Here’s how U.S. states are preparing for a potential recession

Last month, the World Bank said a global recession is likely. And within the U.S., there is a 57% probability of a recession by January 2024, according to an analysis from the New York Fed.

How each state may fare on an individual basis in the event of a recession varies widely. Part of that is because a recession means more of a reliance on rainy day funds — or state reserve funds.

Justin Theal, an officer with the Fiscal 50 project at Pew Charitable Trusts, described rainy day funds as a state’s “best line of defense during a recession without major cuts.”

“If we assume that we are going to head into a recession next year, states are more prepared than they have ever been for a recession, and one of the key things to look at for state preparedness is how much they have in their rainy day funds,” Theal told Yahoo Finance.

“Fortunately, most states have a record level of rainy day funds right now and still significant amount of flexible federal pandemic aid that is going to provide some breathing room to help manage these budget uncertainties in the short term,” he added. “But as inflation is more persistent than expected, it can really exacerbate many of the long-term challenges that many of the states’ parties face.”

Theal stressed the importance of states closely analyzing their savings to predict what their budgets could look like in future uncertain economic conditions and to make policy changes accordingly.

Financial tools like budget stress tests can help determine if a state’s revenue stream is volatile. California, New Mexico, North Carolina, Utah, and Maine are frequent users of the budget stress test, which helped North Carolina reach its recommended savings goal in 2022.

A majority of states have a sufficient amount in their rainy day funds, according to Pew Charitable Trusts. California has the highest savings with over $47 billion, and Montana has the least with $118 million.

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However, large funds aren’t always the best indicators for how long a state can rely only on its savings, as some states with larger budgets tend to have more expenditures. For example, Wyoming is the only state with a reserve fund of over $1 billion and can use its rainy day funds for up to a year, which would equal nearly all of its spending. Illinois and Washington, on the other hand, would last only four days for just 1% of their typical spending.

And as the Urban Institute noted, “because no two states share identical political or economic characteristics, it is hardly surprising that states experience differential responses to upturns or downturns in the economy.”

Hawaii, a state heavily reliant on tourism, was unable to count on rainy day funds alone to balance its budget during the Great Recession.

“Changes in the general economy differentially affect each of these states,” the Urban Institute wrote. “The national business cycle may not be the most accurate representation of a given state’s economic situation.”

Sales tax as a source

States typically rely heavily on revenue sources like sales taxes, income taxes, and property taxes.

Sales taxes account for slightly more than 29% of state government revenue on average, according to Pew. There are currently 45 states (along with Washington, D.C.) that utilize general sales taxes, and that money is the largest source of revenue in 14 of them. Among the states most reliant on these taxes are Texas, Florida, and Nevada.

During economic downturns and inflationary environments, consumers tend to pull back on spending. More than half of U.S. consumers have indicated a willingness to scale back on shopping because of higher prices and are prioritizing staples over discretionary and big-ticket purchases. That doesn’t bode well for state sales taxes.

“Inflation typically boosts sales tax revenues in the short term as consumers continue purchasing goods at elevated prices, but during periods of sustained high levels of inflation in which price increases outpace wage growth, reduced spending is expected,” Katherine Loughead, a senior policy analyst at the Tax Foundation, told Bloomberg. “This typically leads to sales tax collection declines, especially since many states have exempted a variety of basic goods from their sales tax base.”

According to the Urban Institute’s latest State Tax and Economic Review, inflation-adjusted growth in state sales tax was weak in the second quarter of 2022. Rising prices on goods led to a general growth in sales taxes, though not enough to balance out consumers pulling back on their spending.

“Elevated inflation across all states is disrupting these revenue trends — whether the state is more reliant on sales taxes, which tend to closely follow the ebbs and flows of inflation over time, or if the state is more reliant on personal income taxes, which tend to become more volatile during inflationary conditions,” Theal said. “Overall, no state has gone unscathed in terms of inflation on their state finances.”

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Tanya is a data reporter at Yahoo Finance. You can follow her on Twitter @tanyakaushal00.

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