Ask an Economist: States' Rainy Day Funds Grow as Tax Revenue Strengthens
Many state governments have seen solid growth in their tax revenue over the last two years. A study led by Kansas City Fed Research and Policy Officer Huixin Bi shows that recent changes in the federal tax code contributed to the uptick in states’ revenue. The study explores how states have used this revenue windfall to build rainy day funds at a much faster pace than before the Great Recession.
How much recent tax revenue growth have states experienced?
According to the Fiscal Survey of States by the National Association of State Budget Officers, state revenue collections grew 7 percent on a nominal basis in fiscal year 2018, compared with 2.4 and 1.8 percent in fiscal 2017 and 2016, respectively.
Also, strong gains in April tax collections led many states to end fiscal 2019 with revenue growth higher than estimated.
Do special circumstances contribute to revenue increases?
Yes. The Tax Cuts and Jobs Act (TCJA) of 2017 enacted changes in the federal tax code regarding personal income and contributed to the uptick in states’ revenues. The size of this boost varies depending on how states choose to measure personal income. For example, various states may use federal tax income (FTI), federal adjusted gross income (AGI), or their own definition of income as a starting point for state income taxes.
The majority of changes in the TCJA that broadened the tax base, such as eliminating personal exemptions and limiting itemized deductions, directly affected FTI but not AGI. Our study showed that states using FTI saw much stronger growth, as they directly inherited most TCJA changes. States using AGI or their own definitions would have needed to take legislative actions to conform with the federal tax code.
How do tax windfalls help states weather economic downturns?
Rainy day funds are reserves that help states manage budget shortfalls during times of economic slumps or declines. In recent years, states have bolstered these reserves at a much faster pace than before the Great Recession. From fiscal 2003 to 2007, GDP-weighted state revenue grew at an average annual rate of 7.3 percent.
Over the same period, states raised their GDP-weighted average of rainy day funds (measured as a share of state expenditures) by only 0.44 percent. By comparison, in fiscal 2018, state revenue grew at a slightly faster pace, but the increase in rainy day funds more than tripled to 1.52 percent. Also, before the recession, states with smaller rainy day fund balances did not appear to invest many resources in shoring up these funds. However, by fiscal 2018, states with smaller or no rainy day funds—such as New Mexico, Connecticut and Oklahoma—had raised their rainy day funds at a much faster pace than most states.