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What a Tricky Economic Cycle Means for State Budgets

Revenues are coming in slower, creating some shortfalls. Following recent boom times, even a bit of belt-tightening is going to come as a shock.

Massachusetts Gov. Maura Healey visits a learning center in Westfield.
Massachusetts Gov. Healey had to start the year off with sizable budget cuts in the face of a $1 billion shortfall. (Don Treeger/TNS)
In Brief:
  • After rapid growth, income and sales taxes have turned anemic.

  • On the plus side, states collectively hold $160 billion in rainy-day funds, but they’re starting to miss the extra money sent by the feds due to COVID-19.

  • The situation is more worrying than dire, but lawmakers are having to relearn the habit of making tough choices.

  • Aaron Michlewitz, who chairs the top budget-writing committee in the Massachusetts House, has reasons to be worried. Democratic Gov. Maura Healey started the year by unveiling a set of spending cuts to address a $1 billion budget hole. “The scariest part about what’s gone on over the last six or seven months here is that every month has been a different story” in terms of which revenues are coming in above or below projections, Michlewitz says. “It’s certainly going to make for a challenging fiscal cycle, without a doubt.”

    After enjoying enormous growth following the immediate economic shock from the pandemic — as well as record amounts of federal aid — states are now seeing a revenue slowdown. “Prior to the pandemic, growth was steady at about 4 to 5 percent,” says Lucy Dadayan, an economist at the Urban-Brookings Tax Policy Center. “Now, even if it’s growing, it’s by 1 to 2 percent in nominal terms.”

    Slowing revenues are leading to shortfalls in some states, most notably California, where the size of the budget hole seems to keep expanding. It’s currently $73 billion, at least according to the Legislative Analyst’s Office. Democratic Gov. Gavin Newsom says it’s about half that size, but that’s still a lot of billions.

    On the bright side, California, like most states, took advantage of the recent boom times to make sure its rainy-day fund was fully loaded. Collectively, states ended the 2023 fiscal year last summer with a record $160 billion in reserve funds. “Rainy-day funds are completely stocked,” says Tim Storey, CEO of the National Conference of State Legislatures. “States are in a better position to weather whatever happens than perhaps ever, and I don’t say that lightly.”

    But what’s coming next? That’s the big question. The economy continues to grow, which is obviously good news for state budgets, yet lawmakers know they’re in for a period of retrenchment under any scenario, due to the winding down of federal COVID-19 funding programs.

    For that reason, even a return to normal budgeting — in which they will inevitably face tough trade-offs to make the numbers work out — may feel like a sudden shift into austerity.

    “Budgeteers and legislative leaders are now more skittish than they were a year ago,” Storey says, “even though a year ago every economist was saying a recession was imminent.”

    How We Got Here

    States benefited from an unusual set of circumstances in the wake of the pandemic. In 2020 and 2021, Washington sent some $800 billion their way through various aid packages, including more than $300 billion that they were free to spend pretty much at their own discretion. The American Rescue Plan Act alone contained $195 billion in direct aid to states and the District of Columbia.

    At the same time, states benefited from both economic growth and sizable gains and initial price offerings in the stock market. “The stock market in 2021 increased by almost 33 percent,” Dadayan says. “It was the strongest growth since 1983.”

    Even inflation, while a significant problem overall, meant more money for states, with sales tax revenues reflecting higher prices.

    “Some of it, I do think is just a little bit of a market correction,” Michlewitz says. “We grew so fast, so quickly, that it was bound to stabilize or come down a little bit.”

    The stock market has been going gangbusters lately, but mostly too late to be reflected in upcoming April income tax filings. States are now suffering from inflation, having to pay higher prices for things like construction and also generally having to increase wages to compete in what remains a tight labor market. “States will have to make choices about what areas to prioritize because their funds will be more limited,” says Brian Sigritz, director of state fiscal studies for the National Association of State Budget Officers. “There’s no doubt it will feel different than it has for the past couple of years.”

    Having said all that, the picture is not completely dire. For one thing, while revenue growth is sluggish, states are continuing to collect more money. Also, the extra federal funding, while winding down, continues to slosh through state budgets in sizable amounts.

    All told, Sigritz says, revenues in the current fiscal year are projected to be a third higher than they were in 2019, prior to the pandemic. That’s not exactly austerity.

    Bills Are Coming Due

    To a large extent, lawmakers were smart about spending their extra cash. They primarily used one-time money for one-time costs, such as building infrastructure projects or putting extra deposits into their pension accounts.

    That wasn’t the case everywhere, however. Baselines for many programs have been expanded, and while some states offered temporary tax cuts or one-time rebates, others made permanent cuts to their rates. “The surpluses that stemmed both from that aid and the strong economic recovery from COVID created a fiscal and political environment where lawmakers made permanent cuts to taxes,” says Wesley Tharpe, senior adviser for state tax policy at the Center on Budget and Policy Priorities, a progressive think tank. “Essentially, temporary dollars are partially masking some serious permanent revenues that are coming down the pike.”

    For two or three years, states were able to have their cake and eat it, too — cutting taxes, increasing spending and putting money away in rainy-day funds. That moment has now passed, but it doesn’t mean states are sinking into a deep hole, suggests Jonathan Williams, chief economist at the American Legislative Exchange Council. “Lawmakers are certainly cognizant that the good times are not going to last forever,” he says. “While it feels relatively like an austere budget scenario, given the gusher of federal funds in recent years, states are still sitting on robust rainy-day funds.”

    Williams is concerned, however, about budget proposals that rely on familiar bad habits to avoid dealing with tough choices, such as skipping pension fund payments. But he says there’s at least one “very positive outcome” from the current flattening of revenues: “There needs to be a real, grownup discussion around needs versus wants.”
    Alan Greenblatt is the editor of Governing. He can be found on Twitter at @AlanGreenblatt.
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