Reserve balance recommendations from the state treasurer and Moody’s

By: Emily Makings
3:43 pm
January 16, 2020

The state treasurer released the 2020 Debt Affordability Study this week. It notes that in FY 2018, Washington’s debt per capita was the sixth highest in the country at $2,512. That said, “when the broader liability profile, including pension and OPEB liabilities, is taken into account, Washington’s liability metrics are near the national median measures and the State’s relative ranking improves significantly.”

More interesting to me, however, were some of the treasurer’s recommendations. He recommends that the state

  1. “establish a formal policy with targeted amounts” for the unrestricted general fund balance,
  2. maintain the budget stabilization account (BSA, or rainy day fund), and
  3. “set a target amount for the BSA of 10% of revenues.”

On the first point, any resources that aren’t spent by the state form the unrestricted ending fund balance. They then become the beginning balance for the next year and are available for appropriation. With the four-year balanced budget requirement, legislators have an incentive to leave funds on the table in the current biennium to help balance the budget over the second biennium. The treasurer points to a recommendation from the Government Finance Officers Association that states should keep two months of operating revenues in the unrestricted fund balance. Although more saving would be a good thing, my first thought is that it may be more practical to increase the transfers to the constitutionally-protected rainy day fund than to set a target for the unrestricted balance.

On the third point, although there is not currently an explicit target for the BSA balance, the state constitution provides that when the BSA balance reaches 10 percent of general state revenues, the Legislature may appropriate the excess funds to the education construction fund with just a simple majority. As we noted in our policy brief on the governor’s 2020 supplemental budget proposal, if no appropriations are made from the BSA in 2019–21, its balance is estimated to be 8.5 percent of general state revenues. If $318.7 million is appropriated from the BSA for homelessness programs, as proposed, the BSA balance would drop to 7.3 percent of general state revenues.

As we’ve written, these days budget experts suggest that the appropriate amount of reserves will be specific to each state and will depend on things like revenue volatility. The treasurer cites an October 2019 report from Moody’s in which they updated their stress tests of states. Stress-testing is a way to determine how a recession might impact a particular state and to show whether current reserves would be sufficient to weather that recession.

Moody’s finds that, in 2019, Washington was prepared for a moderate but not a severe recession. To avoid spending cuts or tax increases in a moderate recession, a typical state would need to have 11.2 percent of revenues in reserves and Washington would need to have 9.6 percent in reserves. To avoid spending cuts or tax increases in a severe recession, a typical state would need to have 16.1 percent of revenues in reserves and Washington would need to have 15.0 percent in reserves.

Moody’s notes, “In general, states that rely the most on commodities and very progressive income taxes experience the most potential stress.” The report also discusses the role of income taxes in revenue volatility:

Personal income tax revenues are much more volatile than sales taxes because they are linked explicitly to personal income and not personal consumption, which proves much more stable over time. What is more, as part of more explicit tax reforms, which have taken place largely over the past two decades, many states have exacerbated that volatility by moving to more progressive personal income tax structures targeting their highest earners. An unintended side effect of that progressivity is greater amounts of volatility in the tax code. By putting more of their eggs in one basket, states have made their tax bases more dependent on a smaller number of taxpayers with extremely volatile incomes, manifesting higher highs and lower lows for tax collections.

When states have such volatile revenue sources, it is even more important that they maintain strong reserves.

Finally, a recommendation from Moody’s for states: “To sufficiently protect their budgets and their economies from increased volatility and fiscal drag, state and local government policymakers should be investing in their budget processes and making stress-testing a higher priority.”

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