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Arizona Fiscal Issues

Arizona's Budget Stabilization Fund

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" The expenditure of the BSF during a recession provides direct stimulus to the state by avoiding substantial reductions in the government sector at a time when other segments of the economy are weak and by avoiding major cuts in health and welfare benefits that can have between a 1-to-1 and a 6-to-1 federal-to-state match. This federal flow of funds into Arizona can also act as a strong countercyclical force. "

 

 

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By Alberta H. Charney, Ph.D.
November, 2009

Key Points
Introduction
Other States’ Stabilization and Emergency Funds
The Budget Stabilization Fund in Arizona
Changes from the Original BSF Statute
Performance of the BSF
Issues with the BSF
Other Emergency Funds
References

Key Points

  • All 50 states have some form of a budget stabilization fund (“rainy-day” fund), with a wide variety of provisions and rules or methods for deposits and withdrawals.
  • Arizona’s budget stabilization fund (BSF) was established in 1990. It was designed to smooth out cyclical fluctuations in revenue to the Arizona state government general fund.
  • Significant changes have been made to the BSF since the original legislation. In particular, the original design of the BSF allowed it to have a balance equal to 15% of the general fund, but the current cap is only 7%.
  • In each of the two recessions since the creation of the BSF, the available funding was substantially inadequate to offset the cyclical declines in revenue and thereby prevent large spending reductions.
  • Relative to its stated purpose of smoothing the revenue stream, the BSF has too small a cap, the BSF formula does not transfer enough monies into the fund during periods of budget surpluses, a change in legislation restricts withdrawals from the fund, and the BSF has been used for expenditures not related to the business cycle.
  • An adequately designed BSF not only provides revenue and stimulates the economy during periods of economic decline, but restricts the passage of permanent tax cuts and spending increases during periods of temporary budget surpluses.

Introduction

In the private sector, an economic slump reduces demand for goods and services. The drop-off in sales leads to a general reduction in business activity, frequently resulting in layoffs of personnel no longer needed.

In the public sector, however, most public functions experience only a small reduction in the rate of increase in demand during recessions. Most government functions are tied to the population, which continues to grow (though less rapidly) during an economic slump. For example, the number of students to educate does not decline, nor does the need for police,  fire, and correctional services. While the demand for a few services falls off, such as inspections of buildings under construction, demand for some public-sector functions is countercyclical. For example, the demand for unemployment insurance benefits rises during recessions, as does the number of people eligible for public welfare. Enrollment in community colleges and universities frequently increases during slumps because of limited employment opportunities.

Thus, unlike the private sector, an economic slump does not lead to a decline in the demand for services in the public sector. However, government revenue collections are highly cyclical, falling during economic downturns. Therefore, it is especially important for the public sector to have funds set aside to offset revenue decreases during an economic decline.  In order to minimize the need to enhance revenue and/or reduce spending during an economic downturn, all states have adopted a budget stabilization fund (sometimes called the  “rainy-day fund”).

Continued public spending during a recession using budget stabilization fund monies helps mitigate the impact of a recession. When the economy is strong, use of a rainy-day fund helps control public expenditures by setting aside, rather than spending, excess revenue.

Other States’ Stabilization and Emergency Funds

All states have some form of budget stabilization fund, but there is a wide variety in procedures for transferring monies to and from the fund and in the maximum amount that can be deposited in the fund (the “cap”). The limits, when expressed as a percentage of the general fund, tend to be between 4–15% of the general fund or budgeted revenues, but Utah and Wyoming have no cap on their stabilization funds.

A very few states express their limit as a fixed dollar amount. Some states make deposits into their stabilization fund by requiring a percentage (say 50%) of unanticipated revenue surpluses to be deposited into the fund, some mandate a percentage of general fund appropriations of revenues go to the fund, and others make annual appropriations to the fund.  Funds may be controlled by the legislature, the governor, formula, or some combination.  Most states also have a fund for unexpected natural or man-made disasters. These are usually under the control of the governor or an emergency management agency within the administrative branch of government.

The Budget Stabilization Fund in Arizona

The severe cyclicality of the Arizona economy and the composition of the state’s revenue sources cause revenue collections to be more cyclical than in the average state (see Chapter 10). Thus, the existence of a rainy-day fund is of particular importance in Arizona. In fact,  various analysts have suggested that strengthening Arizona’s budget stabilization fund may be the most important improvement that can be made to the state’s fiscal system. Marshall Vest makes this point at the end of Chapter 10. According to Elliot Pollack, “Above all else, implement a budget stabilization fund at least equal to the originally recommended 15% of prior year general fund expenditures.”1

The Arizona Legislature created a budget stabilization fund (BSF) in 1990 (a year with a substantial general fund deficit). The BSF was designed by the Arizona Joint Legislative Budget Committee (JLBC) to set aside revenue during times of strong economic growth to be spent during periods of weak growth or recession. Transfers are between the BSF and the state’s general fund. The BSF is administered by the state treasurer. 

A budget stabilization fund is an important tool for the fiscal management of the state general fund because:

  • The state must maintain a balanced budget even during severe economic downturns.
  • Arizona’s revenue structure is extremely cyclical, partly because of its mix of revenue sources and partly because of the strong cyclicality of Arizona’s economy.
  • The health and welfare component of state expenditures is countercyclical, increasing during difficult economic times and decreasing during strong growth periods.

Current key features of the BSF have been outlined by the Arizona Senate research staff 2. Some of the following is verbatim from their background report; other portions have been expanded for explanation:

  • The deposit into or withdrawal from the BSF for a given fiscal year is determined by comparing the “annual growth rate” of inflation-adjusted “Arizona Personal Income” (AZPI) for the calendar year ending in the fiscal year to the “trend growth rate” of inflation-adjusted AZPI for the most recent seven calendar years.
  • AZPI in the BSF formula is defined as total Arizona personal income minus transfer payments. Transfer payments are a component of personal income that consists of payments to persons by governments and businesses for which no current services are performed. Major examples of transfer payments include retirement and disability insurance payments; certain medical benefits and reimbursements; income maintenance benefits (such as Social Security payments or food stamps);  unemployment insurance benefits; veterans benefits; and federal education and training benefits. Transfer payments are subtracted from Arizona personal income because the size of these payments does not reflect the condition of Arizona’s economy; in some instances, the transfer payments are counterindicative of Arizona’s economy.
  • AZPI is adjusted by the gross domestic product implicit price deflator in order to remove the effects of inflation.
  • The “annual growth rate” is the growth rate of adjusted AZPI in the calendar year that ends in the current fiscal year compared to the previous calendar year.
  • The “trend growth rate” is the average of the previous seven calendar-year growth rates of the adjusted AZPI.
  • If the annual growth rate exceeds the trend growth rate, the excess multiplied by the general fund revenue of the prior fiscal year equals the amount recommended for deposit into the BSF. Thus, if the annual growth rate is 6% and the trend growth rate is 5%, then 1% of the prior fiscal year’s general fund revenue would be recommended for deposit into the BSF.
  • If the annual growth rate is both less than 2% and less than the trend growth rate, the deficiency multiplied by the general fund revenue of the prior year equals the recommended amount to be withdrawn from the BSF. Thus, if the trend growth rate is 5% and the annual growth rate is 2%, nothing would be withdrawn from the BSF. If the trend growth rate is 5% and the annual growth rate is 1%, then an amount equal to 4% of the previous year’s general fund would be withdrawn from the BSF, assuming it has an adequate balance.
  • By a two-thirds majority, the Legislature, with the concurrence of the governor, can decrease a signaled deposit or increase a recommended withdrawal.
  • At the end of a fiscal year, the BSF’s total balance cannot be larger than 7% of that year’s general fund revenues.
  • In addition to the fixed income investments available to the treasurer, the Legislature in 1998 allowed the treasurer to invest up to 25% of the BSF in equity securities.

The Arizona BSF is unusual in that it is formula driven. Only a few states have similar arrangements for their rainy-day funds 3. While subject to legislative appropriations for deposits and withdrawals, the BSF formula provides both a signal and suggested dollar amount of deposits to the BSF in “above average” economic times and fund withdrawals during “below average” economic times.

The Arizona Economic Estimates Commission (EEC) meets in the spring (the last quarter of each fiscal year) to calculate the annual growth rate and the trend rate in AZPI, and to determine the formula-driven appropriation to, or transfer from, the BSF. The commission must complete, certify, and report its findings to the governor, the state treasurer, the president of the Senate, the speaker of the House of Representatives and the JLBC prior to June 1. The EEC calculations do not result in automatic BSF deposits or withdrawals; rather, they are recommended amounts to be appropriated or withdrawn subject to legislative action.

The timing of the EEC meeting creates practical difficulties. First, formula-driven recommendations for a given fiscal year that cannot be made until near the end of the fiscal year can create cash-flow problems during a fiscal year with a weak economy. Second, the formula that determines the transfers for the current fiscal year is based on data for the period 6–18 months prior to the end of the fiscal year. Economic conditions can change rapidly within a given six-month period, so the formula-driven recommended transfers to, and withdrawals from, the BSF may not reflect current economic conditions or expected future conditions.

In reality, the Legislature requires information about revenues and expenditures, and estimates of needed withdrawals or likely required deposits into the BSF, before the spring.  In periods of economic growth, the EEC formula recommendations tend to be used to determine deposits into the BSF, assuming the cap has not been reached. However, in periods of economic downturn, the Legislature must use its two-thirds discretion to access BSF money during the fiscal year.

Changes from the Original BSF Statute

Three key features of the operation of the BSF differ from the original 1990 design. First, the balance of the BSF currently is limited in size to 7% of the prior year’s general fund revenues, but under the original 1990 statute, the balance could reach as much as 15% before deposits to the fund would be stopped. The 15% size of the cap had been calculated by the JLBC using prior business cycles and revenue collections to be the amount necessary to smooth Arizona’s revenue flows through a modest recession. Despite the original determination of a 15% ceiling, the Legislature reduced the size of the cap to 5% from 1995 through 1997 before gradually increasing it to 7% in 2000.

Second, another change made in the mid-1990s was adding the condition that withdrawals from the BSF would only be made if the annual growth rate in AZPI in the prior calendar year be both below the trend line and below 2%. Presumably, the 2% floor was added to avoid withdrawing monies when economic growth is slowing but not yet in a recession. This requirement results in the formula sometimes failing to recommend payouts during downturns. For example, in both 2002 and 2008, the formula did not recommend payouts because the adjusted AZPI was 2.10% and 2.88%, respectively. In both cases, the Legislature authorized substantial withdrawals from the BSF to close budgetary shortfalls.

Third, despite the BSF being designed solely as a management tool to smooth the fluctuations in the business cycles, it has been used as a contingency fund for other types of fiscal emergencies or requirements. In 1999, the Legislature allowed the BSF to provide partial funding for major renovations to the Arizona State Hospital. In 2000, legislation was passed that required liabilities related to the alternative fuels legislation to be funded by the BSF up to $200 million. The BSF was to be reimbursed by the general fund at a rate of up to $16 million annually, but this reimbursement provision was repealed. From 2001 through 2007, the BSF financed unplanned taxpayer refunds associated with the alternative fuels program of about $119 million, according to the JLBC.

Performance of the BSF

The first payment into the BSF was made in fiscal year 1994. In the next fiscal year (the one in which the limit was dropped to 5%), the cap already was reached. In the next two fiscal years (1996 and 1997), the formula called for a transfer to the BSF, but no deposit was made to the fund because of the 5% limit. While the dollar limit of the BSF rose gradually each year because of the increasing size of the general fund (before adjustment for inflation or population growth), the fund’s interest earnings kept the balance at the limit. In fiscal years 1998 and 1999, the gradual increase in the percentage limit from 5-to-7% allowed some deposits to be made to the fund, though less than those indicated by the formula. With a weakening economy, withdrawals from the BSF began in fiscal year 2001. The total transferred to the general fund from fiscal years 2001 through 2003 was $455 million, some $339 million less than called for by the formula. Substantial spending reductions had to be implemented in order to balance the general fund budget.

An improving economy caused the formula to indicate that a small deposit to the BSF should be made in fiscal year 2004, though this was not done. However, large deposits to the BSF from fiscal years 2005 through 2007—during the economic expansion—again pushed the reserve to the 7% maximum allowed. Most of this was used in fiscal year 2008, leaving little to balance the fiscal year 2009 budget, which was billions of dollars out of balance. Thus, in each of the two economic downturns since the creation of the BSF, its balance was substantially inadequate to offset the general fund budget deficit.

No reasonably designed budget stabilization fund could have completely avoided the current fiscal crisis in Arizona, because of the unusual length and depth of the recession that began late in 2007. However, the BSF, as currently designed, also failed to adequately serve the needs of the state in the more typical 2001 recession. The fund is limited to 7% of the general fund, but the three major sources of revenue can fall by an amount closer to 8% per year during a normal recession. If population growth and inflation are at normal recessionary levels, then the 8% decline in revenues reflects a 12–14% reduction in the state’s ability to provide services to the ever-growing population in an increasingly expensive environment.

To make matters worse, recessions typically impact more than one fiscal year’s budget.  Recessions commonly impact revenues for three years, with slow growth one year, negative growth the next, and flat or slow growth the third year. Thus, even with the original 15% cap,  the funds in the BSF may not be sufficient to offset the loss of revenue during a recessionary period.

With the 7% cap on Arizona’s budget stabilization fund, and the below-2% requirement for annual growth before tapping the BSF, Arizonans can expect that services will be cut during the slowdown year prior to the recession, again during the first year of the recession despite using up the entire budget stabilization fund, and yet again during the third year because the flat or slow growth in revenues will not keep up with population growth and inflation, much less the continuing increase in demand for public welfare services.

Issues with the BSF

Simulations of the operation of the BSF reveal several weaknesses in the current BSF statute.  First, capping the BSF at 7% of the general fund provides a substantially inadequate amount of monies to transfer to the general fund during a typical economic downturn. The Citizens Finance Review Commission in 2004 made the following recommendation regarding the BSF: “The state should increase the current limit on the budget stabilization fund (the ‘rainy day fund’) to its original 15% cap and take measures to make ‘raids’ on the fund more difficult.”

Second, even if the cap is returned to 15%, as in the original legislation, the fund will rarely, if ever, achieve such a balance based on the formula-dictated transfer to the fund during years of strong economic growth. Thus, in a typical economic expansion, the fund balance will fall well short of 15%, particularly if the fund balance during the prior economic recession dropped to zero or only a few percent of the general fund.

Third, the transfer formulas may be too conservative to provide for substantial payouts during downturns. The “less than 2% growth” requirement has resulted in $0 withdrawals recommended by the EEC even during severe recessions. The Legislature overruled this requirement in both 2002 and 2008. This rule was not in the original design of the BSF.  During previous economic downturns, Arizona’s population continued to grow by 2% or more, making this requirement almost impossible to meet.

Fourth, the BSF has been raided for unplanned expenditures not related to the business cycle.  Some states have a variety of emergency and contingency funds designed to cover fiscal emergencies unrelated to fluctuations in the business cycle. In addition, ad-hoc rather than the formula-recommended transfers to and from the fund have been made. These issues could be resolved by specifying the operation of the BSF in the Arizona Constitution rather than in statute.  Constitutional provisions that transfers to and from the fund be made automatically without legislative action and that the BSF be allowed to attain at least 15% of general fund revenue would generally ensure the effectiveness of the BSF.

Without such a constitutional provision, revenue cyclicality can contribute to long-term structural deficits through the actions of government leaders. During strong growth periods that have resulted in temporary budget surpluses, politicians have given back the surpluses to taxpayers by cutting tax rates permanently, limiting the size of the BSF, and expanding public programs. During the 1990s, the Arizona Legislature cut taxes repeatedly and reduced the cap on the BSF. More tax reductions were passed during the mid-2000s, and expenditure commitments grew. Both sets of actions contribute to long-term structural deficits and increased financial instability. A requirement to place excess monies into the BSF would preclude making permanent tax cuts without commensurate reductions in spending and also would prevent permanent increases in spending without identifying a new revenue source.

Both politicians and voters tend to have a short-run view of the budget and large rainy-day fund balances become a target when memories of the last downturn have faded. The National Association of Budget Officers (NASBO) suggests that multiyear budgeting and forecasting may provide a framework for political discipline and avoiding the turbulence created by budget cuts during recessions. The true costs of new spending and tax reductions are more easily understood when costs are shown for more than the current budget period 4.

If the BSF were fully funded and the state still experienced a budget surplus, the excess revenue dollars could be rebated back to taxpayers rather than permanently cutting taxes during periods of rapid, but temporary, revenue growth. However, if the BSF were capped at 15% or more, such a situation is unlikely to occur.

Recessions and business cycles are an economic reality. The BSF is an excellent tool for fiscal management. It is important for voters, politicians, and policymakers to understand that a fully funded BSF will help prevent the public sector from having to make spending cuts to popular programs during the next recession, and will help the entire state economy by acting as a strong countercyclical stimulus. The expenditure of the BSF during a recession provides direct stimulus to the state by avoiding substantial reductions in the government sector at a time when other segments of the economy are weak and by avoiding major cuts in health and welfare benefits that can have between a 1-to-1 and a 6-to-1 federal-to-state match. This federal flow of funds into Arizona can also act as a strong countercyclical force.

Other Emergency Funds

Other than the BSF, two other stabilization funds have been created in Arizona 5. The medical services stabilization fund is to be used if the appropriations for Arizona’s Health Care Cost Containment System (AHCCCS) are insufficient in a fiscal year to cover the cost of AHCCCS medical services (Arizona Revised Statutes 36-2922) 6. This medical emergency fund receives transfers from the medically needy account of the tobacco tax and health care fund. It has had a zero balance since fiscal year 2004.

The temporary assistance for needy families (TANF) stabilization fund was established in 1997 to supplement existing appropriations when caseloads for the TANF program exceed budgeted projections. The TANF emergency fund has had a zero balance since fiscal year 1999.

In one national report, Arizona is listed as having a governor’s emergency fund to be spent only on man-made or natural disasters 7. However, there is no set-aside money for declared emergencies; rather, the governor is authorized to spend up to $4 million in a fiscal year for such emergencies, to be funded out of unrestricted general fund monies (Arizona Revised
Statutes 35-192).

For more background on this important subject please review the following EBR articles:

Crisis in State Government

The Effects of the Economic Cycle on Government Revenue

Highlights from "Riding the Fiscal Roller Coaster: Government Revenue in Arizona, the 95th Arizona Town Hall"

References

1. See the executive summary of Arizona’s Optimal Tax Structure—A General Overview (July 2003), prepared for the Citizens Finance Review Commission.

2. Arizona Senate Research Staff, “Arizona’s Budget Stabilization Fund” (November 5, 2008).

3. National Association of State Budget Officers, Budget Processes in the States (Summer 2008).

4. National Association of State Budget Officers, Budget Stability: A Policy Framework for States (July 1995).

5. Arizona Joint Legislative Budget Committee, “Arizona Budget Stabilization Funds.”

6. The Arizona Revised Statutes.

7. National Association of State Budget Officers, Budget Processes in the States (Summer 2008)

This analysis was first published as part of the background report for the 95th Annual Arizona Townhall - Riding the Fiscal Roller Coster: Government Revenues in Arizona. For further information on these issues, please refer to this full report.

For additional information, please contact us.

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