States Must Prepare for a Decline in Investment Revenue to Avoid Fiscal Instability

Understanding the Surge in State Investment Income

The unexpected surge in state investment income has transformed fiscal landscapes across the nation. Historically, earnings from investments were a minor component of state revenues. Yet, following the 2020 recession and subsequent recovery, coupled with generous federal aid, states found themselves with unprecedented surpluses. By the end of fiscal 2023, general fund ending balances skyrocketed from $33 billion to $251 billion nationally. Rainy day funds also saw a significant boost, increasing from $77 billion to $183 billion over the same period.These surpluses, combined with rising interest rates starting in March 2022, led to substantial investment yields. For instance, Florida's interest and investment earnings soared from $223 million pre-pandemic to over a billion dollars by fiscal 2024. Alabama reported a staggering 902% increase in interest earnings from state deposits between fiscal 2022 and 2023. Illinois witnessed an even more dramatic 1,257% rise during this timeframe.

Investment Earnings: A Double-Edged Sword

While the surge in investment earnings provided immediate financial relief, it also introduced new challenges. States typically invest surplus funds conservatively, prioritizing liquidity and minimizing losses. Pooled investment funds, often invested in U.S. Treasury bonds, became unexpectedly lucrative. In New Hampshire, these earnings were the largest source of revenue growth in dollar terms for fiscal year 2024.However, the future of this revenue stream is uncertain. As states’ total balances decline and interest rates drop, investment earnings are expected to fall. Data suggests that Florida, Maryland, Montana, and Pennsylvania’s earnings peaked in fiscal 2024, while Michigan’s peaked in fiscal 2023. The loss of this revenue could significantly alter states’ fiscal outlooks, particularly if they have become reliant on these earnings for ongoing expenses.

Strategies to Mitigate Fiscal Risks

Recognizing the volatility of investment earnings, some states have implemented strategies to mitigate potential budget problems. Ohio Governor Mike DeWine vetoed a measure that would have directed rainy day fund interest earnings to the general fund, emphasizing the importance of preserving budget stability. Montana passed legislation requiring all interest earnings to be transferred to a newly created fund for debt repayment, ensuring these one-time funds are not used for recurring expenses.Alabama and Utah have adopted proactive approaches to manage extraordinary investment earnings. Alabama’s deputy director of the Legislative Service Agency, Kirk Fulford, highlighted efforts to focus abnormal growth in funds toward one-time expenses. Utah conducts trend analyses to identify nonrecurring revenue, using only the ongoing portion for recurring expenses.

Learning from Past Fiscal Challenges

The current situation mirrors past instances where states faced temporary revenue spikes. Whether from higher tax collections during economic booms or major legal settlements, states have developed strategies to navigate these fluctuations. New Hampshire uses long-term projections to determine sustainable spending levels, ensuring that current commitments can be maintained in the future.By limiting the use of one-time dollars for ongoing expenses, states can benefit from revenue surges without setting themselves up for fiscal cliffs. This approach not only addresses the current challenge but also provides a framework for managing any future temporary revenue increases effectively.