State Budget Surpluses, Rainy Day Funds, and Deficits
Today, the 110th General Assembly convened, and one of the biggest items on their agenda will be how to address a state budget surplus. In our Tennessee State Budget Primer – released last month – we jump into the topic of budget surpluses, the trade-offs they represent, and how they relate to economic downturns, rainy day funds, and structural deficits. Given the Legislature’s emerging agenda, we’re republishing the chapter below.
♦ Deficits occur when revenues and spending are out of balance. Cyclical deficits occur during economic downturns like recessions, and structural deficits are fundamental and not based on the economic cycle.
♦ Reserves – often called Rainy Day Funds – help states smooth out the ups and downs of economic cycles.
♦ By the end of FY 2016‑2017, the balance in the two reserves is expected to total over $900 million, which is nearly $200 million less than the amounts stowed away going into the Great Recession.
♦ Surpluses are separate from rainy day reserves and are not automatically deposited in the Reserve for Revenue Fluctuations.
♦ End-of-year surpluses are often used for non-recurring investments, even though they are often accumulated from regular recurring revenue sources.
♦ Both savings and surpluses, while fiscally responsible, represent a trade-off as they are not available for recurring investments in programs and services or cuts to taxes.
♦ Under a balanced budget, structural deficits can be hard to identify in the absence of long-term estimates of revenue collections and spending needs, which Tennessee does not publish. However, we do know:
♦ The state’s budget growth has outpaced state tax collections for years – a deficit made up for with growth in federal spending.
♦ The state’s sales tax base is not keeping up with changes in purchasing patterns, which could represent a problem for future revenue collections.
♦ Recent budget growth has been slower than growth in state personal income and gross domestic product, which are often used as proxies for the demand for government programs and services (i.e. spending).
DIGGING DEEPER: DEFICITS & SURPLUSES
Policymakers are responsible for the state’s fiscal health in both the short-term and long-term. The constitutional balanced budget requirement creates the obligation for policymakers to evaluate a constant stream of difficult trade-offs on an annual basis. Even with the best year-to-year and mid-year estimates about taxing and spending, both unexpected economic conditions and underlying trends in a state’s tax and spending decisions have the potential to back state policymakers into a corner. Understanding how these dynamics work and the tools at state policymakers’ disposal is important because these scenarios can potentially force difficult choices about taxing and spending.
Imbalances between revenues and expenditures that occur because of economic downturns are known as cyclical deficits. Let’s take, for example, the Great Recession that lasted from 2007 to 2009. During and immediately after the recession, Tennessee had higher-than-usual need for the programs and services funded by the Budget with fewer-than-usual resources to fund them.
Because personal income falls during recessions, smaller paychecks mean fewer dollars for personal spending and lower sales tax revenues for the state. At the same time, more people may need state-funded programs to help them bridge the gap until conditions improve. In FY 2008‑2009, for example, Tennessee sales tax revenues fell by nearly 8% or over half a billion dollars from the prior year. Meanwhile, enrollment in TennCare jumped by 4% – which, at the time, was the highest annual enrollment increase in a decade.
Fortunately, states have a tool that helps smooth out the ups and downs of the economic cycle. Reserves – also known as rainy day funds – allow states to shore up funding when revenues are flowing well and/or needs are relatively low. Those reserves can then be tapped when revenues falter and/or needs increase. In Tennessee, these reserves are called the Reserve for Revenue Fluctuations.
The Reserve for Revenue Fluctuations is not the only vehicle at the state’s disposal for saving money to use in tight years. For example, the TennCare Reserve is a separate reserve that holds excess funds specifically for TennCare. In dire situations, the Legislature can allow these savings to be used to help out both TennCare and the General Fund. The TennCare Reserve was an estimated $283 million at the end of FY 2015-2016.
The Great Recession proved a worthy foe to most states’ rainy day funds. Despite the infusion of additional federal dollars for everything from highway projects to state Medicaid programs like TennCare, nearly all states enacted some combination of program and spending cuts, tax and fee increases, and reserve taps. In FY 2009‑2010, for example, 45 states cut their General Fund expenditures – including 39 that made cuts mid‑year. By the end of FY 2012-2011, 22 states had completely or nearly completely (i.e. $10 million or less) depleted their rainy day funds.
Tennessee tapped nearly $800 million from both the Reserve for Revenue Fluctuations and the TennCare Reserve over the course of the recession and recovery but, unlike many other states, never depleted either reserve. Instead, the state balanced its use of reserve dollars, which are considered a non-recurring source of revenue, with recurring base spending reductions and state employee salary freezes.
When accounting for both reserves, Tennessee could cover state government operations at current Budget funding levels for around 23 days. By the end of FY 2016‑2017, the balance in the two reserves is expected to total over $900 million. Although this is the highest level of reserves the state has had in years, the anticipated balances are nearly $200 million less than the amounts stowed away going into the Great Recession.
Even though the state never depleted its Reserve, Tennessee bolstered the laws governing the Reserve for Revenue Fluctuations in the wake of the recession in order to raise the target Reserve balance (see page 31 of the Tennessee State Budget Primer).
Although the Reserve for Revenue Fluctuations might be viewed as a savings account of sorts, any differences between spending and collections aren’t simply deposited to the Reserve. In fact, each year’s appropriations bill specifies a target balance for the Reserve, which dictates the size of the deposit that year regardless of whether the state could conceivably “afford” more based on its actual spending and collections.
Many appropriated programs have reserves in any given fiscal year. These program reserves represent the difference between any revenues available for the program and actual spending. In some cases, programs are able to keep and roll these reserves over from one year to the next. Mostly, however, these unspent funds revert back to the General Fund for re‑appropriation for other purposes in future years.
In addition to these so-called “reversions,” the General Fund also accumulates dollars when revenue collections outpace budgeted estimates – an issue inextricably tied with revenue estimation (discussed on page 10 of the Budget Primer). Some excess collections may be reserved specifically for the next fiscal year; while others are combined with program reversions in the Reserve for Future Requirements. This latter reserve is often referred to as the surplus. At the end of FY 2014‑2015, these two reserves totaled $873 million – $479 million was reserved for FY 2015-2016 and $394 million was surplus. All told, these reserved funds and surpluses along with the Reserve for Revenue Fluctuations and the TennCare Reserve totaled over $1.6 billion at the end of FY 2014-2015.
When the spending and revenues are out of balance even when times are good, it is referred to as a structural deficit. A structural deficit could present itself either as current underspending or as a projected future budget gap. In the first case, spending may be limited to a level that is within revenue constraints but below what may be warranted. In the second, the growth of revenues and the growth in spending diverge.
In the case of the federal government, it is easy to identify the structural deficit in the form of growing national debt. However, under balanced budgeting it can be hard to tell if a structural deficit exists because expenditures for certain programs can be constrained regardless of the need or demand for them. In this section, we explore a few potential metrics to identify a structural deficit.
One potential approach is to take a look back at how the state’s revenues have grown over time relative to state spending. For example, since FY 1993-1994, Tennessee’s state tax revenues grew by a total of 145% while expenditures grew by 185%. The difference, of course, has been offset by other revenue sources – namely the 253% cumulative growth in federal resources. It is difficult to objectively discern if the state’s need for programs and services is outstripping the ability to pay for it with the state’s own resources or, alternatively, if spending is simply growing faster than state tax revenues because of the availability of federal dollars.
Another avenue for identifying a structural deficit is by looking forward – in other words, using multi-year projections of revenue collections and spending needs. The Budget does not include multi-year projections for either revenues or expenditures, and we’ve already discussed how difficult the task of projecting revenues is even one year out (discussed on page 10 of the Primer). Recent experience, however, suggests that our state tax revenues are on the mend. In fact, by the end of 2016, Tennessee’s tax revenues were up 8% over peak collections in 2008 – even when adjusted for inflation. Last fiscal year, revenue collections exceeded projections by 7% – growing by nearly 7% from the prior year.
On the spending side, most agree that multi-year spending projections should be based on maintaining current services, but states approach the task differently. Under no circumstance in Tennessee do recurring expenses automatically grow as part of the base budget. However, each year’s Budget includes new recommended cost increases to the recurring base budget associated with items that are non‑discretionary for one reason or another – like TennCare and the Basic Education Program. These annual cost increases are based on the underlying requirements and conditions driving their non-discretionary status (e.g. expected enrollment and health care cost increases).
Other recurring items, however, do not receive perennial recommended cost increases, even though some would argue that increased spending would be necessary to maintain the current level of service or effort due to factors like inflation, population growth, and infrastructure deterioration. In fact, last year, the Legislature’s research arm identified over $6 billion in needed but unfunded transportation projects, and the Tennessee Advisory Commission on Intergovernmental Relations (TACIR) recently estimated that the state needs $41.5 billion of public infrastructure improvements through 2019.
In the absence of reliable projections, some have identified other ways to recognize a structural deficit. One way is pinpointing certain warning signs for structural deficits – that is, features of a state tax revenue system that may contribute to structural deficits because they either compromise revenue growth or cause spikes in the need for spending. Some of these include things like sales taxes that exclude services or internet sales (see discussion on page 24 of the Primer), age-related tax breaks, and constitutional or statutory tax or spending limits.
The state’s Comptroller, for example, has pointed to the sales tax as an indicator of a structural deficit – specifically, that state sales taxes have traditionally been increased every six to eight years to keep up with the growth in government expenses. The last time that the state increased the sales tax rate was in 2002, and recently, sales taxes on groceries and income taxes on dividends have been cut.
Others point to proxies like inflation or population growth to model how state spending should grow to meet needs. The figure below shows Tennessee’s average annual state spending growth since FY 1994-1995 and within the last three gubernatorial administrations. This information is shown alongside average annual growth in a few measures that might drive or illustrate demand for state programs and services. These include state population, state personal income, and the overall state economy (i.e. the gross domestic product or GDP).
Tennessee’s constitution limits the growth in Budget expenditures paid for with state taxes from year to year to no more than the growth in the state’s personal income. However, the requirement can be overridden with a simple majority vote of the General Assembly.
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 The Sycamore Institute analysis of State of Tennessee, “Comparison of Programs” and “Budget by Functional Area” from the FY 2016-2017 Tennessee State Budget and TennCare, “TennCare Historical Expenditure and Enrollment Data.” LINK
 Tennessee General Assembly Office of Legislative Budget Analysis, “Reserves,” 109th General Assembly Budget Summary Session Report: 2016. LINK
 National Association of State Budget Officers, Fiscal Survey of the States: Fall 2010. LINK
 National Association of State Budget Officers, Fiscal Survey of the States: Fall 2012. LINK
 National Bureau of Economic Research, “U.S. Business Cycle Expansions and Contractions.” LINK
 State of Tennessee, “General Fund: Comparative Balance Sheet – June 30, 2014 and June 30, 2015” table from the FY 2016-2017 Budget.
 The Sycamore Institute analysis of State of Tennessee, “Comparison Statement of State Revenues” from the FY 2009-2010 Tennessee State Budget and Tennessee Department of Finance & Administration, “Table 2: Revenue Collections by Fund, Year to Date,” July 2016. LINK
The Pew Charitable Trusts, “Amid Slow Growth, Tax Revenue Has Recovered in 29 States,” Fiscal 50: State Trends and Analysis, September 1, 2016. LINK
 The Sycamore Institute analysis of State of Tennessee, “Comparison Statement of State Revenues” from the FY 2016-2017 Tennessee State Budget and Tennessee Department of Finance & Administration, “Table 2: Revenue Collections by Fund, Year to Date,” July 2016. LINK
 National Association of State Budget Officers, Budget Processes in the States: Spring 2015. LINK
 Susan Mattson and Kim Potts, Tennessee Transportation Funding: Challenges and Options, Office of Research and Education Accountability, Tennessee Comptroller of the Treasury, January 2015. LINK
 Tennessee Advisory Commission on Intergovernmental Relations, Building Tennessee’s Tomorrow: Infrastructure Needs Inventory July 2014 through June 2019, August 2016. LINK
 Iris Lav, Elizabeth McNichol, and Robert Zahradnik, Faulty Foundations: State Structural Budget Problems and How to Fix Them, Center on Budget and Policy Priorities, May 2005. LINK
 Tennessee Comptroller of the Treasury, Quarterly Fiscal Affairs Report: January 2016. LINK