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How States Can Plan for Budgetary Effects of Coronavirus—and Market Swings

Stress testing procedures help policymakers anticipate a range of scenarios

By The Pew Charitable Trusts, March 16 2020 11:02 am

CONTENT PROVIDED TO THE NEW JERSEY GLOBE FROM THE PEW CHARITABLE TRUST
by JEFF CHAPMAN

The coronavirus is already affecting state budgets, from pressure on public health systems to revenue losses from canceled events. Lawmakers in states such as California are passing emergency funding measures, while other officials—including Maryland Governor Larry Hogan—are looking at withdrawing money from rainy day funds to meet emergency needs.

But the ultimate fiscal impact of the outbreak—and of the recent drop in oil prices—is highly uncertain. In addition, state legislatures will need to wrap up their budgets for fiscal year 2021 well before having any clear answers. With such a high level of uncertainty, policymakers need to design contingency plans that begin with robust reserves. If they don’t have such reserves, lawmakers may find that when they return to their capitols next year—or sooner if they need to hold emergency sessions—they will need to identify tax increases and spending cuts.

But how cautious should states be? No matter how events unfold, the current situation serves as an example of why policymakers need to think regularly about the resilience of their budgets. Circumstances outside the control of state governments—and that could have a significant impact on revenues and expenditures—tend to occur with little warning.

To be better prepared,  a handful of states have begun using “budget stress tests” to examine different scenarios and estimate potential shortfalls from adverse events—such as the fiscal and economic effects of a fast-spreading disease, for example. By using these estimates to plan, policymakers can reduce the impact of a fiscal crisis and keep long-term priorities on track.

In this case, a stress test would start by looking at the possible impact to a state’s economy of the coronavirus and oil price shocks. The potential effects will differ by state or region: For example, if the disruption in world trade continues to reduce imports and exports, manufacturing states that are more reliant on the global economy for raw materials and parts could be particularly vulnerable. If travel continues to decline because of legal restrictions, widespread illness, or people avoiding others who may be sick, states with tourism-based economies may feel the impact especially hard.

The testing helps analysts translate perceived economic vulnerabilities into potential fiscal impacts, including reductions in revenue because of declining economic activity or increased pressure on Medicaid programs. Again, each state may have unique fiscal vulnerabilities, such as a tax system that relies heavily on severance taxes on oil production or an unemployment insurance trust fund in danger of insolvency.

Stress tests cannot predict how adverse events like those facing states today will play out, but they can help estimate the size of a budget gap under various scenarios. By considering a range of possible outcomes—from a milder impact to more severe—lawmakers can determine the amount of risk they are willing to accept.

With information from these tests, budget writers can then compare potential gaps between revenue and spending with the resources available to make up the difference. If they find they have insufficient funding options to close any potential hole, they may choose to boost savings or forgo new tax cuts or spending plans until more information is available.

Ideally, this testing would happen as part of the regular budgeting process. For example, Minnesota has been using stress testing to set targets for how much money the state needs to save to cover unanticipated revenue shortfalls for at least two years. When the state has a budget surplus, one-third of the extra money is automatically deposited in the rainy day fund—under state law—until the target is met.

Regardless of what kind of impact the coronavirus ends up having on state economic and fiscal conditions, this kind of uncertainty can throw fiscal policy into disarray—unless lawmakers employ strong analytical tools, such as budget stress tests, that can give them the information they need to make educated decisions that meet the needs of their constituents.

Jeff Chapman directs The Pew Charitable Trusts’ state fiscal health initiative.

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