The Outlook for State Budgets Heading Into 2023

With a few major exceptions, state officials expect their budgets to be in strong positions for the coming year. The robust projections come even as worries linger about the health of the nation’s economy overall.

“The economy has proved much more resilient than anybody expected,” said Shelby Kerns, the executive director of the National Association of State Budget Officers.

Governors and lawmakers have been cautious in spending new revenue, given recent disruptions in the economy. They’ve watched warily to see how the pandemic, supply chain disruptions, record-setting inflation and increased borrowing costs would affect state budgets, she said.

As a result, states have been shoring up their financial positions. As federal aid and unexpectedly robust tax returns poured in, they dedicated most of the surpluses to one-time expenses. States paid down debts, shied away from short-term borrowing and poured money into their pension plans.

Perhaps most significantly, they built up cash reserves. According to a new NASBO report, the amount of money states set aside in “rainy day funds” or left at the end of the year tripled in the last two fiscal years. At the end of fiscal 2022, those funds had a collective balance of $343 billion. The median state had nearly 12% of yearly revenue set aside.

“States are better prepared than they have ever been for a downturn,” Kerns said.

An Uneven Economy

Economic turmoil can hit state governments differently than everyday consumers, depending on the source of the trouble. The Great Recession, for example, hobbled state finances for years after the downturn ended.

But the inflation-related worries of the last year have left state revenues relatively unscathed, Kerns said.

States collect the bulk of their revenue from taxes on income, sales and corporate profit. The labor market is still robust, and unemployment is low, meaning people are still paying income taxes, Kerns noted. Sales taxes keep up with inflation, because they are based on the price of goods. And corporate income taxes remain solid, because companies are still mostly in good financial shape.

States, though, avoided many of the expenses from higher inflation. The sectors that are driving higher consumer prices have been housing, food and fuel. Those aren’t major expenses for state governments, Kerns said.

The areas where inflation is most likely to hamper state budgets are construction and paying money to retain government workers, she added.

Mark Zandi, the chief economist for Moody’s Analytics, said Thursday there’s a “better than even chance” that the U.S. economy can make it through 2023 without a recession.

Inflation seems to be tapering down, households are in strong financial positions, and businesses that have been struggling lately to hold onto workers are going to be reluctant to lay off their employees, Zandi said during a briefing held by the Volcker Alliance.

The political situation could also help ease investor anxieties, too, said Emily Brock of the Government Finance Officers Association. Republicans are set to take over the U.S. House next year, while the U.S. Senate and White House remain in Democratic hands.

“We might actually positively characterize gridlock in the form of a calming down,” Brock said. “Markets love gridlock. We’ve endured so much uncertainty, $5 trillion in stimulus funding in the recent past. So certain and deliberate policy making might be welcome in the markets.”

State Surpluses Abound

In state capitols, governors and lawmakers are preparing for their upcoming legislative sessions and questions of how to allocate unusually high budget surpluses.

Florida Gov. Ron DeSantis, a Republican, signed a law this month to give frequent drivers of the state’s toll roads a reprieve. The law could cost up to $500 million, but the state projected a surplus of $21 billion this summer.

“When your surplus gets too big, it’s like, OK, we need to get this back to the taxpayer,” DeSantis said. “This is one thing we’re going to do, but we’re going to do much more in terms of tax relief for people throughout the state of Florida.”

Missouri is anticipating a $6 billion surplus, setting up debates in Jefferson City over how much of it to spend on beefing up the state workforce, boosting support for charter schools or continuing to offer more tax cuts.

In Wisconsin, the clash is over who should benefit from a $6.6 billion projected surplus for the upcoming two-year budget cycle. The Republicans who control the Wisconsin Senate are exploring the idea of imposing a flat 3.5% income tax, or about half the current rate for the highest-income taxpayers. Democratic Gov. Tony Evers, on the other hand, wants to lower income tax rates for middle-class residents.

Oil and gas revenues helped boost New Mexico’s revenues to $2.5 billion more than anticipated for the coming years. Democratic lawmakers are talking about using the extra money for infrastructure projects, schools, health care and targeted tax relief.

Meanwhile, outgoing Maryland Gov. Larry Hogan is expected to leave a $2.5 billion cushion for his successor, Democrat Wes Moore. The state also has another $3 billion in its rainy day fund. Hogan, a Republican, cautioned against spending too much of the excess.

Notable Exceptions

Not all states are enjoying such rosy budget pictures.

New York Gov. Kathy Hochul, who championed tax cuts while the state coffers were flush last year, now faces questions about whether the state should raise taxes amid a worsening budget. “This year, it’s a totally different story,” the governor acknowledged. Hochul said she opposes raising taxes.

California lawmakers, meanwhile, must figure out how to bridge a $24 billion gap in their upcoming budget negotiations. The state’s overall expenditures for that year are $226 billion.

California’s nonpartisan Legislative Analyst Gabe Petek said his office assumes that the economy will continue to be weak, but not head into a recession.

The state is already seeing lower revenues because of changes in the economy. State revenue increased 30% two years ago and 20% last year. This year, Petek said, analysts expect a decrease of 7.1%.

The Golden State depends on personal income taxes for 70% of its revenues, and half of that money comes from the top 1% of wealthy taxpayers. They pay most of their income taxes on capital gains, particularly when companies go public. But the number of initial public offerings in California went from about 80 through September of 2021 to nine in the same period this year, Petek said.

“I would characterize it for us as a notable but manageable budget problem,” he said.

Balancing the budget will be easier in the coming year, because lawmakers set aside nearly $23 billion in reserve funds they can tap to alleviate some of the stress, he said.

Scott Graves, the director of research for the California Budget and Policy Center, said California legislators should not have to make drastic cuts to state services to make the budget pencil out. They can tap reserves or use money from special funds to avoid that.

Democratic lawmakers seem to want to avoid major cuts, he said, and have been using the phrase “protect our progress” to describe that approach.

“As long as the state doesn’t descend into some kind of deep recession, there’s really no need or excuse for cutting into safety net programs—or really any public services—at this point,” Graves said. “The legislature and governor have a lot of tools in their toolbox, which includes our reserves, that they can draw on to try to get us through tough times.”