Recessions Happen. Understand Montana's Risk

The 2023 legislature allocated general fund resources to rebates, filling reserve balances, behavioral health, debt reduction, infrastructure, funding for highways and roads, pensions and trust funds, and tax policy changes.

Included in these financial decisions was the decision to leave reserve balances at 40% of annual expenditures. to provide a cushion if revenue collections declined. In addition, the legislature adopted a positive structural balance that was 16.0% of annual ongoing revenues. In other words, ongoing revenues were 16.0% higher than ongoing expenditures.

The updated state general fund is estimated at $929 million for FY 2025 and the budget stabilization reserve fund at $522 million is at its FY 2025 statutory limit. Both provide the state with solid financial resources in the event of an economic downturn or recession. Current reserves are 55.0% of annual ongoing general fund expenditures.

Risk to the state’s budget can come from a variety of sources. The report takes a look at these highest risk categories:

• Volatile Revenue Sources like Income Taxes
• Montana's Federal Funding Risk
• Aging Infrastructure
• Unfunded Liabilities like Pension Systems

Shortfalls often occur during economic recessions, and the severity of the shortfall can be dependent on both the severity of the recession as well as the volatility of a state’s revenue portfolio. A volatile revenue source is one that tends to deviate from its long-term trend, or one where a long-term trend is not easily discernible. Furthermore, if a state’s larger sources tend to be more volatile, revenue shortfalls may occur at a higher frequency than if a state’s revenue portfolio was composed of large, stable sources. A recent  report  from the Pew Charitable Trusts found that over the last fifteen years Montana had the 12th most volatile revenue out of the 50 states.  Key reasons for the volatility: 1) in the past, reliance on natural resource revenue; and 2) increasing reliance on individual and corporate income taxes.

Montana's revenue streams are anticipated to be more volatile than in the past. Corporate and individual income taxes have grown faster than other predominant revenue sources and in recent years have accounted for roughly two-thirds of total general revenues.  Comparatively, two decades ago the income tax share of general revenues was closer to approximately 50%.

During periods of economic downturns, income and other volatile taxes often experience greater declines and can be counter cyclical of natural resources. For example, during the Great Recession, natural resource revenues remained stable, while income tax collections dropped significantly. Back in 2009, natural resource revenues were 8.8% of total collections, but in FY 2024 were just 2.9%. As a result, the use of natural resources as a stabilizing factor during a recession is not as impactful as it once was.

As more volatile sources account for a larger share of general revenues, the collective decline in revenues will likely be greater than was seen in past recessions. To analyze the impact of both a minor and major recession under Montana’s current revenue composition, each revenue source’s growth rate from both the 2001 recession and Great Recession were applied to FY 2024 revenue collections. The results are shown in the figure. The two-year decline in FY 2009 and FY 2010 totals $716 million.  

During economic volatility, in addition to year-over-year revenue declines there is an additional budget pressure due to the growing nature of the budget to keep up with inflation and population growth. The following chart illustrates simulated growth rates during a recession and the length of time it takes to return to structural balance.

While Montana's revenue streams are currently exceeding ongoing expenditures, the same is not true with the federal government budget. Future federal action may lead to a reduction in spending in the states in order to reduce the federal gap between revenues and expenditures.

Montana receives more federal revenues than most states. Data in the following two graphs comes from the  Pew Charitable Trusts’ Fiscal 50 . First, compare Montana’s percentage of state revenue from federal funds with the total for all 50 states – This chart shows years 2006-2022. Over this time, Montana averages more than 40% of state revenue from federal funds, considerably higher than the total for all 50 states. Should Congress decide to trim back federal funding to states, Montana's state funds (general and state special) would need to offset the federal funding losses.

The next graph shows the same metric for all 50 states, including Montana (red dashes) and the 50 state total (black dots). It is clear from this image that Montana has been near the top of this distribution for the past several biennia.

Aging infrastructure adds risk to budgets and failure of infrastructure can cause expenditure emergencies. The Legislative Fiscal Division plans to expand data collection activities beyond local government water and wastewater system baseline data to include evaluation of that data and to begin collection of additional data related to local government stormwater systems, roads, bridges, and buildings. Also planned is an update of the 2008 inventory of K-12 facilities. This work will give the legislature a better sense of the status of current infrastructure in the state.

According to the  Pew Charitable Trusts’ Fiscal 50  ". . . Outstanding [Montana] debt was 3.0% of the state's own-source revenue, compared with 18.7% for the 50-state total. And in fiscal 2019, the most recent year of data, unfunded retiree health care was 2.3% of Montana's own-source revenue, compared with 45.0% for the 50-state total." During the 2023 session legislators passed legislation that resulted in paying off all general fund general obligation debt.

In comparison, Montana has higher liabilities for pensions than other states. Pew further stated that . . . "in fiscal year 2021, Montana's unfunded pension liability stood at 79.9% of the state's own-source revenue, compared with 49.1% for the 50-state total." Pension liabilities are the largest source of financial risk from liability.

In June 2024, the Legislative Fiscal Division staff presented a  Financial Outlook  for Montana. The report focused on the unique financial situation at this point in time for Montana. State reserve balances are strong and can cushion finances from quick shocks. General fund structural balance is strong, with ongoing revenues exceeding anticipated costs for current services.  Yet, the state has various risks for the future.  The analysis identified four key areas of risk on future state finances:

• State revenues are volatile and federal income tax changes may compound volatility
• General fund pressures if federal funding changes for transportation and public health
• Aging infrastructure may cause unexpected emergencies
• Unfunded liabilities of pension systems higher than other states

1. Evaluate an updated structural balance with HJ 2 revenues and present law expenditures.
2. Evaluate alternatives for the legislature to consider use of structural balance to pay down infrastructure and pension liabilities.

This report was based on in-depth research conducted by fiscal analysts in the Legislative Fiscal Division. While the main report presents the summary of the findings, the following provides a more detailed analysis, including statistical graphs and simulated modeling.

If a state’s larger sources tend to be more volatile, revenue shortfalls may occur at a higher frequency than if a state’s revenue portfolio was composed of large, stable sources. A recent  report  from the Pew Charitable Trusts found that over the last fifteen years Montana had the 12 ^th  most volatile revenue out of the 50 states.

Montana’s general fund revenue sources coupled with the state levied 95 mills and interest earned on treasury cash make up Montana’s general revenues. In FY 2024, the largest general revenue source was individual income tax, totaling $2,245 million, and the smallest source was wine tax, totaling $2.5 million. To measure volatility, the absolute value of the inflation-adjusted median year-over-year change was calculated. Figure 1 below illustrates the relative size of the general revenue sources, measured as the last ten years’ average in inflation-adjusted dollars. They are ranked by size on the vertical axis with the size of the bubble representing each sources’ relative size. On the horizontal axis, sources are ranked by their volatility, with the most volatile being on the right-hand side of the graph and least volatile on the left-hand side.

As the graph illustrates, individual income tax, corporate income tax, and oil and natural gas taxes are relatively large and volatile sources. In contrast, property taxes, vehicle taxes, insurance taxes, and video gaming taxes are relatively large but far more stable. Figure 2 below shows a similar graph for the prior decade.

While the positions of the revenue sources have remained generally unchanged, the relative sizes of many sources have decreased compared to individual income taxes. For instance, in the graph above property taxes, vehicle taxes, insurance taxes, and video gaming taxes collectively were 51% the size of individual income taxes. In the prior graph representing the last decade this collective total was only 36% the size of individual income taxes.

Figure 3 further illustrates the historical growth patterns of Montana’s large revenue sources, as well as their corresponding volatility. The graph shows inflation-adjusted indexed growth of Montana’s top seven general revenue sources, as well as statewide personal income.    

Excluding vehicle taxes and fees, all sources have seen real growth since 2000. Until the most recent year, FY 2024, the state levied 95 mills had real growth of 4% compared to FY 2000 but jumped to 26% at the end of FY 2024. Video gaming taxes have experienced real growth of 11% but had negative growth as recently as FY 2020. Insurance taxes have seen strong and stable real growth, but this growth is modest when compared to the state’s two income taxes as well as oil and natural gas taxes. Also, as was illustrated earlier, the two income taxes and oil and natural gas taxes have much more sporadic growth than the other four revenue sources on the graph.

Since 2000, Montana has experienced three instances when ongoing general revenues decreased nominally on a year-over-year level. These instances were from FY 2001 to FY 2002 (2001 recession), a two-year drop from FY 2008 to FY 2010 (Great Recession), and most recently a decline from FY 2015 to FY 2016. Figure 4 shows the magnitude of these declines in both nominal and real (inflation-adjusted) dollars. Note that over the course of FY 2009-FY 2010, revenues declined by $533 million in real dollars.

As previous figures have shown, corporate and individual income taxes have grown faster than other predominant revenue sources and in recent years have accounted for roughly two-thirds of total general revenues.  Comparatively, two decades ago the income tax share of general revenues was closer approximately 50%. During periods of economic downturns, income and other volatile taxes often experience greater declines than more stable sources. As more volatile sources account for a larger share of general revenues, the collective decline in revenues will likely be greater than was seen in past recessions. To analyze the impact of both a minor and major recession under Montana’s current revenue composition, each revenue source’s growth rate from both the 2001 recession and Great Recession were applied to FY 2024 revenue collections. The results are shown in Figure 5. The two-year decline in FY 2009 and FY 2010 totals $716 million.

Like the general revenue composition, different types of individual income are more volatile than others. Whereas wages and retirement income are quite stable, income sources such as capital gains, partnership, and interest income are much more unpredictable. Figures 6 and 7 below illustrate this. Even in the trough of the Great Recession in CY 2009, wages only declined 1.6%, and retirement income never experienced a decline. The same cannot be said for the growth rates in Figure 7. Note that the vertical axes ranges are the same size to allow for an accurate comparison, and in some years the annual change in capital gains income is greater than +/- 50%.

Like the general revenue sources, if the more unstable income sources grow faster than those that are more stable, individual income taxes will become more volatile and difficult to predict than they already are. While there were a select few years is the mid 2000’s when these income types had a relatively large share of total income, they have experienced a steady increasing trend over the last fifteen years, as shown in Figure 8.

To measure the hypothetical impact of a more volatile individual income tax, the growth rates from the Great Recession in Figures 6 and 7 were applied to the current composition of individual income (CY 2022 data) as well as that from CY 2013. The resulting calendar year incomes were then used to predict fiscal year collections using linear regression. Figure 9 shows the year-over-year declines based upon both CY 2013 and CY 2022 income tax return data. The two-year decline in individual income taxes using today’s composition of statewide individual income would be $365 million compared to a two-year decline of $217 million under a CY 2013 income composition.

Figure 10 chart provides an example of simulated revenue growth like the state experienced during the 2001 recession and a simulated budget growing with the rate of inflation and population. The graph shows that when revenue shortfalls occur, it takes time for sufficient revenue growth to combat the negative effects of a recession. In this example, a lag of  revenue collections occurs for three years before the growth catches back up with the budget, even when the budget is simply growing with inflation and population.

Federal outlays exceed revenues by $1.7 trillion in FFY 2023 (Congressional Budget Office, or CBO). Over half of all outlays in FFY 2023 are for spending on mandatory programs, like Social Security, Medicaid, and Medicare. The largest spending category in discretionary outlays is national defense.

CBO analysis largely projects the characteristics of the 2023 budget to continue: they project significant federal deficits through 2034, accompanied by growing federal debt.

Outlay growth is projected to be driven by mandatory (entitlement) programs, such as Social Security, Medicare, and Medicaid. Net interest is also projected to be a driver of outlay growth.

Total federal funds budgeted in HB2 for fiscal years 2021-2024 are visible in the graph below. This graph focuses only on budgeted amounts in HB2 in order to set aside non-standard federal appropriations tied to COVID. While many Montana state agencies receive some federal revenues, in total dollar terms most such revenues are tied to three state agencies.

In FY 2023 total federal funds budgeted in HB 2 were $3.22 billion, and $2.22 billion of this total was in the Department of Public Health and Human Services (DPHHS). DPHHS administers the state Medicaid program, along with other federally supported programs like the Supplemental Nutrition Assistance Program (SNAP) and the Children’s Health Insurance Program (CHIP).

Of the remaining $1.0 billion federal funds budgeted in FY 2023, $581.1 million was in the Department of Transportation (MDT), and $188.2 million was in the Office of Public Instruction (OPI). The remaining $230.7 million was distributed among 20 other agencies.

FY 2024 followed a similar pattern: a total of $3.50 billion in federal funds was budgeted in HB2, with $2.51 billion to DPHHS, $589.6 million to MDT, and $173.6 million to OPI.

It is possible federal actors may work to reduce deficits/debt in the future. This policy change may become more pressing if federal interest costs remain elevated or further increase. Federal action to address high and rising deficits and debt could include:

1. Reducing mandatory spending

2. Reducing discretionary spending

3. Increasing revenues

The CBO periodically publishes reports focusing on deficit reduction options. The most recent of these reports is titled Options for Reducing the Deficit, 2023 to 2032 and is split into  Volume 1  (larger reductions) and  Volume 2  (smaller reductions).  The table below is from Volume 1, and several of the options are highlighted. The first 3 options focus on Medicaid and in each case could shift Medicaid expenditures onto states.

The other 2 highlighted options (10 and 12) could impact federal SNAP (Supplemental Nutrition Assistance Program) funding, transportation funding, education funding, and federal funding in other areas. In each case there may be additional pressure placed on states to “fill the gap” left by reduced federal revenues.