State Budget Stress Testing How Utah Budget-makers are Shifting the Focus from a Balanced Budget to Fiscal Sustainability Juliette Tennert, Kem C. Gardner Policy Institute Angela J. Oh, Kem C. Gardner Policy Institute Jonathan Ball, Utah Office of the Legislative Fiscal Analyst Thomas Young, Utah Office of the Legislative Fiscal Analyst June 2019 The Pew Charitable Trusts sponsored this research. It includes the independent views and findings of the authors. The Gardner Institute would like to thank the following individuals from Pew for their support of this report: Kil Huh, Vice President; Mary Murphy, Project Director; Alexandria Zhang, Research Officer; and Robert Zahradnik, Principal Officer. State Budget Stress Testing ANALYSIS IN BRIEF State budget stress tests help policymakers to plan for and create appropriate, measured responses to economic volatility. Utah is the first state to implement comprehensive budget stress testing, evaluating the sufficiency of reserves and other budget contingencies to cover recession-spurred revenue shortfalls and countercyclical cost hikes. In the wake of the 2008 financial crisis and concurrent Great “Stress testing is a tool that governments Recession, Congress imposed a number of financial industry regulations in the Dodd-Frank Act of 2010, including requiring use to prepare themselves for an inevitable bank stress tests. These stress tests predict the impact of varying economic downturn.” degrees of economic downturns on banks’ balance sheets to assess their ability to absorb losses, continue lending, and meet Marcia Van Wagner, Moody’s Vice President and Senior Credit Officer credit obligations. Utah is the first state to adapt financial stress testing to state budgets, analyzing budget gaps, or value at State Budget Stress Test in 4 Steps risk, under economic stress scenarios and adequacy of budget contingencies. The analysis suggests that Utah is prepared for a 1. Define the period of analysis and economic assumptions moderate recession or extended period of stagflation; coping for stress scenarios. with a more severe recession like the Great Recession would be 2. Identify revenue and expenditure components at risk and more difficult. estimate total value at risk under stress scenarios. 3. Inventory and categorize reserves and other budget 2016 State of Utah Budget Stress Test Results contingencies by ease of accessibility. Value at risk under 3 economic scenarios and available 4. Compare total value at risk to total contingencies to reserves by ease of accessibility evaluate overall resilience of state budget. Percent of FY 17 State Fund appropriations 57.3% Utah’s Fiscal Toolkit 50.9% Reserves and Other Budget Contingencies 39.4% Only when value at risk and economic Budgetary volatility are high are Utah policymakers Reserves more likely to tap into revenue Revenue enhancements and Enhancement 12.5% Risk at Value Operating rainy day funds. Reserves Working Rainy Day Funds Spending Value at Risk Value at Risk Value at Risk Reserves Reductions Adverse Scenario Severly Adverse Stagation Cashow Scenario Scenario Management Reserves Accessibility Temporal Balance Economic Volatility INFORMED DECISIONSTM 1 gardner.utah.edu I June 2019 Table of Contents Analysis in Brief . 1 Revenue at Risk .........................................9 Introduction . 3 Expenditures at Risk ....................................11 A Brief History of State Budget Stress Testing . 3 Total Value at Risk ......................................14 Budget Stress Testing in Utah . 4 It Will Take More than Rainy Day Funds: Overview . 4 Identifying Reserves and Other Contingencies . 14 Economic Scenarios: The Backbone of Utah’s Utah’s Fiscal Sustainability Toolkit .......................14 Budget Stress Tests . 4 Valuing the Financial Contingency Plan ..................15 2015 Economic Assumptions: Stress Test Results. 16 Regionalizing Federal Reserve Scenarios ................4 Considerations for Future Analyses . 17 2016 Economic Assumptions: Conclusion: How Budget Stress-Testing is Promoting Purchasing Regional Scenarios .........................6 Long-term Fiscal Health in Utah . 18 Discussion of Different Methodologies Appendix . 19 for Economic Assumptions. 6 Endnotes . 29 Minding the [Hypothetical Budget] Gap: References . 30 Estimating Value at Risk . 9 Figures Figure 1. U.S. Real GDP Growth, 2015 Dodd-Frank Act Figure 10. Higher Education Enrollment ....................11 Stress Test Supervisory Scenarios ........................5 Figure 11. Pension Contribution Rates ......................12 Figure 2. Utah and U.S. Real GDP Growth, Figure 12. Share of General Fund/Education 2015 Utah Budget Stress Test Scenarios ..................5 Fund Expenditures. 12 Figure 3. Utah and U.S. Unemployment Rates, Figure 13. State Fund Expenditure Scenarios, 2015 .........12 2015 Utah Budget Stress Test Scenarios ..................5 Figure 14. State Fund Expenditure Scenarios, 2016 .........12 Figure 4. Utah and U.S. Unemployment Rates, Figure 15. Total Value at Risk, 2015 and 2016 ................14 Last Recession ..........................................5 Figure 16. Fiscal Sustainability Toolkit ......................15 Figure 5. U.S. Real GDP Growth, Inflation, and Figure 17. Reserves and Contingencies .....................15 Unemployment, Moody’s Analytics Scenarios ............7 Figure 18. 2015 State of Utah Budget Stress Test Results ....15 Figure 6. Share of General Fund/Education Figure 19. 2016 State of Utah Budget Stress Test Results ....16 Fund Revenues .........................................9 Figure 20. 2016 State of Utah Budget Stress Figure 7. State Fund Revenue Scenarios, 2015 ..............10 Test Detailed Results. 16 Figure 8. State Fund Revenue Scenarios, 2016 ..............10 Figure 21. Hachman Index, 2017 ...........................17 Figure 9. Medicaid Enrollment .............................11 Tables Table 1. 2015 Utah Budget Stress Test Table 7. State Fund Revenue at Risk, 2016 ..................11 Economic Assumptions .................................6 Table 8. Economic Drivers of Expenditures Table 2. 2016 Utah Budget Stress Test at Risk Estimates .......................................13 Economic Assumptions .................................8 Table 9. Expenditures at Risk, 2015 .........................13 Table 3. Economic Drivers of Revenue at Risk Estimates ......9 Table 10. Expenditures at Risk, 2016. .13 Table 4. 2015 Revenue Declines Through Peak/Trough ......10 Table 5. 2016 Revenue Declines Through Peak/Trough ......10 Table 6. State Fund Revenue at Risk, 2015 ..................10 INFORMED DECISIONSTM 2 gardner.utah.edu I June 2019 Introduction During economic downturns, governments address market accelerating revenue, or delaying cost experience without volatility by providing a social safety-net and by retraining reducing total expenditures. Such budget gimmicks usually workers. In that sense, the demand for government services have unintended consequences that must be corrected later. is counter-cyclical to the broader economy. Ironically, most They almost always create perceptions of crisis and instability. governments finance such activities using pro-cyclical tax Yet businesses and citizens crave surety and stability. collections. In other words, governmental services are most An alternative exists to bail-outs, broken promises, and demanded at a time when governments can least afford it. gimmicks during times of economic distress. By probing The United States government addresses this apparent potential risk, measuring its probability and magnitude, and contradiction by issuing debt. While most state constitutions creating multiple contingencies, state and local governments prohibit borrowing for operating expenses, state governments, can prepare for downturns without taking too much revenue in the past, have benefitted from Uncle Sam’s line of credit out of the economy for a rainy day. Stress testing budgets via economic stimulus and bail-out programs. Many states allows governments to create appropriate, measured responses recognize that our federal government is becoming increasingly to economic volatility. over-leveraged and that it may not be as willing in the future to To that end, the state of Utah has taken a page from the borrow on behalf of states. Moreover, the political dynamics in Federal Reserve’s playbook in order to assure consistency and some states may be oriented toward lower reliance on federal solvency at all points of the business cycle. Under the Dodd- funding more generally. Frank Act, the Federal Reserve requires banks of a certain size to Economic volatility – and attendant revenue shortfalls/spend- stress test their assets. The idea is to predict what will happen to ing spikes – also drive interesting political dynamics. Dramatic bank balance sheets in hypothetical economic downturns and government revenue increases typically precede an economic determine how much a bank must have in reserves to weather correction, and they in-turn can drive ongoing commitments the storm. Utah is doing the same thing for its state budget – to constituents, which may be tax cuts or program expansions. using the same scenarios produced for banks by the Federal Projected revenue growth is pledged before it is collected – Reserve. The state compares value at risk due to revenue which leads to dashed expectations and broken promises when declines combined with budget pressure from increased that revenue does not materialize. demand for government services to a portfolio