Are state budget reserves adequate to handle a recession? It depends.

Washington Research Council analysts Emily Makings again examines the question of the adequacy of state budget reserves. Her assessment draws upon State Treasurer Duane A. Davidson’s recent Debt Affordability Study 2020. The study shows, as Makings writes,

…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.”

The adequacy of budget reserves are particularly relevant in this session. First, because recession risks remain somewhat elevated during this extended period of economic uncertainty. As we’ve reported, recession is the “top external worry” of business leaders. And, second, because Gov. Inslee’s proposal to dip into budget reserves to fund homelessness programs has sparked some legislative controversy. 

Last year, Pew Research reported that Washington was in better shape to handle a recession than most states. Returning to the treasurer’s debt study, Makings writes,

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.

Davidson’s report includes this chart, showing unobligated balances and the budget stabilization account as a percentage of state spending.

As she points out, there is no fixed guidance on how much a state should have in reserves; the volatility of a state’s revenue stream is an important variable. States that rely heavily on graduated personal income taxes, including capital gains taxes, need larger reserves because of the volatility of those taxes.

Commenting on the November revenue forecast, WRC economist Kriss Sjoblom wrote,

Given the substantial probability the ERFC places on the pessimistic scenario, the governor should propose a budget that preserves a healthy four-year reserve.

It’s unlikely that any state can or should maintain reserves at the level required to weather a deep recession. But being prepared to handle a moderate recession is a reasonable expectation. According to Moody’s, then, the target should be 9.6 percent. As noted above, he treasurer recommends 10%.

Makings writes,

…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.

We again emphasize the importance of fiscal restraint and maintaining adequate reserves, particularly in times of high economic uncertainty.