Speculation about the possibility of a recession has been spurred by debate over a range of issues, including trade, monetary policy, and politics. But for U.S. states, the prospect of a looming recession prompts a question that echoes from the last economic turndown: This time, are we ready?
Typically, a state’s recession readiness can be measured by the amount of cash it has in reserve, and with good reason. Reserves are one of the primary tools available to offset a budget gap, along with spending reductions or tax increases. Of the three, reserves are the least painful to deploy.
Overall rainy day fund balances have never been higher, according to data collected from the spring survey of state fiscal conditions by the National Association of State Budget Officers (NASBO). In fact, the current reality may be better than reported because some states budgeted additional deposits after the survey was finalized. Those include Pennsylvania ($317 million to the Budget Stabilization Reserve Fund), New Jersey ($401 million to the Surplus Revenue Fund), and Delaware ($125 million into a new Budget Stabilization Special Reserve Fund).
A few states also improved their savings policy structure in fiscal year 2019. For example, Arizona increased the maximum size of its rainy day fund, Nebraska added a savings rule to set aside additional dollars during periods of especially high revenue growth, and Texas modified its investment rules to get a greater earnings return from the fund balance. States are being more deliberate about their savings, often harnessing the ebbs and flows of the business cycle to guide their strategy.
Despite these positive developments, states may not be as prepared for the next recession as they think. Reserves are an excellent tool to build budget flexibility, but three important trends mean states could need more on hand to weather a downturn.
Growth of fixed costs reduces budget flexibility
For many states, an increasing share of spending is committed to programs that generally must be funded annually, regardless of broader economic circumstances. These include spending items such as debt service and state retirement system contributions, as well as federal-state safety net programs such as Medicaid and the Children’s Health Insurance Program.
Medicaid far and away represents the biggest share of such fixed costs. Second only to K-12 education in terms of state spending, the program has taken up a greater share of resources over time. In fiscal year 2000, it represented 12.2 percent of total state spending, but it grew to 17.1 percent by fiscal 2016, according to Pew’s analysis of data from the Centers for Medicare & Medicaid Services. In addition, Medicaid spending tends to increase during a recession as more people become eligible because of hardships. The program serves as an important countercyclical program for individuals and families, but it also increases costs for states when they can least afford it.
Cuts may be more difficult now than during the Great Recession
Spending levels in many areas that were cut to free up cash during the Great Recession are still not back to pre-2008 levels. A recent Pew brief, “The Lost Decade,” illustrates this point, highlighting state budget decisions and funding levels a decade after the start of the steep downturn. For example, adjusting for inflation, state funding for higher education is still down 13 percent from pre-recession levels, and infrastructure spending is at its lowest point relative to gross domestic product in 50 years.
Perhaps most significantly, states greatly reduced their noneducation employment workforces. As of 2018, total employment was down 4.7 percent—about 132,000 positions—from 2008, when state governments had 2,822,500 noneducation employees nationwide. With state governments leaner in this respect, further cuts during the next recession could hamper their operations significantly.
Volatility in recent revenue gains
Most state revenue increases in recent years have been driven by a surge in personal income tax collections. According to Pew analysis of state-level data from the Census Bureau, such taxes averaged just over half of total revenue gains from fiscal 2012 through 2018 for the 41 states that collect it as a major source. As shown in Pew’s Fiscal 50 Revenue Volatility Indicator, personal income collections tend to experience more fluctuations than other major sources, such as sales taxes. This means that personal income taxes see greater swings up but also more significant swings down over the course of the economic cycle.
Compounding this issue, NASBO’s recent spring survey shows that a large portion of revenue increases in personal income come from the most unpredictable area, the non-withholding component, which includes income from interest, dividends, partnerships, self-employment taxes, and—critically—capital gains. These sources are notably subject to big swings in the stock market, which can often occur during periods of economic distress. Because state revenue growth relies on more volatile sources, policymakers may need to plan for steeper declines by accruing more reserves.
The central question: Is your state prepared for a recession?
Each state’s current level of preparedness is different. Some have more budget flexibility in terms of rainy day fund size, fixed cost commitments, and revenue and expenditure volatility. And although median rainy day fund balances have never been higher, states’ reserves vary significantly.
To accurately assess the amount a state needs in reserves, more policymakers are requiring studies to account for their unique factors. In the 2019 legislative sessions, for example, Montana and Nebraska passed laws requiring their fiscal analyst offices to “stress test” the annual budget, using various revenue and expenditure scenarios to determine the next recession’s potential financial impact. They follow leaders such as Utah and Minnesota that already regularly assess their preparedness.
States may not be able to control the timing or severity of a recession, but most can do more to understand the potential effect on their budgets and make sure that policymakers have the tools at their disposal to prepare and respond effectively.
Mary Murphy is a project director, Steve Bailey is a manager, and Airlie Loiaconi is a senior associate with Pew’s state fiscal health project.