In 2008, most states and local governments were substantially underprepared for any economic downturn, let alone one the size of the Great Recession. Now, five years since the end of the recession, state and local governments have never lagged the rest of the economy by a greater margin.
Policy-makers have recognized this weakness, and as a result many states are in the process of rethinking the way they set aside budget reserves to get them through economic downturns. These efforts generally involve looking closely at tax and revenue volatility, which is a great place to start, but revenues tell only part of the story. Economic downturns also cause large spikes in social services spending, predominantly Medicaid. The Great Recession showed that, even with augmented funding from the federal government, state budgets can be squeezed by higher demand for mandatory public welfare spending. This is a key reason that state-government employment has yet to return to its pre-recession peak even though tax revenues have more than fully recovered.
At the same time, policy-makers need to be conscious of being too conservative in building their rainy-day funds so as not to deprive important programs of much-needed funding. Inadequate funding for education and infrastructure in particular can have devastating long-term effects. The question for state and local policy-makers, then, is how much to set aside to avoid a major future fiscal correction without stunting current economic growth.
The only way to properly account for both the spending and revenue sides of the reserve equation is to holistically stress-test a state or local government's fiscal framework for a rainy day. Using Moody's Analytics' in-house tax and Medicaid models, we ran the 50 states in the aggregate through a moderate-recession scenario at the beginning of fiscal 2015 and found that an overwhelming majority of them -- even those that study their own revenue volatility -- were still woefully underprepared for even a moderate recession.
Excluding the large natural-resource reserves in Texas and Alaska, the average state has set aside only 3.4 percent of budgeted spending for a rainy day. According to the results of our stress test, the average state would have to maintain a minimum reserve of 8.5 percent of budgeted spending to survive one year after a recession without having to raise additional taxes or cut spending. Thus, if the U.S. economy were to go into recession this year, states would have to quickly come up with as much as $40 billion in aggregate budget savings, further shocking the economy and prolonging the hypothetical recession. Taking into account that the spending pressures from a recession would likely last beyond one year, even higher reserve levels would be more appropriate for some states.
It wouldn't be economical or productive for all states to begin immediately trying to make up all of these differences in one year, but it is imperative that states begin to set reasonable long-term reserve targets so that they can begin to move toward them in a responsible and efficient manner.
To sufficiently protect their budgets and their economies from increased volatility and fiscal drag, state and local government policy-makers should make reserve budgeting and stress-testing a higher priority. At the very least, they should be reviewing the adequacy of their reserves following the Great Recession and its volatile recovery. At best, policymakers should be diligently implementing statutory reserve guidelines based on such reviews and working to expand reserves now, while revenue conditions are still improving. Continuation of current policies risks a repeat of the lackluster recovery and is not conducive to long-term economic growth.