The Outlook for the Indiana State Budget

Updated October 2009

Contents
Introduction
A Checking Account Statement
Fiscal Year 2009
Balances
The New Biennium
The Outlook for the Budget Beyond the New Biennium

Introduction
Indiana’s General Assembly passed a budget in the evening of June 30, 2009. It took a special session, and the pressure of an end-of-fiscal-year deadline that had not been missed for more than a century, for legislators to agree on a spending plan for 2010 and 2011. A new budget wasn't passed until the evening of June 30, just hours before the beginning of the 2010 fiscal year.

The problem was revenues. Indiana's state budget experienced one of its worst years ever in fiscal 2009 (July 2009 to June 2009). The economy plunged into recession. Revenues fell short of predictions by about $1.4 billion. Predictions for revenues in the new biennium, 2010 and 2011, called for slower-than-usual growth. This made budgeting difficult for lawmakers.

Yet, the 2009-11 biennial budget is expected to maintain balances using few "fiscal gimmicks." This was accomplished by cutting spending below appropriations during 2009, writing a very conservative spending plan for 2010 and 2011, and drawing on $2.3 billion in Federal stimulus money to support Medicaid and education spending. As in almost all states, Indiana is not in the best of fiscal health. But the state is faring better than most.

A Checking Account Statement
Here are ten years of past Indiana revenues, spending and balances, and projections for 2010 and 2011, arranged to look like a checking account statement. It's useful for understanding what's happened to Indiana's finances since 2000.

The state budget agency provides plenty of information about the budget’s appropriations, revenues and balances. Unfortunately, it’s all in separate documents, which makes the big picture difficult to understand. The table above draws this information together in checking account form.

Like any household, the state starts the year with balances, which is money in the bank. The state had $1.4 billion at the start of fiscal 2009. We receive state income from taxes and other revenue sources, but not nearly as much as we expected. We write checks to pay for public services, based on appropriations planned in our budget. Our rich but indebted uncle slips us some cash to help out, in the form of American Recovery and Reinvestment Act funds--the Federal stimulus money. We shift some money around with fund transfers, and cancel some previously planned spending with reversions. And at the end of the year, we’ve got money left over, in balances in the bank.

The table shows ten years of actual results, from fiscal year 2000 to fiscal year 2009. Fiscal year 2009 ended on June 30, 2009. The 2010 and 2011 fiscal year figures are based on the May 2009 revenue projections, and on the budget passed on June 30, 2009.

Fiscal Year 2009
Revenues. Revenues were the problem for this budget. The checking account table shows total revenues down $151 million from 2008 to 2009. This was the first year-to-year drop since 2002.

The reason, of course, was the recession which began in December 2007, and intensified in the Fall of 2008. This revenue drop understates the recession’s effect on the budget. Sales tax revenues increased $467 million because of the hike in the sales tax rate from 6% to 7% in April 2008. The higher rate was used during the last three months of fiscal 2008, but for all of fiscal 2009. Without this rate increase, sales tax revenue would have fallen by nearly $200 million.

More important for budgeting is the shortfall of actual revenues below projected revenues. In April 2007 the legislature passed a balanced budget for 2009. Projected revenues more than covered planned spending. Reforms were made in 2008, but these too were balanced. The added state spending due to the reform was matched by an equal amount of anticipated new revenue. Yet, when the books were closed on 2009, revenues had fallen short of appropriations by almost $1.4 billion dollars. That’s the amount shown in the table under Current Year Surplus/Deficit. This is an enormous shortfall of about ten percent of the budget.

Appropriations. State appropriations increased substantially from 2008 to 2009 because of the 2008 property tax reform. In 2009 the state took over the school corporation general funds, county welfare funds, and several smaller local government funds. These had been paid for with property taxes; now they are financed out of the state budget.

State appropriations for K-12 education increased more than $1.3 billion as a result of this tax policy change. This does not mean that local school corporations were awash in new money. Each dollar of added state aid replaced a lost dollar of property tax revenue for the schools. Likewise, health and social services spending rose almost $300 million because of the takeover of county welfare funding.

These spending increases were partially offset by a drop in property tax relief of more than $600 million. This is also the result of the 2008 tax reform. The old methods of providing tax relief—property tax replacement credits and homestead credits—are being phased out. These were credits that reduced the tax bills of property taxpayers. The state compensated local governments for this lost revenue with payments from its budget. Now, tax relief will be provided by eliminating whole functions from the property tax. The credits will disappear, and the property tax relief money will help pay for the added state spending on schools and welfare. The sales tax increase will also fund these new expenditures.

Again as the result of the 2008 reform, in 2009 a temporary tax credit was paid to homeowners, as a bridge between the old and new methods of tax relief. This lessened the reduction of the property tax relief appropriation. By 2011, however, it will be zero. The money will still be providing property tax relief, by paying for the K-12 education and health and social services spending that used to be funded with property taxes.

ARRA: Federal Stimulus Money. ARRA is the American Recovery and Reinvestment Act, the Federal stimulus money passed by Congress in February 2009. There are many stimulus programs, but two were meant to shore up state budgets.

Medicaid is a joint Federal-state program that provides health care for low income people. Each state is expected to finance a fraction of the cost, and the Federal government picks up the rest. In 2009 (and 2010-11) the Federal government increased it share of Medicaid costs. This reduced the state’s spending on Medicaid.

The stimulus bill also included fiscal stabilization funds. These were directed to K-12 education. In 2009 Indiana used this money to make state aid payments to local school corporations, which were owed under the school funding formula. This reduced the state’s spending on K-12 education. Indiana used a total of $992 million in Federal stimulus money in its budget in 2009. It is shown in the table as a separate entry, to make clear how much ARRA money was used in the budget, and to make clear what Indiana will lose when ARRA funds disappear.

The ARRA money could have been counted as reductions in K-12 education and Medicaid spending, making appropriations smaller. Or, it could have been counted as reversions, which are appropriations that are budgeted but not spent, and so revert to the general fund budget. That would have made “adjustments” bigger. That’s how the state budget agency counted ARRA money for fiscal 2009.

Adjustments. When budgets are stressed the state often resorts to extraordinary adjustments. In fiscal 2009, $73 million was transferred to the General Fund from other funds, mostly from the Build Indiana Fund.

Reversions were by far the biggest adjustment, at $357 million. This was an intentional effort to spend less than the original budget appropriated. When this happens the money reverts to the General Fund. A great many agencies and departments spent less than their appropriations. For example, the State Budget Agency itself reverted $10 million, the Indiana Economic Development Corporation reverted $41 million, and the state’s universities, including Ivy Tech, reverted almost $40 million. The amount of reversions in 2009 was probably the most in Indiana state budget history.

Payment delays are an adjustment that was used in the past two recessions. They were not used in 2009, nor were they scheduled for 2010 or 2011. These are delays in payments from the state to local governments, from one fiscal year to the next. This works because the state is on a July to June fiscal year, while local governments are on a calendar fiscal year. If the state delays a property tax relief payment from June to July, the locals get their money during their budget year (just a little late), but the state reduces its recorded spending in the earlier year. This helps maintain balances while reducing the need for spending cuts or tax increases.

Reversions are an accounting trick, a “fiscal gimmick”, but it's a trick that has been useful in the past. It was used after the 1990-91 recession and after the 2001 recession. In each case the payment delays were reversed during the expansions that followed the recessions. Reversals add to a budget’s spending. The last payment reversal from the 2001 recession was made in 2009—that’s the negative $31 million shown in the table.

It seems unlikely that payment delays will be used in the near future. The Governor has pledged not to use this gimmick. Property tax relief payments to local governments are being eliminated, and this was one of the primary payments that were delayed in the past. In addition, school corporations are scheduled to move to a July to June fiscal year, which means a payment delay would create a shortfall in their budgets.

End-of-Year Balances. Start-of-year balances, plus revenues, less appropriations, plus ARRA money, plus adjustments, equal end-of-year balances. The state ended the fiscal year with that same $1.4 billion in balances that it had at the start, despite the $1.4 billion shortfall in revenues. It accomplished this by using about one billion dollars in Federal stimulus money, and about $400 million in reversions and fund transfers. Federal dollars plus reversions plus transfers covered the 2009 shortfall, and left the state with money in the bank.

Total balances are composed of several sub-categories. The famous Rainy Day Fund makes up $365 million of the total. There is also a small reserve to cover potential shortfalls in revenue for Medicaid entitlement payments.

In 2009, more than $500 million was shifted from the general fund balance to the tuition reserve balance. This was done as a result of the 2008 tax reform. School corporations are now totally dependent on state aid to finance their general funds, which are mostly teacher pay and benefits. It is sensible to build a fund to support these aid payments in the event of revenue shortfalls. Unfortunately, the new school funding policy started in the very year that enormous revenue shortfalls occurred. The tuition reserve balance was increased by depleting the general fund balance.

It’s total balances that count, however. The legislature shifted money from the general fund to the tuition reserve fund in 2009. If necessary, it could shift the money right back.

Balances
The state keeps balances to help it pay its bills on time, and to guard against unexpected revenue shortfalls. Payments go out on one schedule, revenues come in on another. The state needs money in its checking account to cover bills in months when revenues merely trickle in. The rule of thumb is that a state needs a minimum of 5% of its budget in balances for this "cash flow" reason.

Balances also help when recessions hit. The state can maintain services and avoid tax hikes by drawing on balances. Having $2 billion in the bank at the start of the last recession meant that spending cuts and tax hikes were delayed, and were smaller when they did occur. Having $1.4 billion in the bank in the midst of the 2007-09 recession will help support spending and fend off tax increases in coming years. The State Budget Agency would like to see balances at ten to twelve percent of the budget to cover revenue shortfalls. They define this as the "prudent range." The graph below shows the history of Indiana state balances as a share of operating revenues, a measure of the size of the budget.

The state's balance is like a balance in a checking account.  If you spend more than you deposit, your balance shrinks. That's what happened in the first half of the 2000's in Indiana. Revenues fell short of predictions by almost $3 billion. Budgets that were thought to be balanced when they were written turned out to have deficits. Balances covered part of the difference, but by the end of fiscal 2004 they were slightly less than 5% of the budget, below the rock-bottom-minimum.

If you deposit more than you spend, your balance grows.  That’s what happened during the second half of the 2000's in Indiana.  Spending was restrained, and for four years revenues came in above predictions.  The state took in more than it spent.  State balances recovered, and topped 10% of the budget by the end of fiscal 2007.

Indiana's balances have rarely been within the prudent range during the past 35 years. During most expansions balances grew well above this range; after recessions, balances drop below it. Balances in the recent 2001-2007 expansion stand out because they did not rise above the prudent range. One reason was that the 2000's expansion was shorter than the 1980's and 1990's expansions, so there was less time to accumulate balances. Another reason was the severe effect that the 2001 recession had on state balances. It took a long time to recover from those revenue shortfalls.

Still, this means that Indiana's budget was in a less healthy position coming into this recession, than it was entering the past three recessions (1980-82, 1990-91 and 2001). The state's budget is in better shape than most other states, but it is in worse shape than it's been in past recessions.

The New Biennium
Revenues are projected to grow slowly in the next biennium, starting from the reduced 2009 level. The 2.1% average growth per year (see the checking account table) is about half the average growth of the previous decade. As a result appropriations are scheduled to grow slowly. The table shows appropriations increasing only 0.3% a year in 2010 and 2011. In total the budget is almost flat-lined.

K-12 education shows large increases in fiscal 2010, but again this is because of the 2008 property tax reform. Calendar year 2009 is the first year that the state will pay the entire school general fund. For the state, the new payments are split between fiscal year 2009 and fiscal year 2010, which is why it appears to take two years to switch to the new funding policy.

In 2008, before the policy change, K-12 education accounted for 37% of state general fund spending. In 2010, the share will be 53%. More than half of all state general fund appropriations will go for local schools. This may imply that schools will be more vulnerable to recessions and expansions in the future. When state revenues fall short, school spending must be cut, because that’s where the money is. School spending will grow only when state revenues grow.

Property tax relief disappears from the state budget as of 2011. That’s when the last of the temporary homestead credits run out. Tax relief will be provided by reduced property tax levies, due to the state takeovers, by a large added deduction from homestead assessed values, and by the “circuit breaker” property tax caps.

Medicaid appropriations also grow substantially in 2010 and 2011. Medicaid is an entitlement, and so its spending depends on how many people are eligible for care, and what that care costs. With the recession, more people are eligible. And health care costs continue to rise rapidly.

In both years the state plans to spend more than it collects from its own revenue sources, by almost $1.3 billion in 2010, and $900 million in 2011. In 2010, this shortfall again is covered by Federal stimulus money, and reversions. Balances are depleted by $100 million. Reversions are not scheduled for 2011 (though they may be used). Instead, the state will draw its balances down by more than $300 million. Balances remain in the 10% to 12% “prudent range” in 2010, but dip below that range in 2011.

The first few months of fiscal 2010 saw revenues fall short of the conservative forecasts shown in the table. In July, August and September revenues fell short of forecasts by $254 million, or about 8%. Should shortfalls of this size continue for the whole fiscal year, the shortfall would be a bit more than one billion dollars. This would deplete the state's $1.4 billion in balances. It would leave balances less than the 5% rock-bottom minimum by the start of fiscal year 2011.

The Outlook for the Budget Beyond the New Biennium
In 2012 Indiana will face a problem, as will all the states: no more federal stimulus money. The ARRA program is scheduled to end after 2011. That leaves a big hole in the Indiana’s state budget.

The scenarios in the tables below look ahead to the 2012-13 biennium—the biennium after this one—to try to measure the likely condition of the budget.

Scenario one has a “business as usual” increase in appropriations. That’s a 3.6% overall increase per year, a rate based on the average over the past ten years. It also shows “normal” revenue growth, at 4% per year, again based on past averages.

The budget doesn’t work. Without the stimulus money the budget runs deficits of almost $900 million per year. Balances run down to 1.3% of revenues in 2012, and turn negative after that. That’s unconstitutional. With normal revenue growth, the state will not be able to increase appropriations at the usual rate in the 2012-13 biennium.

Scenario 2 shows how fast revenues must grow to support business as usual appropriations growth. The answer is 7.5% per year in 2012 and 2013. In this scenario the budget is in deficit in 2011, and balances drop to 4.5% of revenues. This is below the rule-of-thumb minimum of 5%, so for a time the state could face cash-flow difficulties. But the deficit turns to surplus in 2012, and balances begin to rebuild.

Two straight revenue increases of 7.5% are unlikely. It would require a booming economy, or an increase in state tax rates. Or, an extension of the Federal government’s stimulus program could add to revenues. There will be plenty of states with budget difficulties in 2012; we can expect an intense lobbying effort for the stimulus aid to continue. Suppose none of these things happen, and revenues grow a more normal 4%.

Scenario 3 shows that state budget appropriations would have to be flat-lined to balance the budget with normal revenue growth. There is still a deficit in 2012, and balances drop to 5.1% of revenues, but there is a surplus in 2013. Total appropriations are assumed not to change. However, Medicaid entitlements will increase if health care costs keep rising. This implies decreases in other spending categories to keep the total constant, in particular K-12 education, where most of the money goes.

Four percent a year is a more likely pace for revenue growth. That means a typical economic expansion, with no tax increases, and no more stimulus money. If that’s what happens in 2012-13, the budget would have to be flat-lined to maintain positive balances. That means no spending increases, again.

And that means that the General Assembly will again divide a fixed amount of revenue among many competing interests. One added dollar for one function means a dollar less for another. Decisions like that are hard. We can expect another tough budget-writing year for the legislature in 2011.