaster policy and fiscal institutions in the U.S. federal system and their implications for disaster financing and management at both the federal and subnational levels.

Fiscal Implications of Disaster Management in the U.S. Federal System

In the United States, disaster management is a shared intergovernmental responsibility that begins at the local level (Schneider, 1995; Birkland & Waterman, 2008). The local (municipal and county) governments are on the front line of dealing with emergencies that occur within their jurisdictions. As the first responder, they develop basic emergency preparedness and response procedures, and when a disaster strikes, they need to follow a series of prespecified steps to request external assistance from the state, or ultimately from the national government (Schneider, 2008). The higher levels of government, when they get involved, do not have the authority to supersede or overpower the actions of the lower levels. The state governments act as the intermediary between localities and the federal government by funneling federal disaster grants and providing state-owned financial support and technical assistance to localities (McEntire & Dawson, 2007).

The role of the federal government in providing disaster assistance was first institutionalized under the Federal Disaster Relief Act (Public Law 81-875), passed by Congress in 1950.9 The program established the Presidential Disaster Declaration (PDD) system, which gives the president the authority to issue emergency and disaster declarations and provide disaster assistance at the request of the governor of a state where a natural disaster occurs and exceeds the local capacity to respond. Prior to the enactment of this bill, all federal disaster funding decisions had been made on a case-by-case basis.

The current policy framework and procedures for federal disaster assistance are governed by the 1988 Robert T. Stafford Disaster Relief and Emergency Assistance Act, hereafter the Stafford Act. The Act authorizes the Federal Emergency Management Agency (FEMA) to take the responsibility for assessing disaster damage, coordinating government-wide disaster response efforts, and providing assistance to state and local governments as well as affected individuals, households, and businesses.10 The Stafford Act maintains the president’s authority to issue PDDs (including major disaster, emergency, and fire management declarations), which in turn enable federal agencies to provide assistance through a variety of grant programs.

The past few decades have seen a steady increase in the number of PDDs, as shown in Figure 3. Along with this trend is the growing economic losses (measured in the direct damage) of all natural disasters across the United States (as indicated in Figure 4), suggesting increased financial exposure of governments to natural hazards. According to the 2014 statistics compiled by the Office of Management and Budget (OMB), the federal government incurred over $300 billion in direct costs because of extreme weather (including fire incidents) between 2004 and 2014. The majority of these expenditures were for direct disaster responses and relief ($176 billion), and the remaining was spent on flood and crop insurance and wildfire management.

The Fiscal Implications of Managing Natural Disasters for National and Subnational GovernmentsClick to view larger

Figure 3. Number of major disaster declarations and emergency declarations by year. Data drawn from the Federal Emergency Management Agency.

The Fiscal Implications of Managing Natural Disasters for National and Subnational GovernmentsClick to view larger

Figure 4. Annual natural disaster damage in the United States by year (1960–2013). Damage data are drawn from the Spatial Hazard Events and Losses Database for the United States (SHELDUS) (http://hvri.geog.sc.edu/SHELDUS/), maintained by the Hazards and Vulnerability Research Institute at the University of South Carolina. The annual damage includes both direct crop damage and property damage resulting from 18 different types of natural disaster events, including hurricanes, floods, earthquakes, droughts, and tornados. This figure is taken from Miao et al. (2018).

Other scholars and institutions have used different counting approaches to provide estimates of federal disaster spending. For example, a report by the Center for American Progress (CAP) suggests the federal government spent at least $136 billion on direct disaster relief between fiscal year 2011 and fiscal year 2013, which is approximately $400 per household per year (Weiss & Weidman, 2013). The Natural Resources Defense Council (NRDC) estimates that federal spending on climate-related disasters was nearly $100 billion in 2012 alone, which made it one of the largest nondefense discretionary budget items (Lashof & Stevenson, 2013). Cummins et al. (2010) estimate the expected annual federal expenditure on disaster assistance is between $10 billion and $25 billion. As the recent disasters and catastrophes have incurred tremendous destruction and losses, their impact on government finance has become an increasingly urgent issue faced by federal, state, and local governments. To address this challenge requires more careful empirical investigation of the fiscal impacts of disasters across different levels of government.

Fiscal Responses to Natural Disasters: The U.S. Evidence

Only a handful of studies have examined the ex post fiscal consequence of natural disasters in the U.S. context, offering limited, yet mixed empirical evidence. Much of the earlier research employed case studies focused on a single disaster or a single location. For example, Chang (1983) examines the impact of the 1979 Hurricane Frederic on the municipal revenue flows of Mobile, Alabama. He found that while the hurricane caused $1.6 billion direct damage (in 1967 dollars), the city received an influx of $670 million recovery funds from the federal government. Its municipal revenue increased by $2.5 million in one year after the storm, mostly from the city sales tax.11 However, the study also suggested that the hurricane had a negative long-term effect on Mobile’s revenues.

Burby et al. (1991) analyze the direct losses sustained by states and localities during PDD-related incidents between 1980 and mid-1987. Using the FEMA grants data, they found that two thirds of the government units suffered eligible losses of less than $50,000, and 22% had losses less than $5,000. Their findings raise the question regarding the necessity of covering such disaster damage using federal funds given they were relatively low. Roenigk (1993) uses a cross-sectional sample of 112 counties experiencing disasters in the mid-1980s to examine whether federal disaster aid lessened the financial stress on local government. By comparing the counties that received federal aid with the nonaided county governments, he found that federal aid had little impact. He also found that disasters resulted in a larger increase in local tax revenues compared to the increase in local spending within two years following their occurrence, which implies a net positive effect on local government financial condition.

In a more recent study, Fannin et al. (2012) examine how hurricanes affect the fiscal health of northern Gulf Coast county governments. They found that county governments with better financial condition (e.g., liquidity and solvency) before a storm experienced greater reductions in fiscal health than those with a weaker initial status. They suggest that the federal and state governments provided disproportionately more support to local governments in poorer fiscal condition and let those fiscally sound governments draw on their own reserves to finance their disaster management. In an extension of this research, Fannin and Detre (2012) showed that following the 2005 hurricane season, most of the county governments in Mississippi and Louisiana did not see significant changes in liquidity and solvency, except those experiencing high hurricane damage. They note that federal assistance was important in buffering the disaster’s shock to local governments, but it might not have been a reliable “insurer of last resort.”

The distribution of disaster-related fiscal costs between the federal and state governments is more systematically investigated in Miao et al. (2018). Their research uses the panel VAR model to examine the dynamic impact of natural disaster damage on state government finance (including own-source revenue, expenditure, federal-to-state transfers, and long-term debt issuance) using a panel data set over the 1970 to 2013 period. They estimated that when a state’s total disaster damage (from multiple types of natural hazards) increased by 1% as its share of the gross state product (GSP), it would increase the state government spending by 0.2% (share of GSP) and federal transfers by 0.27% (share of GSP) cumulatively in the next five years. This finding suggests that disaster-induced spending at the state level is largely financed through federal transfers, meaning that the federal government bears most of the ex post fiscal costs of disasters. They also found that natural disasters caused a significant and negative shock to property- and income-tax revenues, although their effect on aggregate own-source revenue was insignificant. Overall, their research confirms the countercyclical spending pattern following disasters and substantial redistribution because of the federal aid.

To the extent that disasters can cause public health concerns and adverse economic shocks (e.g., in terms of incomes and employment), they may further increase government expenditures on the traditional social safety net programs. Deryugina (2017) empirically examined the impact of hurricanes that made landfall between 1979 and 2002 on government transfers through a variety of social safety net program transfers at the county level. The study estimated that a hurricane would increase government transfers through nondisasters social insurance programs by averages of from $780 to $1,150 per capita (in 2013 dollars) to an affected county in the 10 years following its occurrence, with the changes mainly driven by medical spending, income maintenance, and unemployment insurance payments. The magnitude of these nondisaster transfer payments is much larger than disaster-related aid (estimated at from $155 to $160 per capita), suggesting that the actual fiscal costs of natural disasters have been underestimated if only disaster aid is included. These findings also imply that victims in developed countries are better insured against disasters than those in developing countries because of the social safety net programs.

Moreover, a government may also borrow to fund its additional disaster expenditures, and in this case, a disaster would increase the borrowing cost for local governments. Very limited research has directly addressed this question. One example is the study by Fowles et al. (2009) that suggests that earthquake risk may influence the interest costs for municipal bonds issued in California. Interestingly, they found this effect only became statistically significant after Hurricane Katrina in 2005, which was supposed to have raised nationwide awareness of natural disaster risk.

Federal Disaster Management Policy: Design and Efficacy

While the empirical literature discussed in “Fiscal Responses to Natural Disasters: The U.S. Evidence” mainly focuses on the implications of natural disasters for public finance, it is equally important to consider the implications of public finance principles and policy structures for managing disasters, both ex ante and ex post. A key question worth exploration is how, within the U.S. federal system, to assign the various disaster management functions (preparedness, mitigation, response, and recovery) and related financial responsibilities to different levels of government.

According to Donahue and Joyce (2001), local governments can most efficiently design and implement their particularized disaster programs (e.g., physical and social infrastructures) based on their local needs. State governments are competent to coordinate and allocate resources among government agencies and across local jurisdictions, whereas the federal government is best positioned to provide widely accessible information and expertise through the creation of a national emergency management framework. To justify intergovernmental disaster grants, they argue that disaster grants from higher to lower levels of government are essential for correcting for fiscal disparities across localities, as well as for the spillover effects (or positive externalities) of local mitigation activities.12

From the perspective of fiscal decentralization, Goodspeed (2015) also argues that disaster prevention and mitigation functions would be better when decentralized at the local level because local governments have better knowledge about their risk profiles and how to manage such risks. He further notes that a national government has a role to play in pooling disaster risks across subnational regions and providing insurance in the form of postdisaster relief. What he observes is “a natural interplay between national and subnational governments” in ex ante disaster mitigation and ex post response and assistance functions.

The advantage of decentralizing disaster management at the local government level has been challenged, however, by scholars from the hazards and disaster research community. For example, Burby (2006) points out that local public officials are often less concerned about natural hazards and put more efforts into addressing other pressing local concerns such as unemployment and education. Their neglect of natural hazards and the pursuit of urban development and expanding the base for tax revenues could lead people to live in riskier places and incur even greater losses from future disaster events (Burby, 1998; Birkland & Waterman, 2008). Additionally, other scholars argue that the federal government provides generous disaster relief and funding for protection works, which further distort local incentive for investing in mitigation. In the remainder of this subsection, we focus on the federal disaster aid policy, including major programs and funding mechanisms, and then discuss the efficacy and implications of these programs based on empirical research evidence.

Under the Stafford Act, the federal government implements a variety of disaster assistance programs that address different needs and functions involved in emergency management. It has been widely recognized that spending on postdisaster response and relief accounts for the largest component of federal disaster financing and liability.13 Once the president issues a PDD, FEMA distributes money from the Disaster Relief Fund (DRF) to provide disaster relief and assistance to the eligible applicants. The DRF is a “no-year” account (i.e., funds remain until expended) that is funded through annual appropriations by Congress and budgeted at a level sufficient for dealing with “normal” disasters (i.e., incidents for which DRF outlays are no more than $500 million). When a large-scale disaster occurs that depletes the DRF, Congress may pass ad hoc supplemental appropriations to augment the funding for the DRF and also direct funds to other federal agencies to disburse to the affected regions (Lindsay, 2014).

The basic disaster assistance provided by FEMA using the DRF falls into three major categories: (1) Public Assistance (PA), which provides grants to state and local governments to fund emergency responses such as debris removal and permanent restoration of infrastructures such as public buildings, roads, bridges, and utilities. PA is FEMA’s largest funded program. (2) Individual Assistance (IA), which includes direct disaster relief for uninsured and underinsured individuals, households and business, disaster housing for displaced individuals, crisis counseling, tax relief, and disaster-related unemployment assistance. (3) Hazard Mitigation Assistance (or Hazard Mitigation Grant Program), which funds mitigation measures that can prevent or alleviate the impacts of future disaster events such as strengthening buildings to withstand earthquakes and developing land-use zoning plans. In delivering federal assistance to PDD-eligible jurisdictions, FEMA has adopted a cost-share policy (e.g., for the PA program) under which the federal government pays (no less than) 75% of all eligible expenses and state and local governments pay the remaining 25% (Brown & Richardson, 2015). In addition, the president has the discretion to make the cost-share adjustment and provide waivers of state and local cost shares for catastrophe situations such as Hurricane Katrina.

In addition to providing direct disaster aid, the federal government also employs a wide range of policy programs in managing disaster risks. For example, it established the National Flood Insurance Program (NFIP) in 1968, which provides insurance policies to private properties with flood risks through a voluntary partnership between federal agencies, communities, and private insurers.14 The program was designed to address the growing cost of flood events, the unavailability of flood insurance in the private insurance market, and to provide an alternative to federal disaster aid. Similar to the NFIP, the federal government established the Federal Crop Insurance Corporations (FCIC) under the U.S. Department of Agriculture (USDA) from which U.S. farmers can purchase crop insurance against their potential losses associated with adverse weather and weather-related plant diseases. In addition, the USDA implements other disaster aid programs, such as the Noninsured Crop Disaster Assistance Program, that help farmers recover financially from natural disasters.15

Many other federal agencies are also involved in providing disaster assistance, including the Department of Housing and Urban Development (HUD), the Small Business Administration (SBA), the Department of Commerce, the Department of Transportation, and the Department of Health and Human Service (HHS). For example, HUD distributes aid to communities through its Community Development Block Grant (CDBG) program to assist their postdisaster recovery, which primarily funds clean-up, restoration of housing and infrastructure, economic development, and hazard mitigation activities. The CDBG funds are often used to offset the disaster relief costs of state and local governments not covered by FEMA and other programs (Boyd, 2010), and they offer more flexibility in spending the federal money.16 The SBA has been another major source of disaster assistance by offering low-interest, long-term disaster loans to businesses and homeowners to help them repair, rebuild, and recover from a declared disaster (Lindsay, 2015).17 For example, affected businesses in declared disaster areas can apply for up to $2 million to repair their damaged properties or equipment.

One common criticism raised about the U.S. disaster policy is that the federal government spends disproportionately more on postdisaster response and relief aid, while deemphasizing mitigation and preparedness (e.g., Donahue & Joyce, 2001; Wildasin, 2008a; Mileti, 1999). Some argue that postdisaster governmental aid is highly politically motivated and does not help reduce future disaster risks (Healy & Malhotra, 2009). Many others have raised the “moral hazard” (or “charity hazard”) problem (Ehrlich & Becker, 1972; Lewis & Nickerson, 1989; Shogren & Crocker, 1991; Coate, 1995; Kim & Schlesinger, 2005; Raschky & Weck-Hannemann, 2007) with regard to federal disaster relief.18 In particular, because postdisaster aid leaves the recipients with limited financial liability for their actual disaster losses, these recipients would expect government relief following a disaster and thus have lower incentives to invest in reducing their risk ex ante.19

In the U.S. federalism context, the federal disaster aid policy has profound implications for the incentives and practices of disaster management undertaken by the subnational governments. As Wildasin (2008a, p. 512) notes, the “assignment for disaster relief responsibility to the Federal government, coupled with significant subnational government responsibility for disaster avoidance policy, creates a potentially serious misalignment of incentives in the U.S. federation.” Using the case of Hurricane Katrina, Burby (2006) argues that federal disaster relief and subsidization of local protection works could reduce incentives for local governments to be more prudent in their land development decisions. In particular, these protection works (e.g., flood control systems, levees, and seawalls) could promote a false sense of security and encourage local development in high-risk areas. By doing so, these communities would increase their exposure to natural hazards as well as their risks for catastrophic losses once a disaster exceeds the capacity of protective infrastructures, which is a problem Burby (2006) frames as the “safe development paradox.”

Some of these claims have received partial support from a relatively small empirical literature examining the welfare implications and efficacy of various disaster aid programs. Several recent studies have confirmed that government assistance can significantly lessen negative economic shock due to disasters. For example, Gallagher and Hartley (2017) investigate the impact of Hurricane Katrina on household finance. Using individual-level credit agency data, they found that households affected by Katrina later experienced significant reductions in their total debt because they used their flood insurance payouts to pay down mortgage debt. In another study, Deryugina et al. (2018) used a panel of tax return data to show that Hurricane Katrina had a small and transitory impact on employment, wages, and total income despite its large effect on residential relocation. Their research found that the income level of the affected population in New Orleans actually surpassed those of the unaffected control group several years later, and this result could be partially due to government disaster aid and tax reductions. Davlasheridze and Geylani (2017) studied the effect of SBA disaster loans on postflood business recovery. They estimated that one additional dollar spent on disaster loans per establishment in a county led to survival of four small businesses (with the effect most prominent in metro and urban counties). Overall, these studies shed light on the role of postdisaster relief in supporting the economic recovery of disaster victims, as well as the redistributional effect of federal disaster aid (because the transfer payments are shared by all taxpayers across the nation).

To test the moral hazard hypothesis, several researchers have examined the effect of federal disaster relief on private purchases of disaster insurance (e.g., Raschky et al., 2013; Raschky & Schwindt, 2009). For example, Kousky et al. (2018) examined the impact of FEMA’s IA grant and SBA’s low-interest disaster loans on household flood insurance purchases at the county level. They found that receiving an IA grant decreased the average insurance coverage purchased in the following year by $4,000 to $5,000, while the IA grant had little impact on the take-up rates (extensive margin) of flood insurance. They found no impact of SBA loans on insurance purchases.20Deryugina and Kirwan (2018) provided similar evidence by showing a negative effect of the USDA disaster aid on the intensive margin of crop insurance (measured by farmers’ out-of-pocket insurance spending). In a working paper, Davlasheridze and Miao (2017) found that increased FEMA PA grants can reduce a county’s flood insurance take-up rates and thereby drive down its total insurance coverage. Taken together, these studies provide empirical evidence on the moral hazard problem of postdisaster relief. Their findings may also suggest the additional social costs of these assistance programs because of their crowding out effect on private disaster insurance purchases. Importantly, such insurance dropouts and lost coverage may potentially lead to more disaster relief to cover uninsured losses from future disasters, thereby affecting the financial soundness of disaster aid programs.

In addition to disaster relief aid, prior research has investigated the cost-effectiveness of governmental expenditures on hazard mitigation programs. In an assessment of FEMA’s hazard mitigation grants, Rose et al. (2007) estimated an average 4:1 benefit–cost ratio for investment in these programs, using the cost data on approximately 5,500 grant projects between 1993 and 2003. A Congressional Budget Office report (2007) suggests that one dollar spent on mitigation programs can reduce future disaster losses by $3. Using natural disaster damage and federal aid data, Healy and Malhotra (2009) found that a $1 increase in federal preparedness spending at the county level is associated with a $15 reduction in future disaster damage, whereas relief programs have little effect on risk reduction. Davlasheridze et al. (2017) examine the effects of different FEMA grant programs on hurricane-induced property losses. Using county-level panel data, they found that a 1% increase in ex ante federal mitigation spending would reduce property damage in the following year by 0.21%, whereas the same increase in ex post recovery spending only reduces future damage by 0.12%.

In addition to the research on disaster aid programs, several other studies suggest that local land use and hazard planning are effective policy instruments for mitigating disaster risk. For example, Burby (2005) showed that a state mandate on local governments to plan for natural hazards led to significant reductions in insured property losses. He estimated that, if all states had required their local governments to develop comprehensive plans with consideration of hazard mitigation, this mandate would have reduced total insured losses by more than $200 million between 1994 and 2000. Brody et al. (2007) examined FEMA’s Community Rating Score (CRS) program, a voluntary program that encourages communities to undertake floodplain planning and flood control measures, and they found that participation in CRS program reduced a community’s flood-related property damage.

In sum, both theories and empirical evidence suggest that the federal government should shift the focus of its disaster grant programs from ex post relief and response to ex ante mitigation and preparedness. One might wonder what influences current federal disaster expenditures, and some scholars have further examined the political economy of disaster relief (e.g., Cohen & Werker, 2008). For example, Garrett and Sobel (2003) found that states more politically important to the president or that had congressional representation on FEMA oversight committees received higher FEMA disaster payments. Their findings, based on PDD and federal disaster data in the 1991–1999 period, further suggested that nearly half of all FEMA’s disaster relief aid was motivated by political considerations as opposed to actual needs. This finding thus challenges the validity of the federal disaster assistance system.

Some argue that the infrequent and unpredictable nature of natural disasters makes ex ante disaster mitigation a lower priority for individuals and communities (Donahue et al., 2014). Healy and Malhotra (2009) note that postdisaster relief is often salient and brings immediate and private benefits to individuals, whereas predisaster spending is less observable, and its benefits are less likely to be realized immediately. Their empirical analysis suggests that voters show a strong preference for disaster relief spending by voting for the incumbent presidential party, while they are unresponsive to federal spending on disaster preparedness. This finding explains why elected officials are motivated to spend on disaster relief and underinvest in preparedness and mitigation activities, despite the social benefits associated with the latter.21

Current fiscal institutions and budgeting rules also play a role in driving excessive postdisaster relief spending at the federal level. As discussed in Donahue and Joyce (2001), the Budget Enforcement Act (BEA), which intended to control discretionary spending, placed caps on disaster spending from annual appropriations. This has led the president and Congress to frequently use ad hoc supplemental appropriations to finance assistance after a large-scale disaster, while at the same time underfunding regular disaster programs through annual appropriations.22 Moreover, these supplemental appropriation bills make it easier for the federal government to declare response and recovery funding rather than to provide a mitigation grant because the latter is hardly justified for emergency purpose.

As shown in Figure 5, supplemental appropriations have been the major funding source for DRF. During the 2005 hurricane season, more than $110 billion were funded through supplemental appropriations for federal disaster assistance (Lindsay & Murray, 2014). It is worth noting that the Budget Control Act of 2011 has introduced a new approach for disaster budgeting by adjusting the spending limit, named “allowable adjustment,” which enables Congress to fund the DRF to a greater degree through annual appropriations rather than through supplemental appropriations (Lindsay et al., 2016).23

The Fiscal Implications of Managing Natural Disasters for National and Subnational GovernmentsClick to view larger

Figure 5. U.S. Congress regular and supplementary appropriations for the DRF (FY1989–FY2013). Data based on the statistics in Lindsay (2014) and Lindsay and Murray (2014). This figure is from Miao et al. (2018).

Overall, the examination of the U.S. disaster policy framework reveals its importance for determining the fiscal costs of natural disasters nationwide and across levels of government. In the U.S. federal system, the state and local governments have the primary responsibility for and autonomy in managing their disaster risks. The federal government plays a critical role in providing postdisaster relief as a risk-pooling strategy, but it also bears a substantial financial burden due to the growing economic losses of natural disasters across the country.24 Moreover, federal transfers through postdisaster relief may distort local incentive to invest in hazard mitigation or implement appropriate land use and planning policies, which raises concerns about the equity and efficiency of the current federal disaster aid policy. However, some researchers also note that federal disaster aid is not as generous as the media and academics often perceive (Kousky & Shabman, 2012). For instance, the disaster relief aid to individuals is capped at just over $30,000, and there are other requirements for receiving such aid (e.g., maintaining flood insurance) which are designed to alleviate the moral hazard problem.

Implications for Government Budgeting for Natural Disasters

Estimating the disaster costs for government and cost-effectiveness of different disaster management strategies has important implications for the financial management of natural disasters, and in particular, for budgeting for disaster aid and hazard mitigation programs. Phaup and Kirschner (2010) argue that ex ante disaster budgeting, by increasing taxes and reducing public expenditures in advance, can reduce exposure to disaster risk and improve long-term well-being in the face of natural disasters. In a survey of 15 OECD countries, they found that many countries appeared to engage in ex ante disaster budgeting by directly offering insurance, supporting private insurance, and using the contingency funds.

Concerning local government budgeting, Settle (1985) discusses different disaster financing instruments including contingency funds, mutual aid agreements, joint power agreements, municipal bonds, insurance programs, tax anticipation notes, and budget transfers. In a recent national survey of 546 counties from 46 states, Clarke (2006) found the average county budgets for performing emergency management functions were approximately $33,000. More than 70% of the counties in the survey drew their budgets from the general fund. The survey results also indicated that a vast majority of these counties participated in several federally sponsored hazard planning and mitigation activities.

A study released by the Government Accountability Office (GAO) indicates that all 10 selected states in the study had established certain budget mechanisms for funding unexpected natural disasters.25 Their financing mechanisms included general fund revenues, contingency funding budgets, supplemental appropriations, and budget transfers. The report also revealed that none of the 10 states maintained reserves dedicated solely for future natural disasters because these states expected to rely on federal disaster assistance to cover most of the costs associated with disaster response and recovery. This finding appears to confirm the moral hazard problem in budgeting practices. As noted in Wildasin (2008b), many states and local governments already maintained modest reserve funds that could be used for disaster financing, but these were entirely discretionary. To address the moral hazard problem, he proposes creating “mandated disaster reserves” at the state level which commensurate with the disaster risk faced by different states.

Conclusion

Natural disasters often cause massive social disruptions and tremendous economic and human losses. Given their uncertain and destructive nature, disasters invariably induce governmental responses and pose nonnegligible financial challenges for all levels of government. As economic losses from natural disasters have been increasing all over the world, there has been growing interest in understanding the fiscal impact of natural disasters as well as the implications of public finance principles and institutions for reducing disaster impact. This article expands the traditional focus on the ex post disaster impact on government finance (e.g., expenditures, revenue, and budget balances) to propose a new model conceptualizing the fiscal implications of integrated disaster management. From a dynamic perspective, we argue it is important to incorporate government investment in predisaster mitigation and preparedness, given their potential effectiveness for reducing long-term disaster risk and related fiscal shocks. We also incorporate the intergovernmental dimension of disaster management and discuss its implications for the cost distribution of disasters across levels of government. This article mainly focuses on the U.S. context by drawing on U.S.-related empirical research to shed light on the interplay between disaster policy and public finance in the U.S. federal system. Nonetheless, our discussion on the disaster aid policy made by the national government and its influence on subnational disaster financing and risk management has the potential to be generalized to other federal systems or country settings.

This article suggests several remaining gaps in the literature that warrant further research. First, regarding intergovernmental dimension, the fiscal federalism theory may suggest that local governments can better deal with their disaster risks, and therefore decentralization might promote more efficient management to reduce disaster losses. Several studies (Escaleras & Register, 2012; Skidmore & Toya, 2013) have found countries with more decentralized governments experience fewer disaster-related fatalities, suggesting a positive role of fiscal decentralization. However, it is questionable whether decentralization can effectively encourage local mitigation efforts in the presence of postdisaster relief offered by the central government. More research needs to be conducted to empirically investigate how fiscal decentralization influences local mitigation spending and natural disaster damage in developed countries such as the United States.

Second, as recent research suggests that disaster aid can, to some extent, reduce the adverse disaster shock to microlevel economic outcomes (e.g., Gallagher & Hartley, 2017), more efforts should be made to systematically examine the role of governmental aid and investment in economic recovery post disasters. Specifically, future research on the economic dynamics of natural disasters (e.g., in GDP growth rate, incomes, employment, and investment) should account for the influence of government disaster responses and grants (e.g., whether the countercyclical spending pattern provides a positive stimulus into the local economy of disaster-stricken regions). Meanwhile, future research on the fiscal impacts of disasters should also incorporate the potential behavioral responses from both government (e.g., tax adjustments) and private agents (e.g., migration, business relocation, adaptation, changes in public risk perception, and self-insurance investment). For example, residential relocation may cause changes in the socioeconomic and demographic characteristics within a jurisdiction, which in turn influence its tax base and revenues. These changes may further affect the capacity and resources of the local government to undertake preparedness and risk mitigation activities. Overall, future research should recognize the dynamic interplay of disaster-induced economic responses and government responses.

Third, because climate change could be worsening certain natural disasters, it would impose continued pressure with a high level of uncertainty on government finance. This situation requires policy makers and researchers to not merely base estimations on past events but rather to incorporate climate projections into their analyses. For example, a recent OMB report provides a preliminary assessment of the fiscal risks associated with climate change facing the federal government, which include an increase of $9 billion to $28 billion in annual expenditures and $60 billion to $110 billion in annual revenue losses in today’s economy by late-century (OMB, 2016). More such assessments, coupling economic analysis with scientific projections of climate change and extreme weather events, are needed to project the financial risks at regional or local scales. Finally, this article mainly focuses on the fiscal implications of disaster management in the U.S. federal system. Nonetheless, our conceptual framework should have the potential to apply to other countries as well as the developing context. More future research is needed to empirically examine the distribution of disaster-related fiscal costs in relation to a country’s disaster policy in other fiscal and political regimes.

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Notes:

(1.) For more details about the statistics, see https://www.ncdc.noaa.gov/billions/

(2.) Some studies further distinguish between the direct and indirect fiscal impacts of natural disasters (Mahul & Signer, 2014).

(3.) For a comprehensive review of the literature, see Cavallo and Noy (2011), and Kousky (2014).

(4.) Numerous studies have suggested that countries located in higher-risk regions tend to undertake more protective measures and suffer fewer disaster losses as compared to those in lower-risk regions (Keefer et al., 2011; Schumacher & Strobl, 2011; Hsiang & Narita, 2012; Neumayer et al., 2014). They attribute these findings to multiple factors such as inherent rationality in policy making, government accountability and motivation to garner voters’ support, as well as adaptation.

(5.) For a more comprehensive review of this literature, see Kousky (2014).

(6.) A natural hazard is defined as a “geophysical, atmospheric, or hydrological event that has the potential for causing harm or losses” (Benson & Clay, 2004, p. 5). From the economics perspective, a natural hazard is an exogenous event that is not determined by the social or economic system.

(7.) It is noteworthy that in addition to intergovernmental aid, the private sector, nonprofit organizations, and international humanitarian organizations are sometimes actively involved in providing financial resources and assistance to disaster-stricken communities. Here we include all of them in the category of external aid.

(8.) The panel VAR method combines the traditional VAR model (a system of equations in which multiple endogenous variables are determined by their own lagged variables, lagged values of other endogenous variables, and exogenous variables) and the panel data approach (which controls for the unobserved cross-sectional heterogeneity). This model is used in multiple studies in the field because it allows for the endogeneity of and interdependency among multiple fiscal variables. It also enables estimation of the dynamic disaster impact one period at a time. For a comprehensive review of the panel VAR methodology, see Holtz-Eakin et al. (1988) and Canova and Ciccarelli (2013).

(9.) It is interesting that in the late 19th and early 20th centuries, disaster management was almost entirely a local responsibility in many communities where seeking external disaster aid was even resisted because of the fear that the community may lose business opportunities. For a brief review of the change in U.S. intergovernmental disaster policy, see Birkland and Waterman (2008).

(10.) By collecting information on the preliminary damage of a disaster (often based on per-capita damage and total statewide damage), FEMA needs to evaluate whether the disaster is beyond the capacity of the affected state and localities to manage and then make recommendations to the president regarding whether a PDD should be approved.

(11.) The study also found that the recovery dollars had a small impact on the city’s sales tax revenue mainly because they were “leaked” to the out-of-town contractors and suppliers.

(12.) More specifically, they argue that natural disasters are rarely contained within the political boundaries and it is very likely the benefits of local risk mitigation actions can spill over to other localities. For this reason, intergovernmental aid is needed to encourage more local investment in disaster risk management.

(13.) According to FEMA (2009), FEMA has spent over $96 billion for disaster assistance since 1989, and only $4.4 billion of the disaster aid was devoted to hazard mitigation activities.

(14.) For an overview of the NFIP, see Brown (2016).

(15.) For more information about the federal disaster assistance programs in agriculture, see Stubbs (2016).

(16.) In recent years, Congress has more frequently used the CDBG program to disburse disaster relief funds. For example, after Hurricane Sandy, Congress approved more than $50 billion in supplemental funding. HUD received the greatest share of funding (approximately $16 billion) from the Sandy Supplemental (Kousky & Shabman, 2012).

(17.) SBA provides three main types of disaster-related loans, including Home and Personal Property Disaster loans, Business Physical Disaster loans, and Economic Injury Disaster loans.

(18.) Moral hazard is an insurance term which refers to the problem that the availability of insurance protection (or more generally, a transaction agreement) lowers the insured party’s incentive to avoid risk.

(19.) One example is that after the 1993 Midwest floods, the House Bipartisan Natural Disaster Task Force stated that “If state and local governments believe that the federal government will meet their needs in every disaster, they have less incentive to spend scarce state and local resources on disaster preparedness, mitigation, response and recovery … (and) people are encouraged to take risks they think they will not have to pay for” (Platt, 1999, p. 39).

(20.) It is noteworthy that the IA program mandates recipients to purchase and carry disaster insurance, and this aid requirement is intended to address the moral hazard concern. In another paper, Kousky (2017) shows that hurricanes increase the take-up rates of flooding insurances, and such effect is mostly explained by the IA aid requirement.

(21.) However, it is noteworthy that, in another study, Donahue (2014) uses survey data to show that a majority of U.S. residents are willing to pay taxes to improve their community’s preparedness, and a low proportion of them would refuse the incentive provided by the government to spend more on their own preparedness.

(22.) By designating disasters as emergency situations, the spending authorized in the supplemental appropriations is then exempted from the BEA spending caps.

(23.) The disaster relief allowable adjustment is based on a modified rolling average of annual federal government appropriation associated with major disaster declarations. Starting from the fiscal year 2012, OMB takes the past 10 annual totals of disaster relief appropriations, drops the highest and lowest years, and takes the average of the remaining eight to calculate the modified average (Lindsay et al., 2016).

(24.) Cummins et al. (2010) estimate that an “unfunded” federal liability for disaster assistance over the next 75 years would be comparable to that of Social Security, given the current approach to disaster relief funding.

(25.) The 10 selected states in the GAO’s review were Alaska, California, Florida, Indiana, Missouri, New York, North Dakota, Oklahoma, Vermont, and West Virginia.