States ask for federal aid to stay on a responsible path

As Congress considers whether to provide state governments with additional fiscal aid in the wake of COVID-19, it is important to recognize that many states made significant strides over the past decade to prepare for a recession. But the severity and speed of this downturn could overwhelm even the best efforts by states to stay on a fiscally responsible path.

A state’s best line of defense against downturns is a rainy day fund. By saving money in these accounts, states create financial cushions that limit the need for budget cuts and tax increases when residents and businesses can least afford them. After being underprepared for the Great Recession, many states adopted policies to ensure they would save in good years so that adequate dollars would be available in bad ones. These efforts paid off: Research by The Pew Charitable Trusts shows that at the end of the 2019 fiscal year, states collectively had more dollars saved in their rainy day funds — with money that could cover a bigger percentage of state spending — than at any time in at least the past 20 years.

And the move toward more saving came from policymakers from across the ideological spectrum, even in states faced with chronic budget problems. For example, states as different as Connecticut and Oklahoma enacted laws requiring that a share of unexpected revenue windfalls be set aside in a savings account rather than invested in a new spending program. At the end of fiscal 2017, both states had rainy day funds worth less than 2 percent of their general fund. Two years later, Oklahoma had 11.5 percent, and Connecticut had 13 percent.

The efforts of states to save have been particularly impressive in light of other budgetary pressures they face from rising health care costs, decaying infrastructure, aging populations, and a host of state-specific challenges. Nebraska, for example, has enacted a series of promising fiscal reforms. Still, the state was forced to substantially spend down its rainy day fund to respond to last year’s devastating floods.

The rainy day funds in most states — even those that have made great strides in recent years toward fiscal balance and sustainability — will be insufficient against the unprecedented challenge posed by the current economic downturn. Plummeting tax revenue and increased costs threaten to force state and local governments to cut spending or raise taxes — actions that will further harm their economies and close hundreds of billions of dollars in budget gaps.

Even states such as California, Minnesota, or Utah that have carefully stress-tested their budgets to ensure they could withstand a recession face large gaps. After living through the pain of a fiscal disaster during the last recession, California built its rainy day fund to one of the highest levels in the country as a percentage of spending. But it is estimated to cover only half of the coming shortfall.

The 50 states have different tax structures and levels of spending, but the economic downturn’s impact on all their finances has been rapid and severe. In response, bipartisan coalitions of the nation’s governors, legislators, mayors, and other policymakers are pleading for federal financial assistance because — unlike the federal government — states must balance their budgets each year, all while preserving essential services such as those provided by firefighters, schoolteachers, and healthcare workers.

Past recessions prompted states to sometimes resort to short-term budget maneuvers that left them — and their economies and residents — worse off in the long term, moves such as delaying payments to schools districts or service providers, reducing investments crucial to future economic growth, and passing the pain to local governments that face the same issues as states but to an even greater degree. Federal aid to cover yawning budget gaps could help states avoid making the same missteps.

One lesson from the Great Recession is that when state governments scale back, the economic repercussions reverberate beyond state borders. With that in mind, policymakers should consider how to ensure that states, despite their efforts to prepare, don’t find themselves able to deepen the recession and delay the recovery.

Jeff Chapman is a director and Josh Goodman is a senior officer with The Pew Charitable Trusts’ state fiscal health project.