State Budgeting, the COVID-19 Recession, and What Comes Next

State finances weathered the Covid-19 pandemic better than some officials had feared, thanks to budget reforms and an increase in reserves during the economic rebound from the Great Recession, fiscal experts said at a Special Briefing hosted by Penn IUR and the Volcker Alliance.

"Those states that have strengthened fiscal procedures were better equipped to handle the acute stress, especially in the initial stages of the pandemic, when it really seemed the economy was in free-fall," said Juliette Tennert, chief economist at the Kem C. Gardner Policy Institute at the University of Utah.

"General fund balances were at an all-time high of $122 billion by the end of fiscal 2019," added Lisa Washburn, managing director of Municipal Market Analytics. "Given that they're projected to fall, based on fall estimates, to $81 billion at the end of fiscal '21, it's clear that they played a significant role in managing budgets during the pandemic."

The Special Briefing was the 19th in a series of 60-minute online conversations featuring experts from the Volcker Alliance’s national research network and Penn IUR. The discussion was moderated by William Glasgall, Alliance senior vice president and director of state and local initiatives and Susan Wachter, Co-Director of Penn IUR. In addition to Tennert and Washburn, panelists included Erica MacKellar, program principal, National Conference of State Legislatures, and Gabriel Petek, legislative analyst for the State of California.

Tennert and Washburn were among the contributors to a new Volcker Alliance study, Truth and Integrity in State Budgeting: Preparing for the Storm, that was the focus of the April 15 webcast. Covering fiscal years 2015-19, the report is the Alliance’s fourth annual assessment of the budget practices of all fifty states and the first to provide grades and an analysis of trends for the entire study period.

In the five budgetary categories studied, “the five-year trend lines told us some very interesting things,” said Glasgall. “We saw that a lot of states used the record-long economic recovery as a reason to fortify their budget processes and their fiscal reserves.”

The report analyzed states' progress toward a set of sustainable budget practices and assigned grades in each category on a scale of A to D-minus. Despite reforms, states received C averages in budget forecasting and legacy costs (including public worker pensions and retiree health care) and Bs for budget maneuvers, reserve funds, and transparency. While there were numerous As, especially in the budget maneuvers and reserve funds areas, only five states received three As apiece. They included California and Tennessee in budget maneuvers, reserve funds and transparency; Idaho (budget maneuvers, legacy costs, and reserve funds); Hawaii (budget forecasting, budget maneuvers, and reserve funds); and Utah (budget maneuvers, legacy costs, and transparency).

Among the five categories, while budget transparency has improved, Glasgall said that many states still aren't disclosing their deferred infrastructure costs. "If and when the infrastructure bill [proposed by President Biden] passes, the first thing we'll want to know is, ‘What needs work?’” he said. “Many states can't answer this question." Long-term forecasting is also "something that needs work," Glasgall said. One-year revenue and spending estimates used by many states are not sufficient to alert officials to structural deficits that may develop in the years ahead. While funding for legacy costs such as pensions and other post-retirement benefits improved in 12 states, 33 "are still experiencing severe to moderate stress" in meeting their obligations, he said.

In contrast, the Alliance found "widespread improvement" in reserve funds, Glasgall said. "Wyoming actually had a year's worth of funds in rainy day funds that stood them in good stead when energy prices plunged."

The impact of Covid-19 on revenue also hasn't proven to be as dire as feared. While states reliant on tourism or natural resources were hard hit, panelists said states with graduated taxes benefited as high-earning taxpayers were able to continue working from home. Meanwhile, sales taxes on online transactions helped offset the revenue lost when brick-and-mortar shops were forced to shut down.

Federal spending has also helped significantly.

“States’ economic and fiscal pain was eased by the $2.2 trillion Coronavirus Aid, Relief and Economic Security Act, passed in March 2020, and the $900 billion for COVID-19-related spending in the Consolidated Appropriations Act, passed in December. Together they injected the equivalent of almost 15 percent of US gross domestic product into the economy in less than a year," the Volcker report found.

Nonetheless the panelists stated their worries about a fiscal cliff that might follow the infusion of federal assistance.

Petek expressed concern but said that California legislators may find ways to avoid plunging off a fiscal cliff as federal budgetary aid winds down in 2024. “"We are thinking about guidance that suggests that the legislature consider ways to use the funding to smooth out the transition off of the federal support," he said.

California's Petek said the Golden State came into the year on "quite strong fiscal footing," with "approximately $20 billion in reserves, the result of a decade of responsible budget practices."

Even last spring, when a roughly $40 billion drop in revenues was expected, "policymakers were able to balance the budget, while largely keeping the states safety-net programs intact," Petek said. "Revenues did not fall as we all had anticipated," he added. "The gap between the assumption and the actual trend has created a what we termed large windfall."

The windfall was estimated in November by Petek's office at $26 billion and more recently by Governor Gavin Newsom's office at $15.5 billion. California officials also projected the emergence of a structural deficit that is expected to balloon to $13 billion by 2024-25, Petek said. His office is recommending using half of the windfall to replenish budget resilience and the other half to address pandemic related expenses.

States that failed to fully repair their budgets following the Great Recession are likely to have a harder time than California, Washburn noted.

"For some states, like New Jersey and Illinois, many years of fiscal missteps, the Great Recession, the tempered economic recovery and their use of questionable budget solutions constrained their ability to adequately bolster their financial position before the pandemic-induced recession hit," she said.

The use of debt to fund operations was among budget balancing tactics those states continued to use, despite the economic expansion, she said. "Illinois did raise taxes and New Jersey continued to make progress on ramping up pension contributions and was slowly building up its reserves, but it just wasn't enough," she said. "When the pandemic and resulting recession hit, these two states lacked the internal financial wherewithal to cover anticipated drops in revenue and borrowed heavily for operations. Illinois borrowed $3.5 billion and New Jersey borrowed $4.3 billion."

How states will fare in the next few years will depend on the impact of the $1.9 trillion American Rescue Plan Act of 2021, as well as on successes in conquering the disease and a recovery in jobs and the US economy, the Volcker report concludes. While states may be restricted from using the money to rebuild reserves or make payments toward pensions and retirement benefits, the funds will help states to shore up finances.

According to MacKellar, states are considering using the ARP money for such items as cybersecurity, housing, and other social services, as well as for education and improving broadband access. Several states may pay back money they borrowed for their unemployment trust funds and for environmental conservation.

"The federal government has really bought states time to rebuild their fiscal position," Washburn said. "Strong fiscal governance is now more critical than ever."

Panelists also agreed that states must be mindful of keeping recurring spending in check against the day that federal stimulus funding—what Petek called “a once-in-a-generation influx of resources”—runs out.

Videos of all webinars on the impact of COVID-19 are available to stream. The next Penn IUR-Volcker Alliance event will be a Special Briefing entitled “The $2.3 Trillion American Jobs Plan and State and Local Infrastructure Needs” on May 20 at 11 a.m. ET, featuring Earl Blumenauer, U.S. Congressman, Oregon, and Member, House Ways and Means Committee; Penn IUR Advisory Board Member Marc Morial, President and CEO, National Urban League; Robert Poole, Director of Transportation Policy and Searle Freedom Trust Transportation Fellow, Reason Foundation; and Richard Ravitch, former Lieutenant Governor, New York State, and Volcker Alliance Director.