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How Big Should State Balances Be?
How big should state balances be? That depends on what state balances are for.
Balances are the amount of money the state has in the bank, usually measured at the end of each fiscal year in June. At the end of fiscal 2011, Indiana is expected to have $678 million in balances, just over 5 percent of the size of the budget.
Balances are used for cash flow, to help the state pay its bills on time. It's usually said that a state needs balances at 5 percent of its budget to handle cash flow. That's what Indiana does. In the past 35 years balances have never fallen much below 5 percent.
Another use for balances is to cushion the budget during recessions. When revenues drop, the state can draw down balances to maintain spending and prevent tax hikes. Without balances the state would have to cut spending as soon as a recession started.
How big should state balances be to protect spending and taxes from recessions? Let's look at the last two recessions. The big revenue shortfalls happened in fiscal years 2001-2003 and 2009-2011.
Indiana started fiscal 2001 with balances of $1.6 billion, a substantial 18 percent of the budget. The 2001 budget was intended to reduce this balance by $345 million with tax cuts and spending hikes. That was a legacy of the good times in the 1990s. Then a recession hit, and revenues dropped below forecasts by $721 million. Now the shortfall was almost $1.1 billion. Balances were reduced by $728 million, and the rest was covered by spending cuts and money transferred from other funds.
There were worse years to come. During 2001 through 2003 revenues fell $3.4 billion below planned spending. All available balances were used. Fund transfers, delayed payments to local governments and spending cuts covered the rest.
So how much in balances would the state have needed at the start of 2001 to avoid those spending cuts, fund transfers and payment delays? About $3.9 billion: the $3.4 billion shortfall, plus a 5 percent balance at the end of 2003. That would have been 42 percent of the budget. Covering just the first year's gap would have required balances at 17 percent of the budget, slightly less than the state actually had.
Balances were built back to $1.4 billion by the beginning of fiscal 2009, about 11 percent of the budget. The recession began in December 2007 and then turned into the Great Recession with the financial crisis in fall 2008. The bottom fell out of revenues in state fiscal year 2009.
Fiscal 2011 isn't over yet, but we can use the December revenue forecast to add up the damage. Revenues fell short of appropriations by $4.9 billion in fiscal 2009 through 2011. Balances were reduced to the bare minimum again, covering $735 million of this gap. Spending cuts and federal stimulus aid covered the bulk of the shortfall.
Without the federal stimulus aid—which can't be counted on in every recession—the state would have needed balances of $5.5 billion at the start of 2009 to cover the Great Recession's revenue gap. Again that's 42 percent of the budget. About $2 billion or 15 percent would have been needed to cover the first year's shortfall.
Two recessions are thin evidence for conclusions, but recessions are (fortunately) pretty rare. And the past two recessions have been hard on state revenues. Not all recessions are so severe.
Still, here's what the evidence says. The shortfalls of the last two recessions could have been covered with balances at 42 percent of the budget. Obviously, Indiana's residents and elected officials would not stand for that. State services would have to be reduced and taxes raised to build balances that high.
What's more realistic? This year's budget bill caps balances at 10 percent of the budget. That's enough for cash flow plus half-a-year's recession, or enough to handle short-run forecast errors. The State Budget Agency cites 10-12 percent as a prudent range for balances. Balances at about 15 percent would be needed to cover cash flow, plus a year's recession. Indiana's balances averaged 14 percent over 1976-2010, so percentages in the mid teens are not unusual.
How big should state balances be? That depends on how much recession we want to cover.