The Outlook for the Indiana State Budget

Updated August 2008

Contents
Introduction
A Checking Account Statement
A Definition of Fiscal Health
Recession and the Budget
Turning the Corner in 2005
The Outlook for the Budget

Introduction
Indiana's state budget has seen some rough times since 2001. The economy faced recession. Revenues fell short of predictions by almost $3 billion. Spending growth had to be restrained. Taxes were increased. Balances fell by $1.5 billion. But the economy began to recover, and state spending was restrained. In 2005 the budget's prospects turned around. Revenues began to exceed predictions. Balances increased, and were back to prudent levels by 2007. Now, though, in 2008-09, the state's economy may be facing another downturn. A slowing economy may create revenue shortfalls.

This essay looks at the causes of budget troubles, and Indiana's response. It discusses what a healthy budget would look like, and assesses the prospects for fiscal health in coming years.

A Checking Account Statement
Here are nine years worth of past Indiana revenues, spending and balances, and projections for 2009, arranged to look like a checking account statement. It's useful for understanding what's happened to Indiana's finances since 2000.

The state starts the fiscal year (every July 1) with money in the bank, the Start of Year Balances. During the fiscal year, revenues arrive from the state's taxes and other sources. Appropriations are authorized by the state's budget, and the money is spent. The state can make adjustments to revenues and spending, by transferring money from other accounts, spending less than authorized (reversions), and delaying payments to future fiscal years. Start of year balances, plus revenues, less expenditures, plus adjustments, equal end of year balances. Balances are kept in several different funds. A measure of fiscal health is balances as a percent of revenues, or of budget size. Ten percent is a prudent level; 5% is the recommended rock-bottom-minimum. The state keeps track of the total payments it has delayed as part of adjustments, in the Payment Delay Liability.

The table shows nine years of actual results, from fiscal year 2000 to fiscal year 2008. Fiscal year 2008 ended on June 30, 2008. The 2009 fiscal year figures are based on the December 2007 revenue projections, the budget written in Spring 2007, and the revisions made during the 2008 legislative session.

A Definition of Fiscal Health
Now we have Indiana budget numbers organized in a way we can understand. But what are we looking for? How do we know if the budget is in good shape? Here's a two-part definition of "fiscal health" for Indiana.

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 smaller when they did occur. Had the economy recovered more quickly, perhaps spending cuts and tax hikes would not have been needed. The State Budget Agency would like to see balances at ten to twelve percent of the budget to cover revenue shortfalls.

Another way of handling a recession is to use payment delays, which should rightfully be called a “fiscal gimmick.” It's a useful gimmick, though. The state pays billions of dollars a year to local governments for property tax relief, and to schools in state aid. The state’s fiscal year goes from July to June, while the local government fiscal year goes from January to December. If the state delays the June payment until July, the locals still get their money (just a little late), but the state doesn’t count the spending until the next fiscal year. From an accounting point of view, the ealier year's expenditures are reduced.

Payment delays were used during the early 1990's recession, and again in fiscal 2002 and 2003. In the two latter years the state postponed a bit more than $700 million in local aid payments. Fiscal health requires that the payment delay gimmick be ready to go in the event of a recession. During the flush years of the 1990's the payment delays were reversed, so the delays were ready to be used again in 2002. The state is almost finished reversing the 2002-03 delays. Full reversal is scheduled by the end of fiscal 2009. Because these reversals are already in the 2008-09 budget, though, effectively the payment delay gimmick is already available. If the scheduled reversal were cancelled, appropriations would drop.

Our definition of fiscal health can say something about timing, too. Balances should be at 10% of the budget, and the payment delays should be reversed, in time for the next recession. The state might avoid spending cuts and tax increases in a mild recession if balances and payment delays are available.

No one knows when the next recession will start, but there's no doubt that the economy is slowing down as of mid-2008. If revenues start to fall short of projections, balances may be needed to cover appropriations.

Recession and the Budget
At the end of fiscal year 2000, on June 30, 2000, Indiana recorded a balance of just under two billion dollars. It was 18% of the budget, well over the prudent level of 10% to 12%. Balances had been near the two billion dollar mark since 1998.

The state's balance is like a balance in a checking account.  If you deposit more than you spend, your balance grows.  That’s what happened in the second half of the 1990's in Indiana.  Every year revenues came in above the previous year’s forecast.  Since we budgeted based on the forecast, we spent less than we took in.  State balances grew large. The legislature even made efforts to spend more and tax less, to bring down balances. Property taxes were made deductable from state income taxes, the homestead credit on property taxes was increased, more money was spent on highways, and more was saved for future teacher pensions. Balances stayed high anyway.

But very suddenly, at the end of calendar year 2000, the economy turned downward. The recession took many people by surprise, including Indiana revenue forecasters. By the end of fiscal year 2001 revenues were $720 million less than the original forecast.  Revenues had actually fallen from the previous year, by $90 million. The $2 billion balance was down to $910 million. That was still 10% of the budget, which is usually good enough. 

But then things got even worse.  Revenues fell again in fiscal 2002, by $340 million from 2001. Revenues fell short of predictions by $820 million. In other words, the budget had been written based on predictions that revenue would rise by $480 million. Instead, revenue fell $340 million. The state's balance dropped to $534 million, only 6.1% of the budget.

In June 2002 the General Assembly passed a tax restructuring plan. The sales tax rate was increased from 5% to 6%. Tobacco and riverboat gaming taxes were increased too. Most of this added revenue was used for property tax relief, to protect homeowners from some of the effects of the 2002-03 market value reassessment. State property tax relief payments doubled. Tax relief became the second largest item in the state's budget, after K-12 education. But about a third of the added revenue went to shore up the state's budget.

With the higher taxes, revenues rose from 2002 to 2003, but not as much as predicted. Revenues still fell short of what had been budgeted. The shortfall in 2003, including the money that restructuring was expected to raise, but didn't, was $1.1 billion. Revenues fell short again in fiscal 2004, by $73 million. All told, from the first shortfalls in 2000 to the last in 2004, revenues came in $2.8 billion less than predicted.

By June 30, 2004, balances had sunk to $533 million, only 4.9% of the budget. That was slightly less than the rule-of-thumb rock-bottom-minimum of 5%. Balances were too low.

The revenue shortfall had been $2.8 billion from 2000 to 2004. The sum of the current year deficits over that period was $4.3 billion. This implies that even if revenues had arrived as expected, the state had planned on spending $1.5 billion more than it took in. In the early years of the decade, this was probably the result of attempts to bring down high balances through higher spending and lower taxes. In the later years it may have been the result of tax restructuring for property tax relief.

Balances declined "only" $1.5 billion. The rest of the $4.3 billion shortfall was covered in several ways.

• Money was transferred to the general fund from other funds. In particular, money that would ordinarily have funded local capital projects in the Build Indiana Fund was transferred to the general fund to cover revenue shortfalls.
• There were hundreds of millions of dollars in reversions, which are appropriations that are authorized but not spent. Several times, governors asked state agencies to spend less than their full appropriations.
• There were over $700 million in payment delays. Payments to local governments for property tax relief and tuition aid to local schools were delayed from one fiscal year to the next. That reduced spending in the earlier year.

The adjustments summed to more than one billion dollars in each of two big years, 2002 and 2003. Over the whole 2000-2004 period adjustments summed to $2.9 billion. About $1.4 billion of this was fund transfers, $770 million was reversions, and $700 million was payment delays. Clearly, the adjustments played a major role in covering the revenue shortfalls from recession. In fact, about two-thirds of the shortfall was covered with adjustments, one-third with balances.

The General Assembly also restricted spending growth after 2001. In the two biennial budgets from 1998 to 2001, appropriations increased 6.5% per year. In the two biennial budgets from 2002 to 2005, appropriations increased only 3.6% per year.

Turning the Corner in 2005
In 2005, for the first time since 1999, actual revenues exceeded predictions. In 2003 the state had predicted revenues at $11,192 million for 2005. Actually, in 2005 revenues were $11,436 million, $244 million more than predicted when the 2004-05 budgets were passed. In 2005 the state's balance increased, from $533 million (4.9% of the budget) to $750 million (6.5% of the budget). Partly this was unexpectely high revenues. Partly it was continued reversions, transfers from other funds and slower spending growth.

Balances were still too low, however. In the budget-writing sessions in Spring 2005, the General Assembly clamped down even harder on spending growth. In total, appropriations grew only 2.6% in fiscal years 2006 and 2007. In both years, once again, revenues came in above forecast, by $303 million in 2006 and $248 million in 2007. This added revenue combined with the spending restraint produced the first "balanced budgets" since 1997. Revenue collections exceed appropriations for the 2006 and 2007 fiscal years.

How was spending growth kept so low?

The state pays almost $5 billion to school corporations—that’s the largest piece of the state budget. Spending growth cannot be held down without reducing growth in K-12 education aid. The increase in K-12 education spending was held to 1.5% per year for 2006 and 2007. To partly make up for this small aid increase (or, for some school corporations, an aid reduction), the legislature changed the rules that limit how much schools could raise in property taxes. The new rules allowed schools increase property taxes more.

The legislature appropriated about 5% more per year for Medicaid. Medicaid is an entitlement program, however, which means that the state must pay whatever people are entitled to receive under the program's rules. Under the eligibility rules, originally Medicaid costs were expected to rise 7% to 10% per year in 2006 and 2007. The state found ways to save on Medicaid expenses.

The state reduces property taxes by paying property tax relief. The state homestead and property tax replacement credits are subtracted from what taxpayers owe. Because of the credits, local governments receive less, and the state makes up the difference with payments to local governments from the state budget. Property tax relief is the second largest item in the state budget. It cost $2.3 billion in 2008, and it was growing. To help balance the state budget, in 2005 the Governor and the General Assembly decided to cap property tax relief. Over the biennium property taxes would continue to rise, but state tax relief payments would not. Property owners would pay instead. The cap became effective in 2007, and this reduced the property tax credit percentages by about 8%. A fixed state relief payment was a smaller share of a growing property tax levy. However, during both the 2006 and 2007 sessions legislators decided to offer added property tax relief to homeowners. The 2007 session added new homeowner relief for taxes in 2007 and 2008.

Increases in revenue growth and spending restraint combined to build balances back to $1.4 billion by the end of fiscal 2008. Balances rose to 10.7% of the budget, exceeding the minimum of the prudent range. The original budget for the 2008-09 biennium allowed appropriations to rise more rapidly, at 3.7% per year overall. This was still less than growth in the earlier part of the decade, but more rapid than the 2006-07 biennium. Both K-12 and higher education saw their biggest increases of the decade. Yet the budgets were balanced, with current year revenues exceeding current year appropriations. Balances remained near 10% of the budget, and the payment delays were scheduled to be reversed by mid-2009.

The Outlook for the Budget
In fiscal 2008 revenues exceeded projections for a fourth straight year. Revenues were $113 million higher than had been predicted when the budget was written in Spring 2007. Indiana revenues have not yet reflected an economic slowdown.

However, the December 2007 revenue forecast reduced projected revenues for fiscal 2009 by about $265 million. The April 2007 forecast had projected Indiana personal income growth to average about 4.5% in 2008 and 2009. The December forecast reduced this projection to 3%. Revenues have not yet been affected by slow economic growth, but the forecast expects that they will be.

What resources can Indiana bring to stave off spending cuts and tax increases, should a recession reduce revenues?

At the end of fiscal year 2008, on June 30, 2008, Indiana had balances of $1,413 million, 10.7% of the budget. By the end of fiscal year 2009, balances are expected to be $1,346, 9.4% of the budget. The $265 million revenue shortfall predicted in December is expected to cut the state's expected balances slightly below the prudent minimum. The rule-of-thumb absolute minimum is 5% of the budget. Indiana's balances reached that level in 2004. In 2009 5% of the budget would be $718 million. Balances are expected to be about $630 million more than this minimum at the end of that fiscal year. That $630 million is available to cover revenue shortfalls.

On the same day that the December forecast was announced, the Governor asked state agencies to spend 5% less than their appropriations during the 2008 fiscal year. Reversions were $133 million in 2008, and are projected to be $91 million in 2009. Reversions have been higher in past years--$323 million in 2003 and $222 in 2005. Those two figures average $180 million above the projected $91 million in reversions for 2009. Perhaps an added $180 million might be reverted to the general fund in 2009.

During 2000 to 2005, fund transfers averaged $276 million per year. The projected figure for 2009 is $13 million, so an added $260 million in fund transfers is plausible.

Indiana expects to fully reverse the payment delays by the end of fiscal 2009. It would seem that the payments delay "gimmick" is ready for use again, if needed. However, the 2008 tax reform has changed the nature of these payments. Property tax replacement credits and homestead credits--which make up the property tax relief category in the budget summary--will be phased out by fiscal 2010. There will be no property tax relief payments to local governments that could be delayed. Most of this relief spending will be used to pay for the state takeover of the school general fund property tax levy. The state will continue to make periodic payments to school corporations, but these payments will be larger, including existing state aid and revenue to replace property taxes. Perhaps one of these periodic payments to school corporations could be delayed from June to July if needed. In 2002 and 2003 payment delays of school aid and property tax relief amounted to $710 million. Perhaps a similar figure, say $700 million in payment delays, would still be available.

These figures sum to almost $1.1 billion without the payment delays, almost $1.8 billion with the delays. If the state is willing to take the same actions in the next recession as it took after the last--running balances down to 5% of the budget, requiring state agencies to spend less than appropriated, tapping other funds, delaying local payments--Indiana may be able to absorb a $1.8 billion shortfall in revenues without reducing appropriations or raising taxes. This $1.8 billion figure is in addition to the $265 million shortfall already projected for 2009.

Whether this is enough depends on how long and how deep is a recession. The 2001 recession resulted in revenue shortfalls much bigger than $1.8 billion. If 2009 and 2010 are like 2001 and 2002, Indiana will be faced with a severe budget problem. A milder recession can be handled. If the $265 million shortfall already incorporated into the budget numbers is all the revenue loss Indiana sees, the state will hardly notice the downturn.

Suppose Indiana wants to avoid payment delays, fund transfers and reversions, and handle a revenue shortfall with balances alone. How big would balances have to be? Again, this depends on how long and deep is a recession. Revenue shortfalls averaged $570 million per year from 2000 to 2004. Let's use this figure. The state has already predicted a $265 million shortfall in 2009, so the "typical" recession year would have $305 million more. To cover a $570 shortfall, then, the state must have balances equal to 5% of its budget ($718 million in 2009), plus $305 million, to cover a one-year recession. That's $1,023 million as of 2009, 7.1% of the budget. The state expects to have much more than that by the end of fiscal 2009. Existing balances can handle such a recession.

A two-year recession would require an added $570 million in balances. That would be $1,593 million, 11.1% of the 2009 budget. A three year recession would require $2,163 million, 15.1% of the budget. The state does not expect to have such balances by the end of fiscal 2009.

At the start of fiscal 2000, the state had $1,991 million in balances, which was 17.8% of the budget. It was not nearly enough to handle the revenue shortfalls that actually occurred. Fund transfers, reversions, payment delays, slower appropriation growth and tax hikes were needed.

Indiana can handle a one-year revenue shortfall with its expected 2009 balances, based on experience from 2000 to 2005. If shortfalls continue for more than one year, the state will have to resort to other measures.

In calendar year 2009, fiscal 2009-2010, the state will take over the school general fund property tax levy. This levy will disappear, and the state will fund the whole of the local school general fund budgets. The property tax is a stable revenue source in recession. Assessed values are slow to respond to property value changes, and tax rates adjust upward to compensate for assessed value declines. The sales and income taxes that fund the state budget are not so stable. Moving from the property tax to the sales and income taxes makes school funding less stable.

A reasonable response to this concern is to increase balances to help maintain school spending should there be sales and income tax shortfalls. The state has increased the tuition reserve to $400 million in 2008 and 2009 for this reason. However, as of this biennium, this is a shift from one segment of combined balances to another. General fund balances are smaller, and tuition reserve balances are higher. Total balances are unaffected.

Come 2010, the state will have to fund a full year of school general fund spending (as well as a full year of county welfare). Appropriations will increase by (perhaps) another billion dollars. Total balances would have to be $100 million higher just to maintain the 10% prudent level recommended by the Budget Agency. If added protection for school approprations is desired, balances would have to rise more.