Trust Article

How States Manage Their Budgets—and How They Don’t

Pew is marshaling its efforts to help states use data-driven ways to manage their budgets, plan for the future, and better serve taxpayers

February 2, 2024 By: Stephen Fehr Read time:

En este número:

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  • How States Manage Their Budgets
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  • Utah Leads the Way on Wildlife Crossings
  • Philadelphia's Wage Tax Has Little Impact for Residents
  • America's New Tipping Culture
  • A Roadmap for Managing Wildfire Costs
  • Navigating the U.S. Political Landscape
  • 5 Facts About Hispanic Americans and Health Care
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  • It's Time to Fix Housing in America
  • Return on Investment
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How States Manage Their Budgets—and How They Don’t

State government leaders throughout the nation head into 2024 better prepared to manage the ups and downs of their finances than they were at the start of the Great Recession in 2007.

Often with technical assistance from The Pew Charitable Trusts, many states have adopted practices and policies strengthening their budgets since that downturn: Several states built large rainy day reserve funds, paid down public pension liabilities, worked to lessen the effects of volatile revenue sources, and evaluated which spending programs were effective and provided value for taxpayers.

Despite these reforms, many state policymakers are still managing budgets for the short term. This leaves states vulnerable to future budget deficits from economic downturns and evolving risks such as natural disasters, climate change, population swings, and technological advancements. And it also makes managing good times difficult when short-term calculations result in unsustainable spending growth or missed opportunities to pay down debt and public pension liabilities.

So Pew is marshaling its efforts to help states adopt standards in public budgeting aimed at preserving past successes while emphasizing long-term fiscal health.

“This is the ideal moment for this work. What states experienced during the COVID pandemic created a real appetite for long-term budget analysis to guide planning,” says Mary Murphy, a senior director on fiscal and economic policy at Pew. “Every state wants its revenue forecast to be as accurate as possible, and policymakers are looking for new ways to use available data to help them assess the long view and to help prepare for the unexpected.”

Murphy’s team spent much of the last year researching budget practices in each state and interviewing key executive and legislative branch officials, culminating in a first-of-its-kind 50-state report released in November. 

The report will serve as a foundation upon which the team will identify states that could benefit from Pew’s assistance going forward. Several state officials already have expressed interest in participating, Murphy says.

The report—“Tools for Sustainable State Budgeting”— focuses on two fiscal practices grounded in data and evidence. They are long-term budget assessments, which project and study state revenue and spending for multiple years, and multiyear stress tests, which gauge risks, anticipate shortfalls, and tackle looming challenges.

Far from wonky and abstract methods, Pew’s intensified focus centers directly on the operations of state governments closest to most Americans’ daily lives. Regardless of their political views, Americans rely on a healthy, well-managed public sector to provide education, public health and safety, transportation, and workforce development. The U.S. economy also counts on the fiscal impact of state governments, whose budgets total over $2 trillion, or about 10% of gross domestic product.

The report adds to a growing range of nonpartisan, fact-based research at Pew that collectively seeks to improve the nation’s “civic infrastructure” from which policymakers can draw to solve problems, whether managing fluctuations in state budgets, expanding broadband connectivity, modernizing the civil legal system, or improving public health.

Most states are enjoying record surpluses, driven largely by federal pandemic aid and higher-than-expected growth in tax revenue. This has empowered states to make historically large tax cuts and spending increases from 2021 to 2023.

The budget report found that 15 states have produced long-term fiscal assessments, 13 have performed stress tests, and eight have conducted both. The eight are Alaska, California, Connecticut, Maryland, Montana, New Mexico, New York, and Utah.

But even some of those states employing the desired assessments still lack the rigorous methods that could inform fiscal decisions such as how much money the state should set aside in reserves. In some of the states, officials don’t reveal what their tests show or reach conclusions about how their data would affect the ability to balance revenue and spending well into the future.

Pew’s report highlights opportunities for states to adopt, improve, and expand the use of long-term assessments and stress tests and to make them a standard part of their budgeting process in a sustainable way that ensures a more stable fiscal future. This is especially important now in the aftermath of the COVID-19 pandemic.

Most states are enjoying record surpluses, driven largely by federal pandemic aid and higher-than-expected growth in tax revenue. This has empowered states to make historically large tax cuts and spending increases from 2021 to 2023. 

As the report notes, “going forward, state leaders must be able to assess whether their decisions will be affordable over the long term or will jeopardize their ability to solve state problems or even sustain programs and services in the future. Unfortunately, the nature of state budget processes discourages such long-term thinking.”

The report marks Pew’s effort to turn that kind of thinking around and help states better plan for the future. 

How long-term budget assessments work

Colorado has demonstrated the importance of long-term thinking. When the state received its latest round of federal pandemic assistance in 2023, the standard annual budget process might have resulted in lawmakers and the governor channeling money into existing programs and services with recurring costs or creating new ones. But once the federal stimulus money ran out, the state would not have the resources to continue paying for them.

“There was great agreement that we couldn’t do that to the state,” says Lauren Larson, who was state budget director then. “We had a thin budget to begin with, and we couldn’t put it on a razor’s edge.”

Instead, she says, officials took a long-term approach by spending nearly all of the money on one-time investments. The stimulus, she said, was a “gift” because it encouraged Colorado to expand its multiyear planning to manage the stimulus money in a way that would keep the state budget structurally balanced.

Structural balance is at the heart of long-term budget assessments that Pew and other experts encourage. The practice of projecting revenue and expenditures over several years is frequently neglected by state policymakers who often focus on balancing the budget a year or two at a time. In its report, Pew recommends a minimum of three years’ projections beyond the current budget year from key revenue and spending categories in states’ general funds.

Disclosing the numbers is not enough, though. Just as crucial is analyzing and explaining the data so policymakers and residents recognize future risks that could knock a hole in budgets and offering recommendations on how to sustain long-term healthy budget balances during turns in the economy.

That’s what happened in mineral-rich New Mexico. Its long-term budget assessment in 2022 warned of recurring deficits through 2050 because of falling oil production as the world economy shifts to alternate energy sources. Lawmakers prudently adjusted future budget revenues by shoring up endowments and trust funds to boost investment earnings.

Pew’s report—as well as many state budget analysts—says officials often overlook the importance of tracking spending when assessing the long-term health of finances. Recurring expenditures include costs that the government must fund every year, such as salaries and materials. The report says officials should include in their stress testing and long-range assessments any government fund in which a shortfall or surplus could affect the budget balance.

“By neglecting to consider spending, states risk understating the size of potential budget shortfalls and, therefore, failing to adequately prepare for them,” the report says.

Long-term assessments also have to take into account surpluses, which also influence budget stability. Maryland, like many states, recently has been enjoying excess revenue in the wake of federal pandemic aid. After assessing the state’s long-term finances, Maryland officials found the surpluses would decline through fiscal year 2028 in part because of increased education and retirement benefit obligations. This finding was a result of officials beginning their analysis by isolating what portion of surplus revenue was temporary because of the federal aid and how much of state spending was ongoing.

A forward-looking assessment of structural balance and potential risks benefits taxpayers—and can save them money. Long-term financial planning that identifies risks is one of the core factors S&P Global uses when it rates bonds sold to investors, says Geoffrey Buswick, an S&P managing director. The higher a state’s credit rating, the lower the cost to taxpayers of repaying bonds, which finance capital projects such as construction and renovation of roads, schools, airports, prisons, parks, water projects, and other infrastructure. Only a dozen states hold the highest, or AAA, rating.

The importance of stress testing

Stress testing informs long-term assessments with factual data such as how much revenue a state would lose in a hypothetical recession. The practice was an offshoot of the 2008 financial crisis. Congress passed the landmark Dodd-Frank Act in 2010 requiring large banks and other financial institutions to perform stress tests to ensure that they could cover losses and pay creditors without a taxpayer bailout.

Going forward, state leaders must be able to assess whether their decisions will be affordable over the long term or will jeopardize their ability to solve state problems or even sustain programs and services in the future. Unfortunately, the nature of state budget processes discourages such long-term thinking.

With the federal legislation as a model, several state and local elected officials and public employee retirement system managers followed Dodd-Frank with their own stress tests of public pension fund assets, which had plummeted during the recession after already having been weakened from years of insufficient contributions and rising benefit costs. Pew’s public sector retirement systems project has assisted states in improving the financial condition of their pension funds using stress tests.

Utah was the first state to stress test its budget, an outgrowth of its work with Pew on evidence-based rainy day fund policies that set targets for reserves. “This was all happening at about the same time as early Dodd-Frank Act bank stress testing,” says Jonathan Ball, Utah’s legislative fiscal analyst, recalling a debate in 2015 between then-Governor Gary Herbert’s staff and legislators over reserve levels. “Someone said, ‘Hey, what about applying Dodd-Frank stress testing to state budgets?’ Indeed, our first stress test just took the economic scenarios from Dodd-Frank and applied them to state revenues and spending.”

Utah’s latest stress test in 2022 consisted of an analysis of all state revenue sources, an examination of major expenditures that drove the budget such as education and Medicaid, and an inventory of budget buffers and reserves to evaluate whether they would adequately cushion the impact of lost revenue and increased spending during a recession. Economists combined the amount of expenditures and revenues over a five-year period, which they called the “total value at risk.” In 2022, the amount at risk was as high
as $5.6 billion.

“The stress tests resulted in a contingency plan of sorts that we call our fiscal toolkit,” Ball explains. “The toolkit is simply a prioritized list of budget buffers including tax increases, budget cuts, and rainy day funds.”

Lawmakers concluded from the toolkit that the state had ample reserves to cover the $5.6 billion at risk. The lesson learned, Ball says, was it is better to have tools in place to avoid hasty, crisis-driven solutions when a critical fiscal situation occurs. “The value of stress testing is in the doing—the exercise itself and the data it generates,” he says. “If you train for adverse conditions before they are thrust upon you, your training will kick in when faced with real adversity and you’ll avoid crisis decision-making. You’ll have options.”

Moody’s Analytics, an economic research firm, and S&P Global, which provides data and ratings about state debt, joined Utah and other states in testing stress scenarios that help elected officials prepare in advance for a turn in the economy. In 2022, at a time when many economists were warning a recession was possible, Montana officials prepared a stress test showing the size of budget shortfalls that would occur every eight, 10, 14, 20, and 40 years. Concerned there would not be enough money to cover the deficits, state lawmakers increased the cap on the state’s rainy day fund by more than 250%, according to Pew’s report, to put aside money to cover downturns.

States with volatile tax collections particularly benefit from stress testing. For example, California measures personal income from capital gains taxes, which fluctuate because people often sell equities depending on stock market performance.

Gabe Petek, the California legislative analyst, says twice a year officials conduct a budget analysis with elements of a stress test. “We first project revenues, spending, and the budget bottom line,” he says. “If the state faces deficits, we estimate how much of those future budget problems the state could cover with its reserves based on a median revenue scenario. Then we conduct sensitivity analysis to determine how likely the budget is to break even, taking into account current economic conditions and, based on those, the range of economic scenarios going forward.”

Simply establishing stress testing does not go far enough, Pew contended in the report. The hope is that policymakers will study the data from testing that will lead to practices and policies to plan for emergencies and ensure that the budget will be structurally balanced for several years. The report noted, for example, that North Carolina’s stress test advises policymakers how much funding should be set aside for unforeseen events. And the state backs that up by requiring automatic deposits of revenue growth into the rainy day fund until reaching the level of savings.

No budgeting tools assure that states can resolve difficult fiscal and political challenges. Forces outside a state’s control—fluctuating oil prices or a pandemic—make it impossible to perfectly predict revenue and spending trends at a given time. Because of this uncertainty, says the Government Finance Officers Association, states should adopt plans making clear how and when reserves will be replenished and the budget will return to structural balance. Adds Petek of California: “Building and maintaining a prudent budget reserve is arguably the most effective way a state can strengthen its fiscal resilience prior to a downturn.”

Kil Huh, a Pew senior vice president who heads the government performance division, says too few states point toward consistent, long-term fiscal stability. The stakes of inaction are high for state residents, which is why Pew has launched this latest effort: “Without planning ahead,” Huh says, “when spending exceeds revenue, state leaders may need to make significant cuts or implement tax increases precisely at the time when residents need help the most.”

Stephen Fehr is a former state fiscal expert for The Pew Charitable Trusts and has covered state governments for the Kansas City Star and The Washington Post



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