Great Economic Uncertainty Requires That States Plan for Budget Swings

Strategies needed to manage unexpected developments and adapt quickly when crises arise

Great Economic Uncertainty Requires That States Plan for Budget Swings
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A cleaner walks along the deserted Las Vegas Strip, where most businesses had been closed for various periods since March 2020 in response to the COVID-19 pandemic. With an economy heavily dependent on tourism dollars, Nevada was hit particularly hard by pandemic-related business closures, forcing the state to drain its rainy day fund, cut education and health care spending, and make other hard choices to balance its budget.
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This article is part of a series on how states can manage uncertainty, balance budgets, and support communities.

Early in 2020, the United States economy was experiencing the longest expansion on record, and many state budgets were in reasonably good shape. The pandemic and resulting economic shutdown put pressure on these governments to protect residents, maintain critical services, and limit broader economic damage. At the same time, they faced an unprecedented level of uncertainty about the amount of money they would have available to respond.

Last summer, expectations for Washington state’s economy were dismal. The shuttering of so many businesses and services had led to a sudden and severe spike in unemployment and a steep drop in sales and gross receipts taxes. The disruptions in travel and international trade were expected to harm major industries in the state, including aerospace. Because of these and other factors, between March and June, the state’s projected fund balance for the end of the 2023 fiscal year fell from a surplus of $859 million to a deficit of nearly $8.5 billion. That represents about 17% of the biennial budget. Despite the alarming numbers, Washington’s rainy day fund provided breathing room.

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COVID-19 Prompts States To Tap Financial Reserves

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The coronavirus pandemic reversed many states’ plans to infuse more money into their rainy day funds—which, at the start of fiscal year 2020, amounted nationally to the largest fiscal cushion in at least two decades.

Having the ability to wait for more information before making major budget cuts or raising taxes proved valuable. By the time the official budget process kicked off in December, the projected deficit was much smaller: about $1.6 billion. Governor Jay Inslee (D) and legislative Republicans proposed using the rainy day fund to fill part of the gap. Going forward, however, the governor has offered a package of tax increases while Senate and House Republicans are focused more on spending reductions.

Some states did not have the cushion to make it through the early months of the pandemic without substantial cuts. The recession hit Nevada’s tourism-dependent economy hard, to the point that the state’s general fund revenue forecast for fiscal 2021, issued in December 2020, was 15% lower than the previous forecast for the same period. By July, Nevada had emptied its rainy day fund, cut K-12 and health care spending, postponed transportation projects, furloughed state workers for one day a month, and required mining companies to accelerate tax payments. Like Washington, Nevada’s revenue situation has improved since last summer, so some of these cuts may be reversed.

Many budget decisions made by states nationwide will be revisited to account for the $350 billion in State and Local Coronavirus Fiscal Recovery Funds in the American Rescue Plan Act that President Joe Biden signed into law on March 11. Still, states’ experiences over the past year demonstrate the need for a set of fiscal tools that can help policymakers manage through uncertain times—starting with the need to build robust reserves.

Although the pandemic put a spotlight on the value of savings, policymakers should consider aligning their state rainy day funds with best practices. Each needs a dedicated fund with a savings target that reflects both the level of risk to the state budget and policymakers’ goals in creating the account. Next, policymakers should adopt a deposit policy linked to revenue volatility to ensure that the state saves at least a portion of atypically high tax collections to help reach its target. For example, when revenue growth in Virginia exceeds the previous six-year average growth rate, 50% of the above-trend funds are set aside.

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Rainy Day Funds Help States Weather Fiscal Downturns

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When states face budget shortfalls, rainy day funds are their best line of defense. Every dollar that policymakers use from their rainy day funds to close budget shortfalls means they have to find one less dollar in spending cuts or tax increases.

Massachusetts, meanwhile, saves windfalls from higher-than-typical capital gains tax collections and legal settlement proceeds. In addition, each account should include a withdrawal policy to ensure that the state can use the money when needed, but not during periods of strong growth. For instance, Minnesota permits withdrawals only when there is a projected deficit and objective measures show a downturn in the economy.

The speed and success of the recovery depends heavily on factors that fiscal forecasters cannot account for easily, such as how quickly COVID-19 vaccines are deployed and decisions on federal stimulus. Preparing for a range of outcomes—including budget gaps—is always important, but it is essential in these unprecedented times. For that reason, a growing number of states are stress testing their budgets—at least 13 have produced official reports since 2018. These analyses help policymakers estimate budget shortfalls that could result from adverse events, such as a new pandemic surge or a weakening job market. Maine and Minnesota use stress tests to help determine how much to put into reserves, which ensures flexibility in difficult times.

States also can use stress tests to develop contingency plans for balancing their budgets if pessimistic scenarios materialize. By doing so, policymakers can avoid having to make drastic midyear course corrections. In Utah, they compare results from the stress test against a series of budget-balancing policy options ranked by their ability to fill a shortfall and the ease with which legislators can access them.

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Budget Stress Tests Help Manage the Pandemic’s Fiscal Impact

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The recession caused by the coronavirus pandemic is hammering state tax collections and putting pressure on budgets nationwide. In addition to the immediate financial challenges, states face considerable uncertainty about the future.

When the pandemic and ensuing economic crash hit, policymakers were able to quickly turn to the established toolkit of options. For example, they issued bonds to fund infrastructure projects they’d previously been paying for with cash, freeing up money for current needs.

Contingency plans can ensure that states are ready for midyear gaps and have buy-in from the legislative and executive branches on the right course of action. When designed well, such plans allow states to avoid under-correcting or overcorrecting to emerging shortfalls. States have also used contingency planning to deal with uncertainty about the size and scope of federal stimulus. Vermont lawmakers, for example, passed a budget for their Coronavirus Relief Fund that included projects that would be funded only if the federal government provided additional funding or flexibility.

Ideally, contingency plans prioritize services and programs that have been shown to produce positive results. For example, in Colorado, the budget office set reversion targets last March for state agencies to return unspent appropriations, providing specific guidance that agencies could use to make  adjustments based on evidence.

By doing so, governments can make the most of taxpayer dollars and improve outcomes for their residents. They can help ensure that agencies have the capacity and framework to make data-driven decisions and encourage them to use evidence when requesting additional funding or identifying areas that can be cut. States can develop and use local data to assess community needs and program performance and supplement that with information about program effectiveness from national research clearinghouses.

Jeff Chapman is a director, Mike Maciag is an officer, and Adam Levin is a principal associate with The Pew Charitable Trusts’ state fiscal health project.

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