Not all state budget estimates are created equal. Although fiscal projections are usually good-faith efforts to translate uncertainty into reasonable expectations, some assumptions merit close scrutiny. As most states approach the start of the new fiscal year, lawmakers should consider how overly rosy assumptions can make policy changes more expensive than expected. A new state budget issue brief from The Pew Charitable Trusts looks at several examples.
In recent years, many states have paid for tax cuts using revenue and economic projections that later proved too optimistic. The Pew brief highlights West Virginia, where a series of business and sales tax cuts were implemented between 2006 and 2013. At the time, policymakers expected the revenue losses from these cuts to be offset by higher severance tax receipts from coal and natural gas production. With those prices plunging, however, the state now has $600 million less in revenue than projected in 2012.
Elsewhere, budget writers have assumed savings that rest on a questionable political or legal basis. New York state budgets in fiscal years 2011 and 2012, for example, assumed hundreds of millions of dollars in cigarette tax revenue from sales on Indian reservations. Yet tribal governments resisted by using civil disobedience and court challenges.
In North Carolina, Medicaid budgets have often assumed savings from programmatic changes that have yet to receive—and in some cases never receive—federal approval, a practice that drew criticism from the state auditor. In fiscal 2014, tens of millions of dollars in projected Medicaid savings were never realized.
States have also sought to reduce Medicaid spending by limiting access to expensive hepatitis C medications Sovaldi and Harvoni for program recipients. Many states have imposed restrictions such as requiring pre-authorization from a specialist or limiting coverage to patients in late stages of the disease.
These restrictions, however, may run afoul of federal regulations requiring full coverage for medically necessary drugs. A recent federal court ruling against Washington state’s Medicaid hepatitis C drug restrictions raises the possibility that these limits could be struck down. Should that happen, states could find the associated savings vanish.
Policymakers should also be alert to assumptions that affect budgetary contributions to state pension systems. Pension funds require regular, ongoing revenue deposits known as actuarial required contributions, or ARC payments. Because ARC levels are calculated using pension plans’ own economic and demographic assumptions, those that prove wrong can leave the system with less money than anticipated, resulting in ongoing shortfalls that legislators must address. Even where lawmakers have regularly made their ARC payments to pension funds, funding ratios—the percentage of liabilities compared to assets—have sometimes fallen. In Arizona, for example, the pension system’s funding ratio fell from 99 percent in 2003 to 72 percent in 2013, despite ARC deposits being consistently and fully made. This is likely to require greater contributions going forward than originally assumed.
Policymakers must be aware that some budget estimates are more sensitive to assumptions than others. For example, estimated costs for a fixed appropriation generally carry higher certainty than the projected costs for a social insurance program or a business tax credit, both of which rely on difficult-to-forecast assumptions about individual or corporate behavior or broader fiscal and economic conditions.
These examples illustrate that even the best budget estimates involve a margin of error. In order to make sound fiscal decisions, policymakers must understand what goes into cost estimates and factor in downside risks. State leaders can take a key first step by working to improve transparency for financial, demographic, and economic assumptions. This will give policymakers a basis on which to evaluate the reliability of their budget estimates and allow them to prepare for unforeseen expenses.
Brenna Erford is a manager and Akshay Iyengar is an associate with the states’ fiscal health team at The Pew Charitable Trusts.