4 Facts About Using State Budget Reserves to Improve Fiscal Stability

Most have record savings but only careful analysis can help determine if that’s enough

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4 Facts About Using State Budget Reserves to Improve Fiscal Stability
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At a time when most states have record rainy day fund savings, they also face mounting threats to their fiscal stability, including slowing economic growth. A recent Pew analysis shows that combined state savings reached a record $134.5 billion at the start of fiscal year 2023; 37 states had record-high balances, the most in at least 23 years. States collectively also posted the largest-ever annual increase in leftover general fund budget dollars, what are known as ending balances.

Still, state policymakers should use proven fiscal management tools to inform optimal savings levels. Rainy day funds serve as many states’ first line of defense against unexpected budget gaps. But, unless officials know how their budget might be affected by potential fiscal shocks or how their long-term fiscal outlooks could be changed by today’s policy decisions, state leaders face a difficult task in determining whether reserve levels, however high they may be, will be enough to weather the next storm.

Fiscal management tools such as long-term budget assessments and budget stress tests can help provide lawmakers this critical information so they can make related policy decisions, such as how much to set aside in savings. As leaders plan for budget uncertainties ahead, considering these four factors will help provide a longer-term view of their reserve levels and how well their states will be positioned to fund their policy priorities.

1. States have amassed record financial reserves in recent years in large part because of temporary factors.

Since the start of the pandemic, a confluence of temporary factors, including higher-than-forecasted tax revenue and historic levels of federal COVID-19 aid, along with earlier policy actions, have helped spur widespread growth in states’ rainy day funds and year-end balances.

After a decline in rainy day fund balances early in the pandemic, states reported that their combined savings reached a record $134.5 billion by the start of fiscal year 2023, according to figures collected by the National Association of State Budget Officers (NASBO). With these savings alone, states could run government operations for a median of 42.3 days, equal to 11.6% of spending—or about 50% more than in fiscal 2019, just before the brief pandemic-driven recession.

Since mid-2020, most states have recorded higher-than-expected tax revenue partially attributable to the unprecedented federal pandemic aid to businesses and individuals. These allocations helped boost personal income, sales, and corporate income taxes. States also were helped by a short-lived shift in consumer spending patterns from purchases of often-untaxed services to typically taxable goods. By the end of most states’ 2022 budget year, cumulative tax receipts since the pandemic’s start, adjusted for inflation, were higher nationwide and in 32 states than they would have been if pre-pandemic growth trends had continued.

States’ end-of-year balances and rainy day funds also got a big boost from the historic federal pandemic aid awarded directly to governments to help compensate for state spending in the response to the pandemic and a historic contraction in the U.S. economy that started in February 2020.

In addition to policymaker actions, some states have rules for fund deposits tied to revenue volatility that have led to some of the above-normal revenue growth or one-time influxes of dollars into state rainy day funds over the past two budget years. For example, Tennessee adds 10% of its year-over-year additional revenue to its rainy day fund, which reached a record $1.6 billion by the end of fiscal 2022—$675 million more than just before the pandemic.

2. Ending balances are not the same as state rainy day funds.

Like rainy day funds, states’ leftover budget dollars or ending balances have also increased substantially and can help manage fiscal uncertainties. Specifically, states’ collective ending balances have increased more than sixfold, from $33 billion at the end of fiscal 2020 to $210.4 billion at the end of fiscal 2022.

But ending balances can fluctuate greatly from year to year, so policymakers should not count on them to cushion against future budget uncertainty to the degree that they can with rainy day funds. For instance, data collected by NASBO indicates that ending balances are expected to decline by roughly one-third by the end of the current budget year.

Rainy day funds, in contrast, are purposefully set aside over time to manage budget uncertainties, should have a defined purpose, and typically have clear parameters for how and when balances should be drawn upon.

3. States face mounting fiscal threats in the near and long term.

Although higher-than-expected tax revenue growth, abundant federal aid, and record financial reserves have improved budget conditions in recent years, states must navigate several looming challenges. Those include slowing revenue gains as economic growth moderates and recently enacted tax cuts take effect, as well as spending pressures from still-elevated inflation and rising wages and a tapering of federal pandemic aid.

States also face budgetary challenges driven by long-term trends. Among the pressures on states are demographic shifts caused by aging populations, declining fertility rates, and slowing immigration; technology-driven disruptions such as increased adoption of electric vehicles; and the impact of a changing climate.

If fiscal pressures arise in the near term, states may find themselves with fewer options to ease budgetary strain than they typically have. For example, the federal government has a long track record of sending extra funding to states to help them respond to economic downturns, such as during the pandemic recession and the Great Recession. But given the historic levels of aid provided to states in recent years, federal leaders may be reluctant to award new aid should states face another downturn soon.

States may find their options to find savings limited as well. During an economic downturn, leaders often reduce costs by cutting back on hiring or keeping vacant positions open. Many states took this step early in the pandemic and have yet to backfill positions left open. Should they face renewed budget uncertainties, states may not have the room to cut jobs or freeze hiring as much as they did at the start of the pandemic.

4. Better data can help state leaders navigate the fiscal challenges ahead.

Lawmakers can avoid crisis-driven decisions and unsustainable budget practices by using fiscal management tools such as long-term budget assessments and budget stress tests.

Long-term assessments can help states identify fiscal challenges that build up over time and determine whether they can afford new investments. And stress tests can help leaders assess how their state budgets would be affected by a range of different economic scenarios, such as a mild or moderate recession. Some states, including California, Maine, New Mexico, North Carolina, and Utah, are already using one or both of these analytical tools to inform how much to set aside in their rainy day funds to address a recession or unexpected emergency.

Angela Oh is a project director and Justin Theal is an officer with The Pew Charitable Trusts’ state fiscal policy project.

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