COVID-19 is having an immense impact on state finances. Revenue collection is in free fall and spending is increasing as people make unemployment claims and switch from private insurance to Medicaid. And unlike the federal government, state governments do not have the option of rampantly running up their “credit cards” through budget deficits. They are required to balance their budgets.
That means tough choices are on the immediate horizon. In response, the National Governors’ Association (NGA) has called for $500 billion from the federal government. While NGA Vice Chair and New York Governor Andrew Cuomo’s state is in dire condition, not all states are doing so poorly.
One reason is that state policy makers long ago developed a tool to help deal with cyclical downturns in revenue. These budget stabilization funds are often referred to as “rainy day funds” (RDF’s) because they enable states to set aside money during good times to use when the next recession or other emergency hits.
Entering 2020, we were in a 10.5-year economic expansion, the longest one on record. Thus, we were due for a recession eventually. Many states managed their finances well during those expansionary years and built up sizable RDF balances rather than pursuing huge spending increases. Others did not.
According to December 2019 data from the National Association of State Budget Officers, those RDF balances varied widely. Fiscally troubled Illinois and Kansas had zero. New Jersey and Pennsylvania had only saved enough to cover about 1 percent of annual general fund spending. New York, Arkansas, and Kentucky had only about 3 percent. Meanwhile, Wyoming, Alaska, North Dakota, and New Mexico all had over 25 percent.
We have been researching state fiscal crises for over a decade. Our findings indicate that states which increase spending faster during good times tend to end up paying for that extravagance later with worse fiscal crises during recessions.
One reason is that expanding existing programs faster and establishing new programs creates unrealistic expectations for the future. When the next recession inevitably hits, those states have much more trouble balancing their budgets. That’s bad news for states like California, Kansas, and Washington, which have enacted some of the fastest spending increases in recent years.
Another reason is that those dollars could have been saved rather than spent. Not surprisingly, we have found that states that enter recessions with larger RDF balances tend to face less fiscal stress than those that did not set much aside. That does not bode well for New York, New Jersey, and Illinois, states whose financial woes have made headlines for years.
However, not all RDFs are created the same. They need two things to function best: strict deposit rules and strict withdrawal rules. If there is no deposit requirement, legislators and governors will not put much money into their rainy day fund. It’s always more fun to spend now than save for later.
In addition, our research found that states with strict withdrawal rules, which prevent the money from being squandered on non-emergency spending, tended to experience much less severe fiscal crises during recessions.
Financial advisors recommend that households set aside three to six months-worth of income as an emergency fund precisely because bad things can and do happen. State governments, with varying levels of success, basically do the same thing with their rainy day funds.
The good news is that many states seem to have learned their lesson from the last recession. As the Cato Institute recently reported, the average state rainy day fund was at 8.4 percent of annual general fund spending, compared to only 4.8 percent going into the last recession.
For those states that did not adequately prepare, the coming recession will be much harder. Hopefully they will show more fiscal restraint during the next economic expansion. However, asking taxpayers in the fiscally prudent states to bail them out with federal tax dollars will only encourage further fiscal profligacy in the future. Given the explosion in federal debt that we’ve already seen, that would be a mistake.
David T. Mitchell is director of the Arkansas Center for Research in Economics and associate professor of economics at the University of Central Arkansas. Dean Stansel is an economist at the O’Neil Center for Global Markets and Freedom in Southern Methodist University’s Cox School of Business in Dallas.