Shortsighted Budgeting in Tough Times Can Create Long-Term Problems

Multiyear spending plans for states help ensure that current decisions won’t lead to future deficits

Shortsighted Budgeting in Tough Times Can Create Long-Term Problems
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Ursula Dysthe teaches kindergarten students at Lupin Hill Elementary School, one of the first elementary schools to reopen in Los Angeles County. To balance California’s budget ahead of predicted gaps in the summer of 2020, policymakers deferred $12.5 billion in payments to K-12 schools and community colleges.
Al Seib Los Angeles Times via Getty Images

This article is part of a series on how states can manage uncertainty, balance budgets, and support communities.

Faced with limited options, especially during difficult economic times, state legislative and executive leaders often respond to immediate fiscal challenges by balancing current budgets at the expense of future ones. But if they draw down savings, delay spending, move up revenue collection, engage in short-term borrowing, or use money from dedicated accounts, they can create difficulties in the future because they only postpone the problem.

A multiyear perspective can help leaders use these strategies responsibly. Rather than scrambling to balance each budget one year at a time, policymakers can think ahead about the appropriate mix of permanent solutions and temporary measures—and when and how to reduce reliance on various stopgaps.

As did many states during the COVID-19 pandemic, California’s forecasters last summer predicted enormous budget gaps that now appear to be overly pessimistic. More recent forecasts predict a relatively small operating deficit for fiscal year 2022, but the picture remains highly uncertain. To help understand the range of possibilities, the state’s Legislative Analyst’s Office (LAO) produced estimates of the likelihood that California will break even over the next five years, given various assumptions about revenue growth.

The LAO found that the budget gap will grow each year, in part because California relied heavily in 2020 on one-time measures to balance the budget. That included decisions to defer $12.5 billion in constitutionally required payments to K-12 schools and community colleges and move dollars from special accounts to the general fund—money that must be repaid with interest.

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Many states ended 2017 flush with unexpected cash. Federal legislation that caps some tax deductions beginning in 2018 prompted many Americans to prepay their state and local taxes. While this surprise revenue was positive news for state budgets, several policymakers struck a cautious tone.

Tackling the state budget from a five-year perspective can inform an important decision that California fiscal leaders face this spring. Largely because tax collections have been higher than expected, they need to decide how to spend an estimated $12 billion to $40 billion “windfall” of one-time revenue. Aware of the long-term challenges, leaders are considering using the money to rebuild reserves and pay for the one-times fixes they used to balance the budget last year. The budget that Governor Gavin Newsom (D) proposed in January would increase reserves by $7.5 billion while paying back more than two-thirds of the deferred school payments in the next year.   

To help make these types of decisions about when to save and when to spend, states should regularly distinguish between ongoing revenue and one-time funds. For example, the Arizona Joint Legislative Budget Committee (JLBC) now projects a budget surplus for fiscal 2022 of $1.6 billion to $2 billion. However, the state should exercise caution before spending those funds, in part because JLBC classified the bulk of the surplus as one-time money. When states apply one-time funding to new—and continuing—initiatives, they can create deficits in future years. Instead, they can use one-time money to replenish a rainy day fund, pay down a pension funding gap, repair school buildings, or update facilities at a state prison, for example. This type of long-term planning will be especially important as states manage an influx of new funding through the American Rescue Plan Act. Policymakers will need to plan for how to budget the money now as well as prepare for when it goes away.

Leaders must also consider whether revenue sources are likely to be reliable going forward. For example, 15 states have legalized recreational marijuana use since 2012. With limited historical data on recreational cannabis markets, forecasting how much revenue a state may bring in is challenging. Moreover, states’ experiences suggest that the initial years can be highly volatile as supply tries to meet demand. Recreational marijuana may provide a burst of revenue upon introduction, but policymakers should not expect consistent growth over the long term.

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Can Recreational Marijuana Revenue Close Budget Gaps?

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Voters in Arizona, Montana, New Jersey, and South Dakota on Nov. 3 legalized recreational marijuana in their states, joining 11 others that already allow regulated use and sale of the drug.

In Colorado, revenue from marijuana has been volatile in recent months, in large part because of the disruption to the state’s economy caused by the pandemic. Policymakers can hedge against this uncertainty and volatility by budgeting marijuana revenue cautiously. They can put the money toward savings, for example, or spend it after it is collected. States could be careful about relying too heavily on such taxes for ongoing spending priorities that require sustainable revenue streams.

New Jersey is trying to take a long view by enacting fiscal protections as part of a new set of tax incentives. This includes establishing annual cost limits on the state’s largest programs in addition to limiting the total cost over the life of each program. As currently set, these caps may be too high to provide sufficient protection, but the state has a policy in place that leaders can adjust to meet their needs. Iowa, for example, since 2009 has capped the total cost of many of the tax incentives authorized each year and regularly reviews and adjusts the total.

Some states, however, have implemented new incentives without fiscal protections, causing budget problems. In certain cases, program costs grow far beyond expectations. In others, sudden spikes put a strain on revenue, crowding out other priorities. For example, the cost of the Michigan Economic Growth Authority (MEGA) tax credit program grew much higher than expected a few years ago. That threw the state’s fiscal 2015 budget out of balance by hundreds of millions of dollars, which resulted in deep spending cuts. And because of the length of the agreements, some stretching 20 years, MEGA is estimated to cost Michigan billions of dollars through at least 2032.

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How States Use Annual Caps to Control Tax Incentive Costs

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Many states place annual limits—or caps—on the cost of the economic development tax incentives they offer. Research by Pew shows that caps are among the most effective tools for governments to guarantee that these incentives do not cost more than expected or intended.

One upcoming test of states’ ability to make long-term fiscal decisions will be the significant new funding expected in coming years as a result of litigation against opioid manufacturers. States will face choices about how to use the funds, including whether to invest in targeted and evidence-based lifesaving efforts or to use the funds to address current budget needs. The latter proved to be the course generally followed with money from the 1998 Master Settlement Agreement with tobacco companies. States need careful planning now to ensure that they have the resources to combat this major health crisis, which has only been exacerbated by the pandemic.

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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