By Matthew Knittel

In November 2023, the Independent Fiscal Office (IFO) released its annual five-year economic and budget outlook for Pennsylvania. For fiscal year (FY) 2023-2024, the forecast projects a General Fund budget deficit of $620 million, but a General Fund surplus balance of $7.5 billion, which includes positive carryforward balances from prior years. When combined with the projected ending balance for the Rainy Day Fund ($6.3 billion), the Commonwealth will have $13.8 billion in savings that could support future spending or be held as savings to mitigate the impact of any future recessions.

After FY 2023-2024, the IFO forecasts that the budget deficit will grow: from $2.0 billion in FY 2024-2025 to $4.0 billion by FY 2028-2029. Several factors will drive this growth:

• The complete phase-out of federal pandemic monies used to support spending.
• Unusually slow tax revenue growth.
• The expansion of the state’s elderly population age 80 or older. From 2025 to 2030, that age demographic will expand by 136,000 residents (+21%).

For many, health care costs increase dramatically after age 80. The state program that provides health care support to elderly residents (and others) is Long-Term Living. For this year, the program was appropriated $5.7 billion (12.7% of General Fund spending). Due to rapid demographic growth, projected program spending expands at a rate of 6% per annum over the next five years, reaching $7.6 billion by FY 2028-2029 (14.3% of expected spending).

For General Fund revenues, two factors will constrain future revenue growth. The first (and larger) factor is the continued phase-in of the corporate net income tax rate reduction. The rate is scheduled to fall from 8.99% for tax year 2023 to 4.99% for tax year 2031. By FY 2028-2029, the tax cut reduces revenues by $1.9 billion. The second factor is Treasury collections from interest earned on unusually large General Fund surplus balances. (Note: the Rainy Day Fund is separate and any interest that accrues remains in that fund and is not counted as General Fund revenue.) For FY 2023-2024, the forecast projects nearly $680 million of interest earned on General Fund balances, which declines to $75 million by FY 2028-2029. The current General Fund surplus balance earns a rate of roughly 5.25%. Over time, Treasury collections contract as the federal funds rate is reduced and balances are depleted because they are used to fund future deficits.

When compared to other states, the structural deficits faced by Pennsylvania are not unusual, nor are the high balances in state savings accounts. For example, the California Legislative Analyst’s Office estimates deficits of $33 billion for each of the next two fiscal years, which represent 15% of projected spending. Based on recent data published by the Pew Charitable Trusts, California has $52 billion in reserve balances (22% of annual spending). Also, the Illinois Office of Management and Budget projects structural deficits of roughly $1.5 billion, which represents 3% of annual spending. However, Illinois has only $2.1 billion in reserve balances (4% of spending). For Pennsylvania, the IFO projects an average structural deficit of $3 billion per annum over the next five years, and current reserve balances of $13.8 billion (28% of spending).

The factors that drive state structural deficits are similar: a combination of the loss of temporary federal funds, recent tax cuts, and strong growth in discretionary spending, such as education and infrastructure projects. The temporary windfall of federal monies (both direct grants and higher tax revenues) facilitated the enactment of permanent revenue and spending changes. Whether states will need to make future policy changes to amend those enacted during the unusual pandemic years will soon become evident, and will depend on state economic performance.

Similar to the states, household savings achieved recent record highs, but much of the excess savings has now been depleted. This is particularly the case among low-income households and renters, who did not benefit from the rapid growth in home prices. The depletion of household savings has not yet had a material impact on state tax revenues, such as sales and use taxes. Consumer resilience is a primary reason why a much-anticipated recession has been repeatedly “postponed.” If the Federal Reserve reduces interest rates in the spring, then a housing market recovery could provide even more relief to consumers and further facilitate the often-mentioned soft landing.

Matthew Knittel has served as director of the Pennsylvania Independent Fiscal Office since its creation in 2011. Prior to his tenure, he was a financial economist for the U.S. Treasury Department and Michigan Department of Treasury. He received a PhD in economics from Michigan State University. He can be reached at mknittel@ifo.state.pa.us.

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