Happy Fiscal 2017! Or Maybe It’s Not So Happy, After All

NEW YORK — Happy fiscal New Year! Or so the National Council of State Legislatures proclaimed in its blog post this month. I second the council’s wish for fiscal 2017, but with a bunch of asterisks, caveats, and warnings, especially for those states that have passed so-called balanced budgets where a lot of work has been left undone. This leaves states—and counties and cities as well—vulnerable to potential economic, fiscal, market, and economic shocks that will inevitably crop up, even if we are lousy at predicting exactly when they might occur.

According to the NCSL, 46 states began their fiscal years on July 1 (only New York, Texas, Alabama, and Michigan start on other dates). But remember not to get too excited every time a governor proclaims that she or he balanced the budget. In 49 states, that’s required by law and the one exception—Vermont—follows the other states’ practice.

Last year, in the Volcker Alliance’s report, Truth and Integrity in State Budgeting: Lessons from Three States, we looked at the ways that New Jersey, Virginia, and California balanced their budgets—and if they did it by using one-time revenue sources to cover recurring costs, while pushing off current obligations for pensions, infrastructure, and education, among other things, to future generations of taxpayers. The Garden State did not fare well relative to the others— evidence of how New Jersey, like Illinois and several other states have suffered for years, and continue to suffer, from such practices under the leadership of both major political parties. This year, unlike 2015, Pennsylvania passed a budget on time, although Democratic Governor Tom Wolf said he would allow the measure to become law without his signature because lawmakers had not come up with a way to pay for it.

Then there’s Illinois, which passed a sort-of budget, a six-month partial spending plan that runs through December and was enacted after Republican Governor Bruce Rauner and Democratic House and Senate leader could not enact any budget at all for fiscal 2016. Among the partial plan’s features are a continued lack of actuarial funding for pensions and late payment of bills, with a backlog now at $7.8 billion and likely headed for $10 billion within months. Including pension underfunding, Moody’s Investor’s Service reckons the state's structural budget gap is equivalent to at least 15 percent of general fund expenditures.

But even for the states with budgets, the environment for most is hardly robust. The Nelson A. Rockefeller Institute of Government estimates that total state tax revenues grew by only 1.9 percent in the first quarter of calendar 2016, continuing a slowdown that began in 2015 after a couple of quarters of more than 5 percent expansion—and a robust 7 percent pop back in 2013. The Rockefeller researchers also note that many states are expecting a further slowing of sales or personal income tax growth for fiscal 2017.

In this climate of restrained revenue growth—and this is not just in the energy-producing states—we’re seeing states use a variety of techniques to balance their budgets. Thus the asterisks next to “balanced.” New Jersey, for example, has a balanced 2017 budget, but has yet to figure out how to pay for the broke state part of the transportation trust fund; repair the longstanding underfunding of the state employee and teacher pensions; and finance the longstanding shortfall in K-12 educational spending under standards the legislature set in 2008, when it passed the State Funding Reform Act.

At least the state ends up with a positive balance in the rainy day fund, in contrast to previous years. Connecticut, by contrast, was forced to tap its rainy day fund to balance the 2016 budget and starts the new year with only $90 million in surplus funds on hand, according to Moody’s, which warns that the Nutmeg State this year faces a significant fiscal gap that will be difficult to manage.

Budget pressures and one-time solutions are taking a variety of forms this year. In California, for example, Gov. Jerry Brown is to be applauded for sticking to the formula he backed—and voters approved—to replenish the state’s rainy day fund reserves. As the Pew Trusts, the Center on Budget and Policy Priorities, and the Volcker Alliance have all observed, it’s not the use of the funds to balance budgets that is necessarily a problem. If times are tough, that’s why you have the surplus cash, after all.

Yet California’s budget was also balanced by passing some critical spending obligations off to tomorrow. According to state budget documents, America’s most-populous state has amassed $77.4 billion in deferred infrastructure maintenance, with three quarters of that for roads and bridges and the like. The current budget’s capital plan barely makes a dent in that. (It’s instructive to note here that even as New Jersey’s governor and legislature in Trenton fight over raising gasoline taxes for the first time in 26 years to pay for road work, six other states boosted their fuel levies on July 1, and about 19 have done so in the last three years, according to the Institute on Taxation and Economic Policy.)

Trillions of dollars in pension underfunding also burden states and localities and belie the term “balanced budget.” Pension underfunding typically compounds at about 7 percent or 8 percent per year, which what most funds use for an assumed rate of return as well as discount rate for their liabilities. That complicates any long-term plans for repair, such as that passed by California voters for their teacher pension plan, CalSTRS.

Indeed, less than half of the U.S. public pension plans that Moody’s studied this spring are receiving enough government appropriations to keep their net liabilities from increasing further. When pensions start to run out of assets—as Puerto Rico’s almost has—and citizens are asked to shoulder huge tax increases to pay for retiree benefits, we’ll see just how difficult it will be to achieve a truly balanced budget.

Let’s also ponder the future of the U.S. economy and markets. At seven years of age, the recovery from the Great Recession is now older than the average of all postwar comebacks and is the fourth-longest since 1858, according to National Bureau of Economic Research data. How long this lasts is anyone’s guess, but at best, economists polled by Bloomberg see no better than 2 percent annual real GDP growth out through 2018. At that point, we’d be approaching the record 120-month recovery that ran from 1991 to 2001. But 2 percent growth is hardly a boom, and it suggests that the cautions about state revenue from the Rockefeller Institute may be well-founded.

Brexit, as well, is a new imponderable. But its effects are being felt already in market volatility that is sloshing over into state budgets. Massachusetts made some last-minute budget cuts because revenue is trailing expectations to the tune of $950 million, probably because capital gains tax collections are falling short. Indeed, government bond yields—the mainstay of pension investments—have plunged worldwide, in no small measure due to concerns over the future of a European Union minus the U.K. This will have a large impact on public employee pension fund returns and, if sustained, may prompt actuaries to recommend larger government—and, perhaps, worker—contributions to close funding gaps. The combination of weak GDP growth and anemic market returns will thus pressure state budgets in numerous ways and tempt policymakers to seek one-time solutions to structural gaps, rather than enact long-lasting reforms.

Moody’s now has negative credit outlooks on 10 states, according to Tom Kozlik of PNC Financial. That may be a record, especially during a period of economic expansion. Only five of the states are primarily energy producers. And the words “structural imbalances” keep showing up in their assessments across the board. (Food for thought: Would those imbalances not exist if states followed generally accepted accounting principles—or GAAP—for budgeting, as New York City has been obliged to do by law since its near-bankruptcy in the 1970s?)

Along with those negative outlooks, fiscal analysts are now asking how well states and cities are prepared for a possible recession. Even though New York’s “economy continues to thrive,” the Citizens Budget Commission recently estimated that the state’s heavy reliance on personal income taxes leaves it vulnerable to losing $59 billion, or 18 percent of tax revenues, over four years should the economy turn down. Two months earlier, Moody’s ran stress tests on 20 big states and concluded that California and Illinois had the weakest flexibility on spending and the most vulnerability to recession of the 20 states.

Fortunately, the U.S. economy and state tax revenues are still growing, albeit slowly. So, like the NCSL, I can honestly wish you a happy fiscal 2017. But perhaps I should qualify that. Happy New Year, to be sure, but be aware that it’s likely to be a challenging one, with plenty of dangers to budgets lurking to trap the unwary.