States Try to Prepare for the Economy’s Wild Ride

Partially because of tax policies, state budgets have become increasingly unpredictable. But a few states are finding ways to manage the craziness.
by | August 2014
 

This is part of the ongoing Finance 101 series that breaks down the basics of public finance for public officials.

Ask budget forecasters if they ever find certainty in their line of work and you will get the same answer: Certainty doesn’t exist. The only sure thing, says Kristen Cox, executive director of Utah’s budget office, is “no matter how good we get at forecasting and modeling, we will never get it right. The trends [we track] are what we know. But it’s the unknowable that will nail you.”

In 2008 many states, including Utah, were predicting another stellar year of revenue growth approaching 10 percent. Instead, the economy took a historic leap off a cliff and state revenues collectively plummeted faster and deeper than at any time in recent memory. Even states that had a large rainy day fund (at least 10 percent of operating revenue), had to scramble to balance their budgets. At that time, Utah’s two reserve funds covered about 8 percent of general fund appropriations and nearly 7 percent of education spending. Utah didn’t come close to emptying the funds, but it had to use cash it had set aside for capital projects to help eliminate shortfalls during the recession.

Most states across the country took bigger hits than Utah did, and are still showing the effects in their rainy day budgeting. Before the recession, states nationwide had amassed a collective 10 percent of their appropriations in reserves (excluding Texas and Alaska, which have outsized funds). Now those reserves average barely 4 percent. Because of slow revenue growth following the downturn, states have not come close to replenishing their reserves. The bottom line is, most state budgets are even less prepared than they were in 2008 for a serious contraction.

But even in the absence of a recession, some states are paying a high price for inaccurate forecasting. The main culprit is the growing unpredictability of state revenues from year to year. At the close of the 2014 fiscal year, New Jersey was slammed with a shortfall of more than $1 billion and a credit rating downgrade as income tax revenue fell woefully short of expectations. The state cut payments to its pension fund to cover the gap, despite a promise in February that it would fully fund pensions in the 2015 budget.

Pennsylvania’s revenue estimates missed the mark badly in 2014 as corporate income tax revenue fell short by more than $300 million. Combined with other revenue estimate misses, the result was a $1 billion shortfall in the proposed 2015 budget, with just weeks to find a solution. Pennsylvania lawmakers finally passed a bill at the 11th hour that included a tax on natural gas drilling to help cover the fiscal hole.

A handful of states, however, are trying to get off the roller coaster and find a better way to manage their increasingly volatile revenues. Among them, Utah has taken the most systematic approach. It studies revenue swings in minute detail to gauge its exposure to risk. It started as a reaction to the dot-com stock collapse in the early 2000s. “Elected officials don’t like disappointing people,” says Utah legislative fiscal analyst Jonathan Ball, recalling the dot-com days. “We had set all these expectations about revenue numbers and then the bottom fell out and we had to go back and tell everyone it wasn’t real.”

After the dot-com debacle was over, Utah decided to create a separate budget reserve fund for public education, so that the state’s schools would be better insulated against the swings of income tax collection, the primary source of school funding. Then, in 2008, lawmakers approved a joint legislative and executive study of the state’s revenue volatility every three years. The idea was to take the temperature of the state’s income streams, spot trends or warnings and adjust policy accordingly. The analysis prompted Utah to raise funding targets for both of its reserve funds up to at least 8 percent of appropriations as its economy recovered from the recession.

The state’s 2011 volatility report found that Utah’s corporate income is by far its most volatile tax base. Studying 50 years of fiscal data, analysts noted that there were 16 years in which corporate income fell and another 16 years in which it grew by more than 15 percent. But the corporate income tax is a relatively small source of state revenue, and did not create the most serious volatility issues. The real problem was the personal income tax, which brings in nearly half the state’s total revenues and can shift in returns dramatically from year to year. And lately, those shifts were becoming more extreme. The result, the report noted, was that “the recent boom and bust cycles appear more pronounced and longer lasting than those from the 1960s and 1970s.”

After the 2011 report in Utah, one main conclusion arose: The state needed to have a codified budget reserves funding policy. It was unclear under existing law whether the funds were simply to cover forecasting errors or instead meant to supplement lost revenue in the event of a downturn. This year, lawmakers passed legislation that mapped out a rainy day fund policy. It requires fiscal analysts to notify the legislature’s appropriations committees when revenues are trending higher than usual -- in other words, when there is a windfall. The legislation advises that lawmakers use windfall money to pay down debt or set it aside for future spending needs in the event of a downturn. “Because if we don’t,” says the bill’s sponsor, state Rep. Brad Wilson, “we are inclined to spend it.”

States have contributed to revenue volatility through their own tax policies. In the 1980s and early 1990s, state tax rates generally increased when the economy soured, in order to stabilize revenue. When the economy expanded, rates generally fell. But since the mid-1990s, tax rates have been less responsive to economic conditions, a function of reluctance among legislators to vote for tax increases at any time, regardless of the economic situation.

In earlier decades, budget forecasters could at least be fairly confident that tax revenues would not stray too far from overall economic performance. Since 2000, that has been less and less true. The big culprit is investment income, which experienced mild swings in the 1990s but very dramatic ones in the 2000s, according to research by economists at the Federal Reserve Bank of Chicago. That’s likely because trading became more accessible and frequent with the Internet, so investment income began playing a larger role in tax reporting, says Donald Boyd, a senior fellow at the Rockefeller Institute of Government. “Really it’s the top tenth of a percent of people where all the money’s coming from,” he says. “So a small handful are driving the big swings in this.”

A total of 43 states have reserve funds of some kind, and while few have stocked the funds as generously as most budget analysts would recommend, there has been a considerable amount of recent attention to the problem. “I think the recession really drove that point home for a lot of people,” says Brenna Erford, a research manager at the Pew Charitable Trusts. Earlier this year, Pew released a report that looked at how state budgeting can smooth revenue volatility and hedge against risk. Pew recommended that states include contingency plans for shortfalls and surpluses in their formal budgets; that they design their rainy day funds so that they are large enough to make a significant contribution to softening economic downturns; and that they time their revenue forecasts closer to the final passage of the budget to minimize error.

Some 13 of the states have rainy day fund deposit policies that are connected to volatility. Virginia has one of the more unique rules; it compares the increase in tax revenue from the previous year to the average increase over the past six years to determine how much to contribute to its stabilization fund. Other states link their funds to a particularly volatile revenue stream. Massachusetts tied its fund to excess capital gains revenue after it drew down on its reserves significantly during the recession. After the capital gains rule was implemented in 2010, the fund more than doubled to $1.7 billion in just two years.

California has struggled painfully with wild variations in its capital gains collection. “They have a highly elastic revenue structure,” says Gabriel Petek, a Standard and Poor’s analyst who notes that from 2008 to 2009, the state’s economy declined by about 5 percent while general fund revenues declined by about 20 percent. This fall, a ballot initiative in California will seek voter approval to harness excess capital gains revenue to pump up its reserve fund.

There are other questions when it comes to rainy day funds’ usefulness. Are they too difficult to access? Texas, for example, requires a three-fifths vote in both chambers of the legislature to spend money from a massive, $8 billion reserve fund that totals 10 percent of appropriations and is largely maintained via oil-related revenues. Or do replenishment rules make withdrawals cumbersome? The Center on Budget and Policy Priorities advises that states eliminate such rules altogether, particularly if they require payback in less than the two to three years a downturn usually lasts. (West Virginia requires payback within 90 days.)

Underlying all these differences is the ultimate question of how much money is enough to provide an effective financial cushion in hard times. There is no right answer to this one. Each state has to tailor its reserve policies to its own tax structure and economy. As the Utah report notes, “some policymakers may prefer to face more risk” rather than have substantial savings held by the government.

But there is one common point. The economy’s wild swings -- and even wilder swings in state revenue -- mean that no state can put enough in reserve to make it through a serious downturn unscathed. “It doesn’t mean rainy day funds are a bad idea, they’re simply not enough,” says Boyd. “You realistically can’t make them big enough politically. Taxpayers look at that and say why are we putting all that money in there?”

Where reserves can make the biggest difference is in a state’s bounce-back. Utah provides a good example. Going into the 2008 recession, the state had nearly $430 million combined in its two reserve funds. Utah needed the money -- in 2009, it ultimately drew down about a third of its general fund and half of its education fund -- but this marked a dramatic difference from what happened in the 2001 recession, when nearly all the state’s $120 million in reserves were withdrawn. The focus of Utah’s current legislative efforts is to find a way to replicate its 2008 performance the next time an economic downturn hits the state. “We learned a lot from the recession,” Wilson says. “The swings can be much steeper and faster than you’d expect. And you have to prepare for them.”

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