The States That Could be Headed for a ‘Fiscal Cliff’

California, Illinois and Pennsylvania could run into budget trouble in a few years, because they’ve been using a one-time surge of money from the federal government to pay for long-term expenses, fiscal experts warned Wednesday.

The sobering warning comes even as states are flush with cash, thanks to strong consumer spending and low unemployment. Some states are reaping the rewards of booming oil prices and, until recently, people trading high-flying tech stocks.

The Volcker Alliance, a nonprofit group that promotes responsible government spending, said the three states are among the most vulnerable for budget stresses when funds from the American Rescue Plan run out in 2026. President Biden signed the coronavirus relief law during his first few months in office. It contained $350 billion for state and local government relief.

The three states stood out because they used a substantial amount of their Rescue Plan money to make up for revenue lost in the early days of the pandemic, when tax revenues seemed to evaporate overnight. At least 12 states told the U.S. Treasury that they would use their aid to help with revenue recovery, the Volcker Alliance noted.

Congress specified that states could not salt away the aid money for later use in reserve funds. It also prohibited states from using the federal dollars to pay down pension obligations or pay off certain kinds of debt.

States have to be careful which projects they fund with the money, to make sure that they don’t create longer-term problems, said Beverly Bunch, a professor at the University of Illinois Springfield’s School of Public Management and Policy and the author of the Volcker Alliance report analyzing the spending of the Rescue Plan money.

“Are [the projects] one-time or short-term, or are they continuing?” she said in an interview. Illinois, for example, has allocated $300 million for anti-violence programs in its new budget. It’s not clear how the state will pay for that program after the federal money dries up. It could raise new revenue or hope that revenues grow enough over time to cover the added expense.

“We’re not saying, ‘Don’t do that.’ We’re saying, ‘Take a good look and have a strategic plan for how you’re going to finance it,’” Bunch said.

Illinois, however, has improved its financial situation since the pandemic began. It received bond rating upgrades from all three major rating agencies, paid off a substantial part of the debt it owed the federal government for unemployment insurance and eliminated its perennial backlog of unpaid bills to vendors.

California, which is flush with a surplus, could face budget troubles soon, said William Glasgall, the director of public finance at The Volcker Alliance. On the spending side, a 1979 ballot measure limits what lawmakers can spend new money on, while separate voter initiatives require increased spending on priorities such as schools, community colleges and debt payments.

California, like New York, New Jersey and Connecticut, depends heavily on capital gains taxes to fill its coffers, but the stock market has lost ground over the last month. If the slide continues, it could wipe out much of that income tax revenue.

“When the stock market is booming, you generate a lot of capital gains. When the stock market is sucking wind, you don’t,” Glasgall said. “Capital gains are kind of the oil and gas of these states, because the markets are so volatile.”

California, unlike many other states, also chose to spend almost its entire allocation of Rescue Plan money right away, which increases the pressure to keep up those heightened levels of spending, Bunch added.

Pennsylvania, meanwhile, told the Treasury Department that it had plans for 63% of its allocation of Rescue Plan money, and that all of that would be dedicated to revenue replacement. That gives it substantial flexibility in how it can spend the money. State officials said they would use it to cover increased Medicaid spending, a boost for early childhood education programs to schools, and more support for local health departments.

“Although some of the health-related spending might be temporary, depending on the pandemic, education needs are likely to continue,” the Volcker Alliance noted in its report. “Pennsylvania appears to be putting some of its [Rescue Plan] support toward ongoing needs, which may present fiscal challenges after those funds are no longer available.”

The Volcker Alliance said states need to be mindful of what happens after the federal money runs out to avoid the types of budget pain they experienced in the Great Recession. Federal stimulus funds ran out just as state budget shortfalls hit their peak in 2010.

“To help narrow the gaps, states shed almost 150,000 jobs and took actions that included Illinois borrowing $7.2 billion to cover government worker pension contributions and California and Florida reducing support for and raising tuitions at public universities,” Bunch noted in the report.

State officials did learn some lessons from the Great Recession, though. They built up rainy day funds to alleviate some of the budget pressures from revenue drops.

And state and local governments have only slowly added more people back to their payrolls, even though state revenues recovered quickly after their initial slide in 2020, Glasgall noted.

Still, revenue recovery was the most popular category of spending among states for their Rescue Plan money, according to plans submitted to the U.S. Treasury Department in August. It accounted for nearly 31% of all planned spending.

Congress laid out specific ways that states could use the money, and it required states to share their plans with Treasury.  

The second-most popular use for the money was to help businesses and residents who were negatively affected by the economic fallout of the pandemic. States, in total, planned to spend nearly 28% of their Rescue Plan money on those programs.

Infrastructure improvements (for water, sewer and broadband upgrades) came in third, at roughly 17% of planned spending. Services to disproportionately impacted communities accounted for nearly 15%.

Close to 9% was dedicated to public health, according to the Volcker Alliance.

The Rescue Plan prohibited states from using their federal aid to pay for tax cuts, but that has proven to be hard to enforce practically and legally. At least 20 states have challenged that part of the law, and many of them have gone ahead with tax breaks.

Bunch said those could pose problems in the long run, too. 

Legislators are “looking at the short term: ‘We’ve got all this money, we’ve got surpluses, we’ve got elections coming up, [so] why not decrease taxes?’” she said. “If they’re temporary decreases, then OK, maybe we can recover. But what if they’re long-term, permanent ones? And then what happens when the federal funds go away? Is that creating its own kind of fiscal cliff?”