This is part of an ongoing series called Finance 101 that explains the basics of public finance for public officials.
Most states and many municipalities are legally required to pass balanced budgets each year. But a budget that is balanced isn’t always one representing a healthy spending plan. At the most basic level a sustainable operating budget is one where “normally occurring revenues are equal to your normally occurring expenditures,” says Suzanne Finnegan, chief credit officer for Build American Mutual. “And alternatively,” she adds, “extraordinary sources of revenue are used for extraordinary, one-time expenditures.”
New Jersey had its credit rating downgraded in 2014 because it was relying on one-time fixes to plug budget holes this year and not paying its long term liabilities. Its $807 million budget gap would also be much larger if the state hadn't pumped $91.6 million worth of one-time tobacco settlement money into the general fund this year.
In the eyes of credit ratings agencies, “regularly occurring expenditures” extend beyond the daily expenses of salaries and supplies to include long-term liabilities like retiree healthcare and benefits payments.
The following are some of the major areas where states and cities can cheat – and often do – en route to “balancing” the budget. Budgets that include these practices are generally not considered sustainable spending plans.
States and cities often don’t pay what they need to every year in order to keep pension plans fully funded. Employees have their contributions automatically taken out of their paychecks. But the government employer has to set aside money in the budget for its share. If money is tight, the government might only pay some (or none) of what is needed for the government to make good on its benefits promises down the road. Pension funds still pay out to existing retirees, however, so the consequences aren’t felt immediately. But the government skimping on a payment leaves the pension fund less healthy at the end of the year than it started.
Illinois has consistently underfunded its pension obligations over the last decade. Once a well-funded operation, the state's pension fund today has less than 40 percent of the money it needs to make good on all its benefits promises for the future.
Deferring maintenance on infrastructure is one of the easiest things to do, particularly because maintenance can seem like an “extra” cost. There’s no visible problem, so the desire to spend money isn’t always there. Sadly, deferring maintenance has become very much the norm across America. Hence, the consistently below-average grades doled out every four years by the American Society of Civil Engineers, which rates the condition and performance of the nation’s roads and bridges.
Unlike pension liabilities, which will likely be the next generation’s problem, the bills from deteriorating infrastructure are coming due today. The lesson isn’t really sticking, however. In the wake of a Minneapolis bridge collapse that killed 13 people in 2007, states closed bridges, reduced weight limits or made immediate repairs. In 2012, the Federal Highway Administration said 67,000, or 11 percent, of the nation's bridges were structurally deficient — an improvement of one percentage point in the five years since the collapse.
Rainy day funds are there for a reason – when the economy contracts, governments are still expected to provide. Consequeently, many will have to draw upon their reserves at that point. Five states — Arkansas, Colorado, Illinois, Kansas and Montana — did not have specifically designated rainy day funds at the onset of the 2008 recession. In a report on the topic, the Center on Budget and Policy Priorities (CBPP) points out that these states (except Montana) “were hit hard by the recent economic downturn, and the lack of a rainy day fund left them more vulnerable to the recession’s effects,” the report said. Among these states, Illinois completely depleted any leftover money it had from previous operating budgets during the recession.
Regularly drawing down reserves, however, is not a sustainable way to balance a budget. In particular, using reserve funds during a budget year that also includes a spending increase will at a minimum create red flags in the eyes of credit ratings agencies.
In the 1980s and '90s, Washington, D.C., consistently hit deficits as mayoral administrations outspent their budgets and squandered reserve funds in the process. In 1995, a Congressional control board took over the city's finances and didn't give budgeting power back for eight years.
Governments that consistently turn to their reserves are not living within their means and are also placing themselves in a precarious position for the next economic downturn.
When and How States Should Strengthen Their Rainy Day Funds (CBPP, 2014)
Why and How States Should Strengthen Their Rainy Day Funds (CBPP, 2011)
Revisiting and Replenishing Rainy Day Funds
Is Your State Prepared for the Next Economic Bust?