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State Strategies to Manage Budget Shortfalls

Contents

• Front Matter
• Chapter 1. Causes of Budget Shortfalls
• Chapter 2. State Efforts to Manage Budget Shortfalls
• Chapter 3. State Methods to Avoid or Minimize Budget Shortfalls
• Limiting Appropriations to a Percentage of Estimated Revenues
• Contingency Budget Reductions and Trigger Mechanisms
• Case Study: Contingency Budgeting In Arkansas
• Case Study: Trigger Legislation in California
• Budget Stabilization Funds
• Case Study: Indiana's Counter-Cyclical Revenue and Economic Stabilization Fund
• Case Study: Pennsylvania's Tax Stabilization Reserve Fund
• Chapter 4. Options to Reduce State Spending in Major Program Areas
• Chapter 5. State Expenditures That Cut Across Programs

3. State Methods to Avoid or Minimize Budget Shortfalls

This chapter reviews several techniques for avoiding or minimizing budget shortfalls:

• Limiting appropriations to a percentage of estimated revenues;
• Imposing contingency budget reductions and trigger mechanisms; and
• Creating and adequately funding budget stabilization funds.

Limiting Appropriations to a Percentage of Estimated Revenues

Five states limit appropriations to avert budget shortfalls due to the unpredictability of revenue. These five states--Delaware, Iowa, Mississippi, Oklahoma and Rhode Island--limit appropriations to a set percentage of the official general fund revenue forecast; the limits exclude appropriations of federal funds. Although two of the measures date back to the 1980s, three were implemented in 1992--just as states were beginning to recover from the fiscal problems of the early 1990s. Three of the provisions are constitutional, and two are statutory. As shown in table 3, the limits range from 95 percent in Oklahoma to 99 percent in Iowa.

The primary goals of the measures are to improve cash management and enhance overall stability. The limits almost ensure a balanced budget. If revenue collections match or exceed the estimate, the process generates a reserve that can be used as a financial cushion against future problems. Some states also consider the limit a fiscal discipline tool.

The measures are similar in design and function. Each of the five states links its provision to its budget stabilization fund. There are some differences, however.

Delaware. Delaware's provision, the first one implemented, allows any general fund revenues in excess of the 98 percent limit to be appropriated in the event of an emergency. The appropriation must be approved, however, by three-fifths of the members elected to each house of the General Assembly. If the funds are not appropriated for an emergency, they must be deposited in the state's budget stabilization fund (the Budget Reserve Account) and are subject to the provisions governing that fund.

Iowa. State statutes require the governor to use the appropriations limit when preparing the budget and the General Assembly to use it in the budget process. The limit is 99 percent of the adjusted revenue estimate, except that the limit is reduced to 95 percent for any new revenue source for the first year that the new revenue source is in place. New revenues refer to money received from new or increased taxes and fees. Any revenues in excess of the appropriations limit flow to the state's budget stabilization fund (Cash Reserve Fund). Once that fund's cap is reached, the money goes to an emergency fund (Economic Emergency Fund).

Mississippi. As part of budget reform in 1992, Mississippi implemented its 98 percent limit on legislative appropriations from the general fund. The limit began with the appropriations for FY 1994. Any collections above 98 percent of the revenue estimate are considered lapsed funds and remain in the general fund until the end of the fiscal year. At that time, half of the general fund ending balance becomes available for appropriation, and the other half is transferred to the budget stabilization fund (Working Cash-Stabilization Reserve Fund). Once that fund has reached its cap, the extra money is deposited in a special fund for education.

Oklahoma. The Oklahoma Legislature is constitutionally limited to appropriating no more than 95 percent of the official state revenue forecast. Between 35 and 45 days before the Legislature's regular session convenes, the State Board of Equalization certifies revenue projections for the coming year and calculates the 95 percent amount. If the other 5 percent of the estimate is collected, it stays in the general fund as a reserve until the fiscal year is over and then becomes available for appropriation. Any revenue that comes in above 100 percent of the official forecast is deposited in the state's budget stabilization fund (Constitutional Reserve Fund) and is subject to the provisions governing that fund.

Rhode Island. Approved in a statewide referendum in 1992, Rhode Island's provision limits general fund appropriations to 98 percent of estimated general fund revenues. Any revenues between 98 percent and 100 percent must be appropriated to the budget stabilization fund (Budget Reserve Account), provided that the deposit does not cause the fund to exceed its cap. If the cap is met, the extra money must be used for reducing state indebtedness, paying debt service or funding capital projects.

Although the provisions in these five states are intended in part to impose fiscal discipline, they do not necessarily limit expenditure growth. If, for instance, revenues are growing at a healthy pace, state spending is also being allowed to grow, although not as much as revenue. Taxes also may be increased or money may be transferred from other funds to supplement general fund resources. Such actions can allow state spending to grow within the constraints of the appropriations limit.

Furthermore, these limits do not guarantee that a state will avoid a budget shortfall. If actual revenues are substantially below projections, spending could exceed revenue collections, leading to a budget gap. Once again, the unpredictability of state revenues emerges as a major contributor to budget problems. Another drawback is that revenue estimators may consciously or unconsciously make higher projections because they know that only a percentage of the estimate will be appropriated.

In addition to the five states that limit appropriations to a percentage of the official general fund revenue forecast, several states have taken other steps to ensure minimum ending balances in their general funds. For example, a Kansas statute enacted in 1990 and modified in 1994 requires a targeted year-end balance for the state's general fund. The minimum balance prescribed by law was 5 percent of total authorized expenditures in FY 1992 and was increased each year to reach 7.5 percent by FY 1995. In Wisconsin, a law enacted in 1977 and modified several times requires an annual year-end general fund balance of no less than 1 percent of general fund expenditures.

Contingency Budget Reductions and Trigger Mechanisms

Another method states have adopted to address fiscal uncertainties is contingency budgeting. A contingency plan anticipates events and the necessary actions to be taken to produce a specific outcome. For example, an event (a revenue shortfall) triggers an action (budget cuts) to produce a desired outcome (a balanced budget). Most states use some form of contingency planning to address budget problems because the other common option--calling a special legislative session to readdress the budget--can be costly and time-consuming. The contingency plans in most states grant the governor some authority to reduce appropriations when the state encounters unanticipated budget problems. In many instances, the governor's authority is limited to specific actions, or the legislature must approve the actions. (For more information on this topic, see Legislative Authority Over the Enacted Budget.)

Despite the time- and cost-saving elements of contingency budgeting, it has important drawbacks. Most notably, contingency provisions by their nature may provide the executive branch with more budget decision making and control than most legislators prefer. Further, large shortfalls may require extensive cuts that, when imposed by the governor, dramatically change legislative spending priorities. To prevent this from happening, legislators may actually prefer convening in a special session.

Because most governors have authority to cut the budget to address budget problems, few states design the budget with contingency budget reductions built into the process. Arkansas and Kentucky are exceptions. In Arkansas, contingency budgeting requires that agencies prioritize their spending so that reductions are predetermined if revenues do not materialize as projected. In Kentucky, the legislature enacts budget reduction and surplus expenditure plans each year that establish the legislature's spending priorities in the event that either a revenue shortfall or a surplus develops. On a less regular basis, states may adopt special contingency plans or trigger mechanisms if budget problems appear to be a strong possibility.

Arkansas and California present two different models of how states can apply contingency or trigger mechanisms to the budget process to mitigate revenue shortfalls.

Case Study: Contingency Budgeting In Arkansas

Case Study: Trigger Legislation in California

As the 1990s began in California, so did a new era of financial hardship and budget deficits. In response, the legislature adopted a two-year plan in 1994 to eliminate the state's budget deficit by the end of the 1995-96 fiscal year. The financing of that plan included the sale of revenue anticipation warrants--short-term bonds that will be repaid from the state's future revenue collections. To ensure that the state would be able to meet its debt repayment obligations, the legislature enacted Chapter 135/94 (SB 1230)--known as "trigger legislation."

The legislation established a fiscal monitoring and adjustment process designed to guarantee that the state would have sufficient cash to repay the revenue anticipation warrants. Projection of a certain level of budget shortfall would "trigger" action to mitigate the shortfall. With the input of the legislative analyst (a legislative fiscal officer), the state controller was required:

• To determine on Nov. 15, 1994, whether the general fund's anticipated year-end cash position had worsened by more than an acceptable amount; and
• To determine on Oct. 15, 1995, whether available cash projected for the end of 1995-96 would fall short of the amount needed to repay external borrowing.

If the state controller determined that a shortfall of sufficient size was projected, the legislation directed the governor to propose new legislation that would provide for general fund expenditure reductions, revenue increases or both to offset the amount of the estimated 1995 or 1996 cash shortfalls. If legislation was not passed by Feb. 15 of the fiscal year, the director of finance would apply automatic across-the-board spending cuts to all general fund programs, except those protected by federal law or the state constitution (primarily K-14 school funding).

The trigger legislation required the legislative analyst to assist the state controller by providing an analysis of general fund revenues and expenditures and to review the state controller's estimate of the state's cash position within five working days of the determination. Under the trigger law, the state's cash position was measured by the estimated amount of "unused borrowable resources" remaining available to the general fund on June 30 of the fiscal year. Unused borrowable resources referred to total available borrowable resources on that date, less total cumulative loan balances on that date.

Borrowable resources consisted of internal borrowable resources (cash balances in special funds that the general fund may legally borrow) and external borrowable resources (such as the proceeds from the sale of revenue anticipation notes and warrants). The amount of unused borrowable resources is the difference between total borrowable resources and the amount of these resources that already has been borrowed by the general fund to finance its cash needs.

As it turned out, the trigger was not pulled in 1994-95 because on June 30, 1995, the state controller projected a $581 million improvement in California's general fund, and the legislative analyst agreed that the controller's estimate of the state's cash position was reasonable. This put the state well above the cash position that would have set off the trigger. Budget improvements in fiscal year 1995-96 also prevented the trigger from being pulled.