States Confront New Fiscal Challenges in a Post-Pandemic Landscape

Tax receipts in most states declined for the second consecutive year in fiscal 2024—an extraordinary event outside a recession. This highly unusual trend underscores that much of states’ historic tax revenue gains during the pandemic were temporary. As budget conditions stabilize after years of volatility, policymakers face two new challenges: maintaining balanced budgets as one-time funds fade while pandemic-era budget commitments persist and determining whether to preserve or deploy record-high budget reserves without a clear sense of whether current savings are sufficient to weather future downturns.

After two years of historically high growth in fiscal 2021 and 2022, total inflation-adjusted state tax collections declined by 9.2% in fiscal 2023. And that trend continued for most states in fiscal 2024. Preliminary monthly data from the Urban Institute shows that inflation-adjusted collections declined in 36 states during the 12 months ending in June—which marks the end of fiscal 2024 for nearly every state—compared with the same period a year earlier. Although total state collections for fiscal 2024 ticked up by 0.2%, this was significantly bolstered by California’s double-digit increase in collections during this period, linked in large part to a temporary shift in the state’s income tax filing deadline. Excluding California, total state tax revenue declined by 2.9% in fiscal 2024.

Structural balance risks

States face higher-than-normal risk of structural deficits when recurring revenue is insufficient to support recurring expenditures. This risk stems from two key factors: the heavy reliance on temporary funds during the pandemic and the subsequent long-term fiscal commitments made by states.

During the pandemic, one-time funds provided a crucial buffer for states, allowing policymakers to maintain services during a period of economic disruption. The unprecedented levels of temporary federal aid along with soaring tax revenues helped strengthen state budget conditions. Aggregate tax revenue growth from 2020 through 2022 exceeded pre-pandemic trends by 38%—or $152 billion—and may have been temporary in nature. However, as these temporary supports phase out, the true health of state budgets is coming into sharper focus.

At the same time, recurring fiscal commitments—including broad-based tax cuts—that were affordable in an environment of abundant resources may now pose challenges as states return to more typical revenue patterns. From 2021 to 2023, virtually every state enacted a tax cut, with 26 states permanently reducing taxes on personal income, corporate income, or both. On the spending side, states implemented a comparable mix of one-time and ongoing policy changes, including across-the-board wage increases for state employees in most cases.

The combination of temporary funds propping up budgets and the adoption of new recurring expenditures or tax cuts has left many states in a precarious position. Policymakers now must grapple with the possibility that their states' finances are structurally imbalanced and vulnerable to deficits as one-time funds dry up but new commitments remain.

Managing record rainy day funds

Most states used this period of fiscal abundance to build budget reserves to record levels. Rainy day fund balances, for example, increased by just under $100 billion from fiscal 2019 to 2023, suggesting that states prudently set aside much of their higher-than-expected tax revenues.

The record increases in rainy day fund balances have provided states with a cushion to help navigate future downturns without resorting to deep spending cuts or tax increases. However, the management of these reserves presents a new set of challenges for state budget officials.

For instance, policymakers in some states may view these record reserve levels as excessive, which could lead to pressure to use these funds for other policy priorities. In Kentucky, where the state’s rainy day fund in fiscal 2023 was 12 times its fiscal 2020 level, legislators agreed that the total was too high and allocated $2.7 billion from savings mostly for infrastructure projects. Similarly, in Pennsylvania, where savings have also risen rapidly, Governor Josh Shapiro (D) proposed tapping reserves to fill budget gaps in education, infrastructure, and safety net programs.

Adding to the complexity is that securing federal aid for states in the next recession will probably be more challenging. The federal government’s $5.2 trillion response to the COVID-19 pandemic was the largest fiscal stimulus package on record.

Designed to combat a much longer recession than what occurred, federal stimulus aid significantly contributed to a historic increase in fiscal reserves. The stimulus included two streams: direct support to individuals and businesses, which helped fuel a state tax revenue wave, and $800 billion in direct aid to state and local governments.

Meanwhile, the cost of providing these funds has added significantly to the national debt. As a result, securing additional recessionary aid from the federal government may be more politically and financially challenging in the years ahead. This uncertainty raises the question of whether states should increase their savings targets to reflect this risk and preserve higher levels of rainy day funds for the next economic downturn.

As states grapple with managing structural balances and record-high rainy day funds, the path forward requires a strategic approach. With temporary funds fading and with new, ongoing commitments to maintain, proactive financial planning is essential to ensure long-term budget sustainability.

A time for proactive fiscal management

States must manage their finances proactively to ensure long-term stability. Budget stress tests, which simulate various economic scenarios, can help to determine appropriate reserve levels, allowing states to prepare for revenue shortfalls without compromising essential services.

Long-term budget assessments are equally crucial, helping states to identify and address potential challenges such as unfunded liabilities or rising health care costs before they become critical. Pew’s research found that, among the states that have completed long-term budget assessments most recently, most identified structural imbalances coming out of the pandemic. And several flagged recent policy decisions—such as permanent tax cuts and spending increases—as having created or exacerbated long-term budget deficits. By focusing on these strategies and learning from such findings, policymakers can make informed decisions that safeguard their states’ financial health and navigate future uncertainties with confidence.

The current decline in state tax revenues presents new and complex challenges for policymakers still grappling with the fiscal aftermath of the pandemic. As the temporary nature of recent revenue gains becomes clearer while pandemic-era budget commitments remain, and with record-high rainy day funds in play, states must carefully balance long-term stability with their other fiscal priorities.

By employing evidence-based tools and practices, state policymakers can navigate these risks effectively, ensuring that their finances remain strong in the face of future uncertainties. This is a crucial time for proactive fiscal management, and the steps taken today will have lasting implications for states’ financial health in the years to come.

Justin Theal is a senior officer with Pew’s Fiscal 50 project, and Gregory Mennis is a principal officer with Pew’s fiscal and economic policy group.