In a Nutshell:

• The Michigan legislature completed work last week on a new state budget, but $7 billion in state revenue remains in reserve for future negotiations on tax relief.
• Policymakers, however, should tap some of that revenue reserve to increase the balance of the state’s Budget Stabilization (“Rainy Day”) Fund as economic forecasters grow increasingly concerned about the potential for a national recession.
• While the BSF balance already sits at $1.6 billion, we recommend boosting the balance to $2.2 billion and retaining a $1 billion balance in the School Aid Fund to ensure the state is prepared to weather an economic downturn.

The state legislature completed its work on a $77 billion state budget in the wee hours of the morning last Friday.  The budget now heads to Governor Whitmer’s desk.  In a press release, the governor called it a “balanced, bipartisan state budget”, so it seems likely to garner her signature in the near future with minimal, if any, vetoes.

Still, both the legislature and administration acknowledge that work remains on another shared goal: tax relief for Michigan residents. Budget leaders have indicated that roughly $7 billion in state revenue was left in reserve under the budget agreement, and that revenue will leave significant room for tax cutting as the legislature and administration seek common ground this fall.

That surplus, however, is dependent on forecasts of continued strong revenue growth; and strong revenue growth will only continue if the economy keeps growing. Over the last month, however, prospects for economic growth have become much less clear.  The Federal Reserve has signaled it will continue to hike interest rates this year to combat persistently high inflation. Those hikes along with continuing supply chain challenges and international turmoil have fueled concerns about the possibility of a national recession.  In a recent University of Chicago survey, 70 percent of the economists were forecasting a recession to occur before the end of 2023.

Before finalizing a tax relief plan, Michigan policymakers should consider another important priority: preparing for our next financial rainy day.

Summary of Post-Budget Revenue Surplus

As we’ve covered in past blogs, the state’s revenue picture has been unexpected rosy since early in the COVID-19 pandemic.  Massive federal relief (e.g., stimulus checks, enhanced unemployment benefits, Paycheck Protection Program) helped drive up incomes and spending – and thus state revenues.  Further, states have received multiple rounds of direct aid from the federal government.

Some of that federal relief has now expired, and most of the state aid has been spent but its effect on the state economy is still being felt.  Growth in the state’s own revenues is currently expected to remain strong.  Even after approving a record-high state budget last week, the combined revenue balance in the state’s General Fund/General Purpose (GF/GP) and School Aid Fund (SAF) accounts is expected to be $7 billion at the end of Fiscal Year (FY)2023.

As noted above, it is expected that the legislature and administration will work this fall to tap into some of that balance to facilitate tax relief for Michigan residents.  That tax relief could come in two forms: (a) ongoing tax relief like an income tax rate cut, an increase in the Earned Income Tax Credit, or changes to the taxation of retirement income that generate permanent annual savings; or (b) one-time tax relief like a sales tax pause on gasoline or an income tax rebate that generate more immediate, but one-time only tax savings.

The table below breaks down the available revenue balances to highlight the amount of financial resources available to finance both forms of tax relief.  The $7 billion combined balance in the first column represent “money in the bank” for the state; any of that funding could be tapped to provide one-time tax relief or cover new one-time spending.  The second column looks ahead to FY2024 and shows the expected gap between estimated annual state revenue and existing annual state spending based on the approved FY2023 budget and known spending pressures (e.g. expected Medicaid cost growth).  Those figures suggest that around $2.5 billion in ongoing excess revenue is available to fund either permanent, ongoing tax relief or new spending priorities in next year’s budget.  Ongoing tax relief beyond that level would eventually require cuts to the existing budget.

Summary of State Revenue Surplus – One-Time vs. Ongoing Resources

Source: Media reports and Research Council analysis of revenue estimates and FY2023 appropriations

Regardless, both the governor and legislature have signaled tax relief will be high priority. Again, though, with economic prospects potentially dimming, policymakers should ensure that sufficient revenue balances are retained to guard against an economic downturn.  But how much would be needed to safeguard the state from the next recession?

Saving for the Next Rainy Day

State rainy day funds build up reserves to help mitigate the impact of economic downturns. A healthy balance helps fill the void when states face revenue declines and safety net spending pressures (e.g., Medicaid) grow during a recessionary period. In our 2018 report, the Research Council documented the history of Michigan’s Budget Stabilization Fund (BSF), noting that the balance at that time was insufficient to help stabilize the state’s budget picture under even a modest economic downtown.

The good news: that situation has now changed.  Since 2018, Michigan has continued to build up its BSF reserves.  The budget approved last week includes another $180 million deposit to the BSF, bringing the total expected balance to around $1.6 billion.  That’s a record high for Michigan’s rainy day fund, and the balance now equates to roughly 5 percent of combined GF/GP and SAF revenues.

But, while the balance has improved, it may still fall short of the amount needed to weather a national recession.  Our 2018 report noted recommendations on an adequate rainy day fund balance ranged from between 5 and 15 percent. More recently, the credit rating agency Moody’s published the results of a stress-test study that suggested states on average would need reserves equivalent to around 11 percent of general revenues to navigate the next recession without revenue increases or budget cuts.

A look back at the BSF’s history illustrates how quickly an economic downturn can deplete what appears to be a healthy reserve balance.  Michigan’s BSF reached its previous peak level in FY1999 when the balance exceeded $1.2 billion.  As the table below illustrates, that equated to 6.2 percent of combined GF/GP and SAF revenues that year. However, the national recession in 2000-2001 quickly exhausted those reserves; by FY2003, the balance was gone.

Michigan BSF Balance as Percentage of Combined Revenue

Source: Research Council calculations based on Senate Fiscal Agency data

Given the state’s economic struggles during the period between 2001 and the Great Recession, Michigan did not take steps to replenish the BSF until FY2012.  Since then, the state has smartly built the balance back up.  But while this latest deposit brings the balance to a record high in absolute terms, the balance remains below the FY1999 threshold when measured as a percentage of combined GF/GP and SAF revenue.

State statute currently limits the fund’s balance to no more than 15 percent of the combined annual GF/GP and SAF revenue.  Today, that would amount to about $4.7 billion.  The Moody’s report would suggest Michigan’s balance should be in the range $3.4 billion to be an effective buffer against a recession.

However, it should be noted that Michigan may have another less obvious recession buffer already in place. More than half of Michigan’s combined GF/GP and SAF revenues flow to K-12 schools, and we’ve noted that multiple rounds of COVID-19 relief funding to school districts have already helped school districts to build up significant budget reserves; our analysis showed 90 percent of districts had reserves equal to at least 10 percent of their annual general fund revenue in FY2021.  Those internal reserves effectively act as rainy day funds at the individual district level and would mitigate the need for the state to tap into the Budget Stabilization Fund to the same degree during a downturn to maintain school aid spending.

Still, given the state’s sizable fund balances, resources are available to provide significant tax relief to Michigan residents while retaining sufficient reserves to guard against the worst-case scenario of a near-term U.S. recession. We recommend that policymakers grow the BSF to $2.2 billion (about 7 percent of combined revenue) and retain a balance of at least $1 billion in the School Aid Fund to ensure the state has those reserves in place.  Effectively, that sets aside $1.6 billion of the current $7 billion combined fund balance as a rainy day umbrella.  That still leaves $5.4 billion in reserves on the table for tax relief negotiations.

Importantly, the added reserves will ensure that both the approved budget and any ongoing tax relief that’s coming are sustainable even if the economy turns sour.