Budget Shortfall Factors
In determining a state’s fiscal health, credit rating agencies and other analysts often look at two fundamental issues. The first is how well a state manages its budget on a year-to-year basis, through good times and bad. The second is a more fundamental review of a state’s tax structure and spending commitments to determine whether the state’s budget is structurally balanced — that is, whether the state’s spending commitments are consistent with expected revenues over the long term.
Delaware Has A Strong Track Record On Year-To-Year Budget Management
On the first measure, Delaware scores very high. The state has maintained the highest credit rating from the three main municipal credit rating agencies, which often cite Delaware’s conservative fiscal management as a key reason for the high ratings. Its state constitution creates a rainy day fund, which receives all unencumbered funds remaining at the end of each fiscal year, so that it equals 5 percent of estimated General Fund revenues.
It also prohibits appropriation of more than 98 percent of estimated General Fund revenues each year. The legislature can appropriate from the rainy day fund to cover unanticipated deficits or tax cuts and may exceed the 98-percent limit, but both of these exceptions require a three-fifths vote and the latter also requires an emergency declaration.
In addition, the Delaware Economic and Financial Advisory Council (DEFAC), created by executive order in 1977, provides non-partisan oversight. The DEFAC meets 6 times per year to make revenue and expenditure projections. When these projections show that a budget deficit is likely, they trigger the legislature to exercise its authority, by three-fifths vote to release funds set aside by the 98-percent rule and the administration may, in addition, revert funds to reduce expenditures.
Most importantly, the state has a strong track record of acting on budget information, by taking prompt measures to offset looming shortfalls and maintain balanced budgets. Figure 1 shows that, the state was able to maintain budget reserves through the Great Recession that were dramatically higher than
However, It Is Now Faced With a Serious Structural Budget Shortfall
Despite its strong record on year-to-year budget management, the state is facing an emerging structural shortfall in its General Fund budget. The state’s challenge in this regard is not unique — indeed recent surveys indicate that well over one-third of state governments continue to grapple with budget shortfalls well after the conclusion of the Great Recession.
Nevertheless, the problem is of concern to Delaware, given that its shortfalls are persisting well into the economic expansion — a time when states should be running operating surpluses and building reserves. The manifestation of the shortfall is evidenced in the right‐hand side of the above chart, which shows that the state’s cash balance was drawn down in two of the past three years to support expenditures included its annual budgets.
In January of 2015, DEFAC presented a forecast of Delaware’s outlook through FY 2019, noting in its presentation to the Advisory Council on Revenues that “despite building economic momentum, Delaware’s budget projections suggest a growing imbalance.”
However, It Is Now Faced With a Serious Structural Budget Shortfall
A logical question is why Delaware is facing budget shortfalls five years into an economic expansion.
As discussed more fully in subsequent sections of this report, part of the problem is related to factors that have been brewing for many years — below-average economic growth, inelastic revenues, and rapid spending increases in Medicaid and employee (active and retiree) health insurance. However, some of the problem faced today can be also traced to how the state dealt with the major budget shortfalls that developed during the 2008 through 2010 recession.
Specifically, Delaware relied heavily on temporary solutions to maintain balanced budgets during the period. Our review of budget-balancing actions taken by the 50 states for fiscal years 2009 through 2012 suggests that, while Delaware did reduce spending on state employees and operations, it made fewer ongoing reductions than other states in core programs such as education, health, social services, and corrections.
As one example, the chart below compares inflation-adjusted K-12 per-pupil funding in Delaware versus the 50-state average during the 2008 through 2014 period. It shows that while other states were cutting per-pupil funding by 4 percent over this period, Delaware was increasing funding by 12 percent.
While in some respects maintaining or increasing funding for public services through a recession may be considered laudable, the reliance on one-time solutions to do so has serious downsides. Because of the insufficient ongoing savings, the state’s underlying mismatch between revenues was not fully addressed, and shortfalls are now reemerging as the temporary solutions run their course.
The expenditure-side effects of the temporary solutions are depicted in the chart below, which shows that while General Fund spending was reduced by 8 percent between 2007 and 2010, it subsequently rebounded by 17 percent in the following two years, in part due to federal funds received under the American Recovery and Reinvestment Act.
Delaware Relied on Some Widely Used Temporary Solutions
Many of Delaware’s one-time budget actions were widely employed by states across the nation. For example, Delaware received temporary federal funds that were provided to all 50 states under the American Recovery and Reinvestment Act of 2009.
Delaware state government’s portion of these funds totaled about $450 million, and were used during the FY 2009 through FY 2011 period to offset General Fund spending for Medicaid, public education, and several other areas. Delaware was also one of many states that imposed temporary tax increases (some of which were subsequently made permanent), and relied on transfers of surpluses from special funds to support spending from its General Fund.
But Its Reliance on Abandoned Property Revenues Was Unique
In addition to these actions used by states across the nation, however, Delaware used an extraordinary increase in abandoned property revenues to help maintain its spending levels. Figure 5 shows that revenues from this source jumped from $126 million in FY 2000 to $325 million in FY 2007, then further to $567 million in FY 2013 before falling back modestly in the subsequent two years. We estimate that the extraordinary growth in revenues from this source from 2007 onward enabled the state to avoid roughly $100 million per year in program reductions or tax increases between 2009 and 2014.
Factors Behind the Increase. The large amount of abandoned property revenues is related to the large number of companies incorporated in Delaware — nearly two-thirds of Fortune 500 companies and well over 90 percent of new corporate businesses each year. In 1965, the U.S. Supreme Court ruled that, in cases where the owner of abandoned property cannot be found, the state where the property’s holder is incorporated has a valid claim to the property, thus enabling Delaware to claim escheated revenues from a company’s operations in all 50 states.
The sharp increase in abandoned property collections was the result of a significant expansion in auditing and collection activities by the state. The expansion was aided by the enactment of Senate Bill 272 in 2010, which codified existing practice. This measure permits the state to estimate a company’s liability for unclaimed property when the company’s records are deemed insufficient to accurately determine the escheatable amounts. In some cases, the state has made estimates based on audit periods going back to 1981.
Revenues May Have Peaked. While the expansion in abandoned property collections temporarily helped the state avoid deeper cuts during the recession, it appears that this revenue source has peaked, and is at risk of declining in years ahead. Moreover, Delaware currently faces a major court challenge that could result in the invalidation of the estimation methodology that has been used to expand collections. Specifically, in March 2015, the U.S. District Court for the district of Delaware denied the state’s motion to dismiss several counts of a lawsuit claiming that the state’s unclaimed property techniques are unconstitutional. While not a final decision on the merits of the case, the ruling signals that the state’s estimation method for collecting abandoned property is at risk.
Even if the state survives this court challenge, however, the abandoned property revenue source is showing signs of being tapped out. A substantial share of the annual collections in recent years has been from the extensive audit activity, which is meeting much resistance from businesses and ultimately poses a threat to Delaware’s otherwise stellar reputation for supporting businesses that choose to incorporate in the state. The long look-back periods and non-evidence-based estimation methodology can easily be perceived by business as an unwarranted additional “tax” or cost of incorporating in Delaware.
In 2014, the Delaware Legislature created the Unclaimed Property Task Force to review the state’s abandoned property program. The task force subsequently issued recommendations that were intended to stabilize collections from this revenue source in the future, albeit at lower levels than in the past. In the legislative session that just concluded, the Delaware General Assembly passed legislation incorporating a number of recommendations of the Task Force designed to improve fairness and foster compliance with Delaware’s Unclaimed Property Program.
Given that abandoned property revenues accounted for 13 percent of Delaware’s general fund revenues in 2014, its likely decline has significant implications for the state’s overall revenue picture. Having used most of the revenues to support ongoing programs, the state is faced with a significant hole in its General Fund budget.