States banking big bucks as Fed attempts to fight inflation

JEFFERSON CITY, Mo. — State governments emerging from the coronavirus pandemic built historic cash surpluses as inflation in prices and wages drove up sales and income tax collections.

Now many states are reaping another reward: banking millions of dollars off those surpluses as the Federal Reserve fights inflation with higher interest rates.

"We're catching both ends of it," said Missouri Treasurer Scott Fitzpatrick, a Republican.

First, "we received a lot of extra money," he said. "Now, nominally, we're benefiting from the increase in interest rates from the Fed."

Missouri is hardly alone. States ranging from Democratic-led Massachusetts to Republican-led Texas as well as politically divided Minnesota all are sitting on large surpluses that are swelling even further thanks to favorable interest rates on investments.

As legislatures prepare for their 2023 sessions, governors and lawmakers are proposing to tap into those surpluses to cover tax cuts and greater spending on priorities such as infrastructure and education. Though most states can afford it, financial experts are nonetheless urging caution because of concerns the U.S. could slip into a recession.

"Some of this is what I call a sugar high," said Phil Dean, chief economist and public finance researcher at the University of Utah's Gardner Policy Institute. "The growth rates are definitely not sustainable."

California could be a harbinger of economic trends. After projecting an unprecedented $97 billion surplus just seven months ago, state officials are now forecasting a roughly $25 billion deficit in the next budget. California imposes higher taxes on the wealthy than most states, leading to pendulum-type swings in tax revenue as the stock market rises and falls.

State budgeters have labored through abnormally uncertain times since the coronavirus pandemic began in early 2020. As governors ordered shutdowns to try to slow the spread of the virus, layoffs skyrocketed and states braced for huge revenue losses. But federal relief payments put spending money in people's pockets, labor markets rebounded and the deep downturn was short-lived.

State tax revenue surged well beyond expectations. After back-to-back years of double-digit percentage growth in revenue, states ended their 2022 fiscal years with a record cash balance of nearly $343 billion, according to the National Association of State Budget Officers.

"Budgets are really strong — historically strong," Tim Storey, CEO of the National Conference of State Legislatures, said as he previewed the upcoming legislative sessions.

Large surpluses put states in a position to benefit as the Federal Reserve raised its benchmark interest rate seven times this past year, making many loans more expensive in an attempt to slow spending and fight inflation.

Texas had projected a $27 billion surplus for its current budget, boosted by strong sales taxes and energy revenue. That's likely to rise to more than $30 billion when a revised revenue estimate is released in January, said Tom Currah, associate deputy comptroller for fiscal matters. That's a larger surplus than the annual general fund expenditures of 40 other states.

Republican Gov. Greg Abbott promised during his reelection campaign that half the surplus would go toward property tax relief.

Surging tax revenue in Massachusetts this year triggered a seldom-used state law requiring $2.9 billion to be returned to taxpayers. Large cash balances allowed the state to collect nearly $57 million of interest in October alone — six times the amount earned during the entire 2021 fiscal year.

Minnesota Gov. Tim Walz reviews notes before speaking about the state's budget Dec. 6 at the Minnesota Department of Revenue in St. Paul, Minnesota. Minnesota is projecting a record $17.6 billion surplus for the next budget. Walz said the state can afford to provide tax rebates and increase spending on education and infrastructure.Alex Kormann ~ Star Tribune via AP, file

Minnesota is projecting a record $17.6 billion surplus for the next budget. A strong economy, with one of the lowest unemployment rates in the nation, pushed individual income, sales and corporate tax revenues higher than originally projected. Political gridlock contributed to the swollen coffers, as the Republican-controlled Senate and Democratic-led House couldn't agree on how to use all the extra money.

Thanks to higher interest rates on the huge surplus, Minnesota expects investment earnings of $428 million this fiscal year — a whopping 1,427% increase over a prior estimate.

Democrats who were victorious in the fall elections will hold full control of Minnesota government in 2023. Gov. Tim Walz said the surplus could be used to provide tax rebates, increase investments in education, modernize infrastructure and add charging stations for electric vehicles.

"We can do all of these things. This isn't a choice of either-or," Walz said.

Virginia finance officials expect the nation to fall into a recession in 2023, depressing the state's tax revenue. Yet the state has so much extra money that Republican Gov. Glenn Youngkin recently proposed an additional $1 billion in tax cuts and $2.6 billion in spending on education, economic development, public safety, behavioral health and the environment.

"Our state government's financial condition has never been stronger," Youngkin said.

Citing a large surplus, Missouri Gov. Mike Parson called lawmakers into a special fall session to pass what he described as "the largest tax cut in the state's history." The first rung of the eventual $760 million income tax cut takes effect in January. Yet Missouri still expects to finish its 2023 fiscal year with a surplus, leaving money to potentially spend on things such as teacher pay raises.

In the first five months of its fiscal year, Missouri already has earned $116 million on its investments — nearly doubling the earnings of the entire previous year. But Fitzpatrick, the treasurer, advises caution for policymakers.

"Even though we're making a lot of money, inflation is outpacing what we're able to make on our money," said Fitzpatrick, who will take office as the elected state auditor Jan. 9. He added: "We need to be careful not to commit the state to a lot of ongoing new expenditures."

Pennsylvania's treasury is projected to rake in $275 million of interest this fiscal year — 13 times the average amount over the past five years. Though comprising just a fraction of the state's overall budget, the interest earnings would be large enough to run any of the state's Cabinet agencies for a full year, except for education, human services and corrections.

Republican Treasurer Stacy Garrity recommended that budget writers put the extra cash into reserve, pointing out that an independent fiscal agency projects a billion-dollar-plus deficit for the 2023-2024 budget year.

"We know that a fiscal cliff is looming, and it's crucial that the Commonwealth prepare as much as possible," Garrity's office said.

Some other states also are forecasting leaner times.

Under a recently revised revenue forecast, Oregon expects to reap $190 million of interest during the current budget cycle — almost double the amount that had been projected just three months earlier. The state expects a $4 billion surplus this year. But state fiscal analysts also expect a mild recession in 2023 that could help flip the surplus into a $560 million budget deficit during the next two years.

"The sharp rise in interest rates this year is akin to taking one's foot off the gas and slamming on the brakes. The car will shake, skid and even fishtail," said a report by Oregon's Office of Economic Analysis. "The ultimate question is does it end up in the ditch or is the driver able to pull out of it?"

Associated Press writers Steve LeBlanc in Boston; Steve Karnowski in St. Paul, Minnesota; Marc Levy in Harrisburg, Pennsylvania; Sarah Rankin in Richmond, Virginia; and Claire Rush in Portland, Oregon, contributed to this report. Rush is a corps member for the Associated Press/Report for America Statehouse News Initiative. Report for America is a not-for-profit national service program that places journalists in local newsrooms to report on undercovered issues.