A range of emerging fiscal risks could disrupt state budgets

Crafting a state budget is a delicate balancing act in the best of times. Policymakers must estimate spending needs, predict revenue trends, and balance countless competing urgent priorities, all while maintaining a structurally balanced budget.

These demands can make it difficult for fiscal leaders to look beyond the needs of the immediate budget cycle and consider how major shifts in the status quo could disrupt their states’ fiscal future. But with major demographic, environmental, and technological changes on the horizon, states must find ways to look ahead and consider the potential fiscal impact of these new and emerging risks to ensure that they have time to plan for and manage these future budget challenges.

Demographic Shifts Pose Risks to State Budgets

States are likely to face significant demographic pressures in the coming decades. Baby Boomers continue to age out of the workforce, and the scale of this exit is unlikely to be matched with new workers because of declines in fertility and international migration. Still, some regions have seen significant recent population growth, driven by remote work flexibilities, refugee resettlement, or simply changes in people’s living preferences. The exact nature of these trends will vary from state to state, but policymakers need to understand how these shifts can affect their states’ economic and fiscal future, both in terms of revenue and expenditures.

Revenue impacts. An aging population and smaller workforce could lead to reduced state tax revenue. Wage-based income taxes and sales taxes may be particularly vulnerable as retirees tend to earn and spend less than full-time employees and often receive favorable tax treatment on the income they do earn. Furthermore, a smaller workforce could be a drag on the economy as a whole, as employers have trouble finding workers with appropriate skills, slowing overall economic growth. A 2019 report from Montana’s Legislative Fiscal Division noted that if employers are unable to fill entry-level positions in the future and jobs remain unfilled, income tax collections would almost certainly decrease. The precise extent of these changes will vary based on state tax structures and localized aging trends, so states should begin assessing how such changes are taking shape and how that could inform future plans.

Spending impacts. An older population also could change the balance of spending demands on services. Although fewer school-aged children could reduce education spending, an older mix of residents could mean more Medicaid enrollees, more demand for expensive services such as long-term care, and possible pressure to increase wages paid through Medicaid to help recruit enough caretakers to meet the need.

Environmental Disruptions Will Continue to Emerge

A changing climate will also bring a wave of major disruptions in coming decades, which could have a range of severe impacts on people and the environment and affect state fiscal outlooks. These changes are expected to include an increasing frequency and severity of acute natural disasters, more persistent chronic physical threats such as extreme heat and sea-level rise, and economic disruptions that could come with attempts to adapt to and mitigate these threats.

Acute natural disasters. The increasing frequency and severity of natural disasters is already putting pressure on state budgets. Although they face different hazards, all states can expect an array of expenses related to natural disasters before, during, and after such incidents strike. Even with the availability of federal aid for the largest events, states’ disaster costs have been rising rapidly, with growing pressure for more investments in pre-disaster mitigation and for state support for response and recovery efforts. As this threat continues to increase, policymakers need to measure the full fiscal impact of these events, manage their budgets so the necessary funding is available when needed, and invest in risk-reducing activities that can help to stem this tide.

Chronic physical risks. Beyond the acute effects of natural disasters, states are beginning to plan for chronic, steady changes that also could carry significant fiscal risk. Sustained sea-level rise or extreme heat, for example, could affect state revenues and expenditures. Coastal states may need to invest significant funds to help at-risk communities adapt to or retreat from rising water levels while also seeing significant economic impact from the loss of previously valuable or productive real estate. States exposed to extreme heat for sustained periods may need to plan for greater infrastructure maintenance costs if such changes decrease the life of road pavement, and they may see increased healthcare expenses as the heat takes a toll on vulnerable populations. Sustained heat could also significantly affect outdoor industries such as agriculture, construction, and tourism; state economies, and therefore revenue, could suffer as a result.

Climate-driven economic transition. Beyond the direct physical impact of climate-related changes, some states could face fiscal disruptions stemming from efforts to transition to lower-carbon economies. States that rely on oil and gas extraction taxes—such as Alaska, New Mexico, or Louisiana—may have to deal with dropping revenue from these extractions resulting in lower tax revenue. Other states with high concentrations of heavy industry with a high carbon footprint could see negative economic impacts during the transition. Policymakers should assess the degree to which their economies and revenue structures may be exposed to this transition and begin to plan accordingly.

Technological Changes Could Bring New Challenges

Technological innovation plays an important role in driving economic growth and prosperity. However, these innovations also can cause significant stress for state budgets by disrupting existing revenue structures or by creating demand for new state expenditures.

Technology-driven revenue disruption. New technological innovations can sometimes cause rapid shifts in spending patterns and can disrupt state revenue collection in the process. The rise of online shopping initially caused states to miss significant amounts of tax revenue, and states should remain vigilant for future technological innovations that could disrupt their fiscal outlook. For example, many states fund road construction and maintenance through a mix of fuel taxes and vehicle registration fees to ensure that those who use the roads generally pay for their upkeep; and drivers generally purchase gas and own vehicles. As more drivers shift to electric vehicles, or high-mileage hybrids, the connection between use of the roads and fuel purchases has started to weaken, and policymakers need to think about alternative ways to fund roads.

New technologies, new costs. Beyond the impact to revenue, keeping up with the pace of technological progress can carry an expensive price tag for state governments. Between 2018 and October 2022, costs related to ransomware attacks on governments in the U.S. exceeded $70 billion, highlighting one of the new challenges that come with more technologically advanced government. And while tools like generative AI could help states become more efficient, they also could spread disinformation and threaten data systems' security. States may need to spend more to ensure that they have sufficient cybersecurity while also making contingency plans for how to respond in the event of an attack.

Emerging State Action to Assess These Risks

As these fiscal threats continue to emerge, some states, and some federal agencies, have begun to identify the risks most relevant to their circumstances and assess the potential magnitude of the fiscal disruptions. For example:

• Montana’s legislature established a joint legislative committee in 2019 charged with gathering and compiling data to examine intergovernmental issues. The work includes preparing demographic projections at least a decade into the future and analyzing the fiscal implications.
• New Mexico’s legislative finance committee produced a long-term budget analysis that projected significant structural budget deficits in future years if revenue from oil and gas extraction decreases over time.
• Colorado has begun requiring agencies to submit annual long-range financial plans that include a description of trends, conditions, or events affecting the agency as part of the budget request process.
• Federal agencies, such as the Congressional Budget Office and the Council of Economic Advisors, have started to assess the impact of a changing climate on the federal budget.

Faced with a number of potentially significant fiscal risks, states can learn from and build on these initial efforts to identify and assess the challenges most likely to affect their fiscal futures.

Peter Muller works on The Pew Charitable Trusts’ managing fiscal risks project. 

This piece was originally published by The Pew Charitable Trusts.