Four Steps to Reduce the Harm of State Fiscal Distress

Research by The Pew Charitable Trusts points to four steps that state governments can take to prepare for temporary budget distress caused by economic downturns or other adverse events, such as the coronavirus pandemic. These strategies offer a roadmap for limiting the damage caused by uncertainty and volatility.

Policymakers can use these tools—identified through interviews with current and former state budget officials—to better handle the costs of unanticipated needs or precipitous drops in expected tax revenue. These actions can help ensure that state leaders don’t have to neglect long-term goals during lean years. Instead, they can position their states to thrive through good times and bad—and avoid many of the short-sighted decisions that policymakers have made in previous budget crises. Each of the articles in this package details one of the best practices.

States should:

• Conduct budget stress tests. “Stress tests” look at different scenarios to estimate to what degree economic downturns or other unforeseen events would throw a state budget out of balance. During a downturn, revenue collections from states’ primary taxes—personal income and sales taxes—stagnate or decline, while demand for means-tested programs such as Medicaid increases. This combination creates a gap between the cost of government programs and the money available to pay for them. By estimating how large these shortfalls could be, stress tests help policymakers plan for the potential need to close them.
• Build reserves. To eliminate budget gaps without harming residents or the economy, healthy rainy day funds are states’ best line of defense. These reserve accounts can provide a financial cushion to help limit the spending cuts or tax increases that states otherwise must need to enact to close budget shortfalls. By saving money when the economy is thriving and revenue growth is strong, states can have resources available to help balance budgets during downturns. In addition to ensuring that rainy day funds are adequately stocked, policymakers can design rules for withdrawal and repayment that ensure the money is available in a state’s time of need.
• Improve flexibility and responsiveness. When reserves on their own are insufficient to close budget gaps, lawmakers need leeway to adopt solutions—such as spending cuts, tax increases, or other budget maneuvers—that won’t undermine their policy priorities. But states often face significant constraints in making these decisions, including laws mandating that certain revenue sources can be used only for specific purposes and supermajority requirements for lawmakers to raise taxes. Policymakers can reconsider these constraints to ensure they have enough flexibility to solve budget problems. Additionally, to avoid making hasty, counterproductive decisions during budget crises, they can develop contingency plans for closing gaps.
• Avoid unsustainable budgeting. State leaders often face pressure to increase spending or cut taxes in good budget years, but unless they act with care, they risk making commitments that will prove unsustainable when budget conditions deteriorate. Good data can help lawmakers understand what a state can afford. For example, states can identify one-time revenue and avoid using it for ongoing expenses. High-quality estimates of the costs of new programs can help policymakers assess whether the proposals are affordable.

Taking these steps will help states regardless of how the current economic situation unfolds. If policymakers hope to have a real impact on the lives of state residents—whether by improving education, lowering taxes, strengthening rural areas, boosting growth, or achieving any other goal—success requires time and sustained strategic investments. But revenue and spending pressures are volatile and uncertain.

State governments may be flush with cash in some years, while at other times, especially during economic downturns, fail to raise enough money to maintain key services. The result is that instead of consistent funding for top priorities, they expand government services one year only to reduce them the next or cut taxes before having to raise them again.

During fiscal crises, merely balancing the budget can become an all-consuming task for policymakers. Without proper foresight, state leaders may make decisions that undermine economic growth and government effectiveness for years to come—instead of decisions that help them pursue long-term objectives that benefit their residents.

Josh Goodman researches state fiscal and economic policy as part of The Pew Charitable Trusts’ state fiscal health initiative.