How Today's Surpluses Can Help States Invest in Budget Stability

As many states enter budget negotiations for next fiscal year with anticipated surpluses, policymakers must ask two critical questions: Is their state sufficiently prepared for unexpected events such as a recession or natural disaster? And, critically, is the current surplus temporary or structural?

State leaders should routinely consider the first question, but the high uncertainty surrounding the economy makes it particularly salient now. If a state is not sufficiently prepared, lawmakers should consider setting aside some surpluses to meet unforeseen needs.

And how they answer the second question helps inform their approach. A structural or recurring surplus occurs when ongoing revenue is expected to exceed ongoing spending needs over the long term. The surplus may be used for permanent tax cuts and/or spending increases in this situation. Most current surpluses, however, are the result of a combination of factors that are unlikely to continue, including unexpectedly strong revenue growth and an influx of significant federal aid to address the impact of the COVID-19 pandemic.

When states use temporary surpluses to fund ongoing priorities, however, they risk profound, long-term deficits down the road that could require tax increases or spending cuts to close. Addressing these structural imbalances often takes years. As a result, states incur higher borrowing costs, struggle to respond to emergencies, and, in extreme cases, fail to pay bills on time to residents and businesses. To avoid this risk, states can invest current surpluses prudently to shore up long-term fiscal stability.

Preparing for the unexpected

Rainy day funds

In recent years, higher-than-forecast revenue and other temporary factors have helped spur widespread growth in state rainy day funds, essential fiscal tools that help weather the ups and downs of the business cycle. Most state rainy day funds are at record levels, but this does not necessarily mean they would provide sufficient cushion in a downturn. To determine whether rainy day savings are large enough, policymakers can use budget stress tests—analytical tools that assess the size of the budget shortfalls states would face under recession scenarios or other temporary challenges.

Recent stress tests have shown mixed preparedness for a potential recession. For example, Utah’s most recent analysis found that the state had sufficient contingencies for even a severe recession. Maine, meanwhile, found that the state was prepared for a moderate recession, but a severe downturn could deplete the state’s rainy day fund and other resources after about 15 months. And in California, which is already projecting a shortfall even absent an economic downturn, the Legislative Analyst’s Office found that the state lacks the reserves to offset the budget gap in the event of a recession.

Many states have greatly increased rainy day fund balances. States that have not boosted savings substantially should consider doing so; larger balances would better position them to weather economic downturns and would be viewed favorably by credit rating agencies. For example, leaders in Rhode Island are moving to ensure additional reserves. The state’s existing rainy day fund is capped at 5% of general fund revenue, which historically has proved insufficient. Recognizing the need for more savings, the fiscal 2024 budget proposed by Governor Daniel McKee would use part of the surplus to create a new reserve fund.

States also can act to ensure that a portion of one-time revenue automatically goes into the rainy day fund by putting in place deposit rules tied to volatility. This means that when revenue is growing much faster than normal, some percentage of the growth is transferred to savings. For example, Tennessee adds 10% of its year-over-year additional revenue to its rainy day fund, which reached a record $1.55 billion by the end of fiscal 2022, or $675 million more than just before the pandemic. Rules such as these can also help ensure that rainy day funds are refilled once a temporary fiscal crisis passes.

Disaster accounts

States play a crucial role in paying for natural disasters. And as disasters become increasingly expensive, frequent, and severe, the pressure on state budgets grows. States use various budgeting tools to pay for disaster costs, including specialized statewide disaster accounts that provide money to state agencies or localities for disaster expenditures. In some cases, they also provide the required match funding for federal disaster assistance grants. As of 2020, 46 states and the District of Columbia had one or more accounts.

This approach allows states to put money aside ahead of a disaster. In some cases, that may prevent the need to employ after-the-fact emergency budgeting tools, such as passing supplemental appropriations or diverting money from elsewhere in state government to respond to expensive disasters. As disaster costs rise, Pew recommends that states assess whether their disaster accounts are sufficient to meet growing risk. If not, making one-time investments to shore up the accounts may be a wise use of current surpluses, coupled with efforts to identify more consistent long-term funding sources.

States should also consider opportunities to invest in disaster mitigation efforts to reduce the impact of future disasters. Research shows that every dollar spent on natural disaster mitigation projects, such as elevating buildings or retrofitting infrastructure, saves $6 on average in post-disaster recovery costs.

Investing in long-term fiscal stability

Paying down pension obligations

Several states have used budget surpluses to shore up their public employee pension systems. Since fiscal 2021, at least 12 states have made payments in addition to required contributions to pay down unfunded pension liabilities. Such supplemental funds can help states save money in future years, and give policymakers flexibility to reduce payments while avoiding underfunding when faced with budget pressures.

Some states automatically direct excess budgetary reserves to public pension systems by law. Connecticut, for example, mandates that reserve funds over a certain threshold be transferred to pay down unfunded pension liabilities. That led the state to contribute an additional $5.8 billion to its retirement systems over fiscal years 2021-23. Because of a similar requirement, Indiana since fiscal 2022 has contributed more than $3 billion in excess reserves to pay down teacher pension liabilities.

Other states have authorized supplemental payments through their regular budget processes. In Illinois and New Jersey, for example, policymakers have committed to making required contributions in full after years of underpayment and authorized supplemental payments of $500 million each to reduce unfunded liabilities further. And even Tennessee, a well-funded state, decided to make a one-time appropriation of $250 million to save costs on required contributions in future years.

States such as Arizona, California, Kansas, Kentucky, and Vermont have taken similar action to pay down liabilities and save on costs. And some policymakers are even considering how budgetary surpluses can be used to support local pension systems. Michigan’s fiscal 2023 budget, for example, included $750 million to pay down liabilities for underfunded pension systems administered by local governments and a supplemental payment to shore up the state police pension plan.

Infrastructure investment and maintenance

State and local governments spend roughly half a trillion dollars annually on transportation and water infrastructure, with federal grants making up about one-quarter of that spending. Still, experts warn that these commitments cannot keep pace with the growing backlog of needed repairs. In a 2019 report, researchers from the Volcker Alliance, a nonprofit organization focused on public finance issues, estimated that the costs for delayed repairs and maintenance accumulated nationally over the past 50 years could reach nearly $1 trillion. Other sources, such as the American Society of Civil Engineers, put the number even higher.

One-time spending can help address the maintenance backlogs, allowing states to use ongoing funds to maintain a good state of repair. Some states use budget surpluses this way, along with a recent influx of federal funds for pandemic relief and infrastructure.

For example, Idaho has increased ongoing transportation funding over the past decade, using strategies such as gas tax increases and higher vehicle registration fees. However, a 2020 report from Boise State University’s Idaho Policy Institute warned that challenges remain, pinpointing bridges as a particular area of concern because close to 45% of bridges in the state with spans 20 feet and longer were at least 50 years old. In response, lawmakers included $200 million in one-time spending for improvements to local bridges in Idaho’s fiscal 2023 budget—enough money to improve roughly one-third of the deficient local structures. Likewise, Maine’s supplemental 2023 budget included $100 million in one-time spending for road and bridge repair projects to avoid debt financing.

Water infrastructure is also a priority. As of 2020, California estimated that 1 million residents, many of whom live in farm communities, lacked access to safe, affordable drinking water. Moreover, recent droughts had worsened the problem while jeopardizing fish and other wildlife populations. To respond, California has used a mix of ongoing and temporary funds. For example, policymakers dedicated $2.8 billion in one-time money from the state’s fiscal 2023 budget to support drought resilience, water conservation, and drinking water and water supply projects.

Meanwhile, New Mexico’s fiscal 2024 budget includes one-time funds totaling $128 million to support water infrastructure projects in the state. Additionally, Idaho is one of several states using federal pandemic relief funds in the American Rescue Plan Act to shore up water infrastructure, appropriating more than half of the state’s $1.1 billion allotment toward water infrastructure. That includes $300 million in awards for communities throughout Idaho to make necessary water and wastewater infrastructure investments.

Jeff Chapman is a director with The Pew Charitable Trusts’ state fiscal policy project, Colin Foard is a manager with Pew’s fiscal federalism initiative, and Corryn Hall is a manager with the state fiscal policy project.