The Big Debate Around Statehouses: What to Do With Budget Surpluses

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Public Finance Update - June 7, 2022

Welcome back to another edition of Route Fifty’s Public Finance Update! I’m Liz Farmer and  this week I’m looking at the major themes in the upcoming state budgets. In the last post-recession era, passing a budget was a harrowing balancing act between cutting services or raising taxes and fees. Deficits were an annual occurrence in a number of places and the federal government largely left states alone to figure it out. 

Not so this time around. 

This newsletter looks at what states are doing with their surpluses and why—in at least one state—getting a budget passed before the July 1 fiscal year start is still going to be a nail-biter. As always, send feedback and tips to: publicfinanceupdate@routefifty.com.

States had another year of exceptional revenue growth driven in part by rising inflation, increased consumer spending and federal pandemic aid. Many are ending the current fiscal year, which wraps up June 30 in most states, with large surpluses, and the big debate in statehouses has been around what to do with the extra money.

Income tax breaks have been the most popular response, an unsurprising development given that it’s an election year for most legislators and governors. Still, the conversation around how to reward taxpayers has been noticeably prudent, said Fitch Ratings analyst Eric Kim.

“The question in a lot of places is how much of this [surplus] is recurring revenue and how much of it is really a one-time shot in the arm?” he said. “Hashing that out is complicated and we expect states to manage their situations with a focus on the long term.”

As such, about a dozen states are generally either implementing one-time rebates or income tax rate cuts that are phased in based on economic triggers. 

Georgia is one place that’s doing both. In April, Gov. Brian Kemp signed measures that provide a one-time $1 billion personal income tax refund and an income tax cut that could eventually total more than $2 billion if state revenue holds up. Georgia’s top rate of 5.75% will drop to 5.49% on Jan. 1, 2024, then lower incrementally each year the state’s revenue grows by at least 3%. The target rate is a flat income tax of 4.99%

Gas tax holidays and grocery tax cuts are two other ways states are giving back to taxpayers in the short and long term.

Generally, the cost of these tax cuts are minimal for states, according to Fitch. Those that have implemented larger cuts (Idaho, Iowa, Nebraska and Oklahoma) have healthy reserves and the budgetary flexibility to adapt to any revenue stresses that may emerge, the agency said.

A Stalemate in Arizona

More than 40 states have passed budgets or have one waiting to be signed by the governor. A few, like California, are making adjustments based on new revenue projections before final approval. But Arizona lawmakers have been at an impasse for over a month and for the second time in two years, the state’s budget is expected to come down to the wire.

At issue is a $5 billion surplus. Republicans, who control the state House and Senate by just one seat each, are divided on what to do with it and the disagreement has pushed the legislature more than 40 days past its usual 100-day session.

In April, lawmakers tried passing a “skinny” budget as a stopgap measure that used the current budget as a baseline and adjusted spending for inflation. But even that failed due to the ideological split: Some members didn’t like leaving the surplus unspent while others thought the budget wasn’t “skinny” enough.

Even so, Ben Giles, statehouse reporter for radio station KJZZ in Phoenix, said he thinks lawmakers are motivated to reach a solution to avoid a government shutdown on July 1. 

"Early voting for the primaries starts in early July, and it's a big election year,” he told Route Fifty. “So it would look pretty bad if they fumbled on this."

Clouds on the Horizon

Of course, the state budget debate hasn’t just been about what to do with extra money. Lawmakers also are contending with sobering issues such as a public sector workforce staffing crisis, the impact of rising inflation on costs, and worries of a recession in the near future.

Brian Sigritz, director of state fiscal studies for the National Association of State Budget Officers, recently said during an Urban Institute event that states are seeing “very high” vacancy levels, particularly in public safety. 

“States are having a very hard time recruiting for their departments of corrections and we’ve seen more than the usual number of governors proposing salary increases,” he said, adding that the pay bumps are also in response to rising inflation. 

States are raising salaries for teachers too. In some states, especially those that rank low on the pay scale, the salary boost is the largest statewide salary increase for educators in decades, reported The New York Times. Alabama, Florida, Georgia, Mississippi, New Mexico and Virginia are just a few of the states that have approved significant educator pay bumps.

Besides increasing salaries, states are using surpluses to pay down existing debt and make extra pension payments, Sigritz said. These moves will also help stabilize state budgets in the event the economy does contract over the next 12 months.

Louisiana, for example, is using some of its surplus to pay off hundreds of millions of dollars in federal debt related to natural disasters, including a $400 million payment to close out its bill for the hurricane protection system built after Hurricane Katrina in 2005. 

Meanwhile, inflation is expected to impact government borrowing. Rising interest rates will make it more expensive to issue debt and bond refinancing activity is expected to slow down this year as a result.

What’s more, states have not only restored their budget reserve levels since dipping into them in 2020, but rainy day savings are at an all-time high. Last year, states grew their collective rainy day funds by $37.7 billion, or an increase of roughly 50% from fiscal 2020, pushing the total held among all states to $114.6 billion, according to The Pew Charitable Trusts.

“We are already clearly slowing down from what was a breakneck pace,” said Kim. “As we get further into the [calendar] year, states will begin hearing more from economists and budget analysts about how they should start thinking a bit more about a recession and how to prepare for it.”