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Flush With Cash, States Face an Uneasy Economy in 2023 | Best States

It’s been a roller coaster ride for state finances since the coronavirus pandemic hit in March of 2020, but the good news is that states entered their current fiscal year with a record level of rainy day funds.

After the nation locked down in the early days of COVID-19, revenues outpaced projections that had been lowered on account of uncertainty over the pandemic, while massive amounts of federal stimulus dollars helped states fatten their coffers.

As 2023 nears the midpoint and fiscal 2024 looms for states, finances are still in pretty good shape even though some states took the luxury of recent surpluses to enact tax cuts and other adjustments to their revenue streams. The moves included short-term help like suspending gas taxes and handing out tax rebates to more lasting reductions.

“Overall, most states have very healthy rainy day funds,” says Lucy Dadayan, principal research associate at the Urban-Brookings Tax Policy Center at the Urban Institute.

The bad news? “The revenues are really weakening, especially in states that rely on higher-income taxpayers,” Dadayan adds. “Total state tax revenues declined 2.5% in nominal terms and 8.2% in real (inflation-adjusted) terms in February 2023.”

But that is off from a year in which revenues far outpaced projections.

States are facing the same concerns over the path of the national economy and their own finances. A year ago, declines in quarterly gross domestic product led some economists to pronounce that a recession was underway. But the second half of 2022 saw the economy outperform, with gross domestic product growing at an annual rate of 2.6% in the fourth quarter.

This year, early economic data raised hopes that a recession might be averted, but with the recent banking crisis and continued interest rate increases by the Federal Reserve, economists now put the odds of a recession this year at 65%. And there remains considerable uncertainty over how quickly inflation will continue to recede.

“Overall, states remain in a strong fiscal condition,” says Brian Sigritz, director of state fiscal studies for the National Association of State Budget Officers. “It’s been a unique situation over the past couple of years.”

As they entered their 2023 fiscal years, data from the National Association of State Budget Officers shows states were sitting on a record $134.5 billion in rainy day funds. That amounted to a median of about 42 days of spending, although the numbers vary widely by state, an analysis by the State Fiscal Health project from The Pew Charitable Trusts shows. Wyoming had the equivalent of nearly a year’s worth of spending, while New Jersey had none.

“For fiscal 2023, states assumed less revenue growth,” Sigritz notes. “But it was less growth off a very high baseline. In both fiscal year 2021 and 2022, you had unprecedented growth in state revenue.”

California and New York saw the steepest declines in inflation-adjusted income tax revenues through February, dropping $3 billion, or 40.9%, in the Golden State and $2.4 billion, or 36%, in the Empire State, according to Dadayan.

California is a prime example of how revenues have fluctuated since the pandemic. After the coronavirus struck, the state – along with many others – forecast a sharp downturn in revenues and a $54 billion shortfall, only to see employees turn to remote work, the stock market rebound and federal stimulus programs provide trillions in dollars to the economy. Last year, California had close to a $100 billion surplus. Now, the state faces a projected deficit of $22.5 billion.

The volatile swings are not just the result of the pandemic, however. California has a highly progressive income tax that relies heavily on high-income taxpayers. A slowdown in the tech industry, along with a drop in initial public offerings of stocks by young companies, dampened revenues coming into the state’s coffers.

California does have a projected $22.4 billion reserve fund, although Democratic Gov. Gavin Newsom has said he may choose to prioritize budget cuts over tapping the reserves until tax collections are tallied.

Dadayan notes that states have varying revenue streams and are affected significantly by trends in the national economy. While states like California and New York saw sharp declines due to their heavy reliance on personal income taxes, for example, states such as Alaska, Texas and West Virginia saw strong revenues by benefiting from tax regimes that depend on taxes on the energy industry, which has done well in recent years.

On top of hits from income taxes, states are also seeing a shift in consumption patterns as Americans spend more on services like eating out or getting a haircut and less on long-lived goods such as furniture that were more popular during the height of the COVID-19 pandemic.

“However, the weakening in state tax revenues in recent months is also in part caused by state policy decisions,” Dadayan says, adding that many states saw their bulging treasuries as a reason to give money back to their citizens in the form of rebates and other relief.

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CARRIZO PLAIN NATIONAL MONUMENT, CA - APRIL 22:   Following recent record-setting rains, the hillsides and pastures are covered in a carpet of goldfields, phacelia, and other wildflowers, drawing thousands of visitors to this remote, dusty part of California that is home to thousands of migratory birds and the largest alkali wetlands in the state, as viewed on April 22, 2023, in Carrizo Plain National Monument, California. Located in the southeastern corner of San Luis Obispo County between the Temblor and Caliente mountain ranges, this 43-mile- long high valley is experiencing an epic wildflower superbloom of goldfield, tidy tips, fireweed, fiddleheads, poppies, lupine, baby blue eyes, and hillside daisies.  (Photo by George Rose/Getty Images)

Rebates or relief payments ran as high as $1,500 in New Jersey, per Dadayan. Mississippi took a different approach in 2022, passing a tax cut of $525 million over four years. Some lawmakers have wanted more, floating proposals that call for eliminating the income tax completely or issuing a $500 rebate per taxpayer. But those now appear dead.

For the 2024 fiscal year, states are projecting revenue growth overall of 0.7%, according to Dadayan. Personal income taxes are forecast to rise by 1.2%, while sales tax receipts are estimated to increase by 1.9%.

Much will depend on the strength of the U.S. economy. A majority of economists are predicting a recession in 2023, although most believe it will be mild. But if unemployment rises much and consumers turn conservative with their spending, state income and sales tax revenues would likely be adversely affected.

At least for now, states have a record rainy day stash to handle any adversity.

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