While some economic shocks are of sufficient magnitude to reverberate across the nation and trigger macroeconomic policy responses, many are confined to particular cities, counties, and states. These local shocks take many forms: plant and base closures, crop failures, industrial restructuring, natural disasters, and property market slumps. And they can be extremely painful, not only for individuals, but also for communities.

When people are thrown out of work or suffer substantial declines in income, those who sell them goods and services lose their customers; in turn, they must lay off employees. People begin defaulting on mortgages and declaring bankruptcy. As the impact accumulates, property values fall and tax revenues slump.

Given the manner in which most local governments are financed–they are often legally constrained to balance their budgets–there are likely to be cutbacks in basic community services at precisely the time they are most needed. As local services decline, the quality of life deteriorates, and those who are mobile and best able to adapt to change often decide to leave. This further contributes to tax losses and declining property values. Even if they can borrow funds, local governments find their financing costs rise as the market assigns their debt higher risk premiums. This inability to respond increases the risk that a short-term shock could develop into long-term decline. If some lose faith in a community’s future, there is a danger that their actions could turn into a self-fulfilling prophesy. The result is a community death spiral, one in which collective action could help, but with the exception of some natural disasters (which trigger federal emergency responses), none is offered.

It doesn’t have to be this way. Just as the federal government provides workers with Unemployment Insurance, it should provide counties, cities, and states with Community Insurance, a self-financing program that would allow communities to pool the risk of tax-base erosion through tax base insurance policies. In normal times, communities would pay an annual premium for the insurance; in bad times, the policy would help make up shortfalls in tax revenues beyond certain threshold levels. The specific terms would vary, but a policy insuring 50 percent of shortfalls greater than 5 percent might provide 7.5 percentage points of insurance for two years in response to a 20 percentage point revenue drop.

Though individual states could offer such programs, the national economy would afford more opportunities for diversifying risk. Such a program would appeal both to poor and affluent communities as it would be more efficient for both not to have to try to build up rainy-day funds on their own, which the current practice to prepare for a community-wide downturn. In addition, over the past 13 years, about a quarter of the states have experienced annual tax revenue shortfalls exceeding 5 percent from the prior year. A similar share of California counties have actually experienced such shortfalls on one or more years over the past five years.

Operating such a plan does require meeting technical challenges: defining the tax base eligible for insurance (obviously, losses due to tax-rate reductions would not be covered), setting premiums at appropriate levels, and defining the level of local government eligible for the program. But these are not insurmountable and are well within the skills of public finance experts.

The aim of this policy is not to prevent long-term change or adjustment. In a dynamic economy, some communities and regions may inevitably have to shrink and decline. Nor is it to finance major new regional economic developments for depressed areas; policies such as tax breaks for enterprise zones may be more suitable for this purpose. But the idea is to provide for easier transitions and to prevent sudden unforeseen shocks from generating downward spirals.