While the federal government struggles to rein in the deficit and come to an agreement on the nation’s debt ceiling, Virginia announced a revenue surplus of $311 million in its General Fund, which covers most of the traditional state services. Virginia is not alone, as more than two dozen states have reported revenue surpluses for the fiscal year that ended on June 30.
Every state except Vermont has a statutory or constitutional requirement to balance its budget. However, through a combination of spending cuts and revenue increases, many states have gone a step further and actually have some funds left over. The key question is whether or not these surpluses are sustainable.
To answer this question, we first need to examine how so many states were able to build up surpluses during such difficult economic conditions in the first place. The primary method has been spending cuts in all major areas of services, including healthcare (31 states), services to the elderly and disabled (29 states and the District of Columbia), K-12 education (34 states and the District of Columbia), and higher education (43 states), to name a few. As seen in Figure 1 below, there was a 10 percent reduction in General Fund spending between fiscal years 2008 and 2010. While spending increased in fiscal 2011, it was still significantly below pre-crisis levels.
Another factor that has helped states build up surpluses is the increase in tax revenues, as shown in Figure 2 below. While spending cuts in 2009 and 2010 were insufficient, by themselves, for most states to run a surplus, a combination of lower spending and higher tax revenues (a 6 percent increase) in fiscal 2011 enabled many state governments to keep their books in the black. It is important to note that this growth in revenues was largely driven by a jump in sales taxes receipts and personal income rather than higher tax rates.
So, are these surpluses sustainable? State government spending is projected to increase in fiscal 2012, but so are revenues, which might suggest an equal effect on both sides of the state government’s ledger and continuation of surpluses. Unfortunately, the picture isn’t so rosy when you dig into the details.
First, research from the Federal Reserve Bank of Cleveland suggests that the increase in tax revenues may be transitory because it was not driven just by an increase in wages but also by the capital gains taxes. Heightened uncertainty about increasing capital gains taxes, combined with the removal of income restrictions in 2010 on the conversion of traditional IRAs to Roth IRAs (where the amount converted is taxable) may have played a role in boosting states’ revenue. There is no way to know for sure because states don’t report capital gains revenue consistently or in real time, but if the source of the revenue growth was capital gains taxes, revenues might fall back down to 2009-2010 levels.
Second, states face the wind down of significant funding that was provided through the American Recovery and Reinvestment Act of 2009. As Figure 3 below shows, that temporary federal aid to states will fall from $89 billion to $23 billion in the coming year.
Third, and most importantly, are the unfunded liabilities of state pension and retiree health plans. For example, while Virginia claimed a budget surplus of $311 million this year, it also withheld $620 million in contributions to the state employees’ pension fund. This effectively means that Virginia is borrowing from its pension fund to avoid balancing its budget. In fact, while defenders of public employees argue that public pensions only cost state and local governments less than 4 percent of their budgets, this proportion is artificially low because of improperly valued pension liabilities. In total, states report underfunding in their pension plans of $438 billion. However, as Andrew Biggs highlights in his Retirement Policy Outlook, the market value of these public-sector pension deficits is in excess of $3 trillion. Therefore, correctly valued, state and local governments should dedicate almost one-quarter of their budgets to public employee pension funding and an additional 7 percent for the costs of health benefits for retired public employees.
Clearly, there is a long way to go before states can claim to have their fiscal house in order.