Budget Basics: Surplus and Deficits — How Are They Computed?
A series that details the fundamentals of New Jersey's budget, as well as its current budget woes
This is the eighth in a 10-part series outlining New Jersey’s fiscal fundamentals. The goal is to demystify some of the state’s financial challenges, and put them in context of the broader issues New Jersey faces. This series is also intended as a way to underscore the importance of state government in a year that will see a new governor and a new Legislature chosen by voters. Follow this link to see the.
Most people would say: “Of course New Jersey has a budget deficit and has had one for many years." Well — not quite true. The state has always had a balanced annual budget in accordance with generally accepted accounting standards. But, first a major disclaimer — I am not counting the pension funds — more on that issue later. Understanding deficits and debt can sometimes be confusing, especially when at times they are simply projections and not actual outcomes.
Let’s see if I can add some clarity.
Background and some terms
The constitutions of all states, except Vermont, require a balanced budget. The real question is: what constitutes a balanced budget? To be balanced at least the following is required: it must be legitimately balanced at the approval stage (July 1) and it must end in a surplus (June 30). And, most importantly, it must be balanced using “modified accrual basis of accounting” (the accepted criterion for state and local governments). Such a criterion means, for example, you can’t push off expenses you incur in the current year into the next: It cannot be balanced on a cash basis.
Some states submit a budget using phony numbers, especially on the revenue side. Some states borrow short-term notes to adjust cash-flow needs, but do not repay the loan by year end. Some states balance on a cash basis — not on a modified accrual basis. All these actions and similar actions really result in deficit budgets.
Surplus is the difference between resources and expenditures — with resources being opening fund balance (surplus from prior year) plus revenues then minus expenditures.
The chart below is an example for fiscal year 2017 (in millions of dollars)
2017 ($) Opening Fund Balance(Surplus) from fiscal 2016 450 Plus Revenues in fiscal 2017 34,600 TOTAL Resources 35,050 Expenditures (34,650) ENDING FUND BALANCE (Surplus) 400
In this example, the state opened with a surplus from the prior year of $450 million, and after accounting for revenues and expenditures ended with a surplus of $400 million. But what is critical is how states account for revenues and expenditures.
This is critical because some states count cash disbursed as expenditures as contrasted to accruing obligations. Let’s say that at the end of the year the state disbursed $4 billion to Medicaid providers, but had an additional $1 billion in bills owed for services. On a cash basis, expenditures would be $4 billion, but on a modified accrual basis (the correct way) the expenditures would be $5 billion.
Revenues could also be manipulated. Consider one example: The state collects $14 billion in income taxes, but has not yet made refunds of $800 million. On a cash basis, the collection would be recorded as $14 billion — but the correct amount is $13.2 billion.
Observe how the surplus can be manipulated – and there are more ways.
- All states are required (per standards issued by the Government Accounting Standards Board — GASB) to have an audit of its Annual Financial Statements which must be based on a modified accrual basis of accounting. But unfortunately, there are no GASB standards for budget displays. So, on the audited Annual Financial Statements, a deficit of $ 2.5 billion might be displayed, for example, but the budget is balanced (on a cash basis). Not good transparency — and very confusing to the public.
New Jersey does not do that: the Ending Fund Balance (surplus) on the audited Financial Statements match (with minor and inconsequential differences) the surplus displayed in the budget documents. That is very good.
Now, to my disclaimer about pension funds as it relates to deficits — and this point is very important to understand the current problems of the state.
Some would argue the budget is not in balance because it has not fully accounted for what should have been appropriated for pensions. Consider the following logic and debate:
The actuary certifies that $4 billion should be appropriated for the pension system to be fully funded. But the state only appropriates $2 billion. From one point of view, the full $4 billion should be accrued, which would result in a deficit on a modified accrual basis of accounting.
Others argue that the pension funds are separate funds — not part of the state’s General Fund and analyzed separately. Therefore, it does not infringe on the integrity of the surplus/deficit computation for the General Fund.
We may have an annual budget surplus … but our fiscal future is bleak
A final critical observation about surplus: some would argue the courts have permitted the state to shortchange the pension obligations incurred each year, in effect allowing the dramatic underfunding of the systems that many would argue the framers of the Constitution sought to prevent. This annual underfunding is the root cause of the long-range problems facing the state.
Further, recent independent reports by reputable organizations recognize these pension (and health-benefit obligations) costs as real future obligations and is the principal reason why these organizations — as well as the rating agencies — consider New Jersey as one of the worse states in terms of fiscal condition.
Confusing? You said it, and we could go even deeper into the accounting and budgeting of government funds, and the legal parameters of the Constitution. But, we would really be in the weeds. But you get the point: We may technically end each year in a balanced-budget situation (and that is good), but the unfunded liabilities of the retirement systems are large and growing and are the major cause of the dire long-term fiscal situation.
Various budget projections can be confusing
An observer might say: I often read that New Jersey is projecting a deficit of $10 billion — or some other large number. Or revenues are falling short by $500 million during the year. Does that mean New Jersey will be in deficit at the end of the year? No.
Some terms are in order, specifically baseline budget, current service budget, structural deficit, and structural imbalance. Each of these terms has a defined meaning — with slight nuances. But in each case it does not mean that the current budget is in deficit or the budget being prepared will ultimately be in deficit. Basically, the terms simply project the budget at various points in time.
For example, a baseline budget or a current service budget essentially suggests that if you begin your planning based on the current year’s spending level and then add inflation, make a caseload of adjustments (more people on Medicaid, and so on), expand programs (say, more money for mental health issues), fully fund pension requirements, and fund all statutory or constitutional requirements (school aid) you will have your baseline budget number — and that calculation will lead to a deficit.
That number, however, will always be higher than projected current revenue. And the ultimate budget must be balanced within revenues. So why do this exercise and why project the state has a deficit of XXX billions of dollars when it is not possible to fund all these needs? Essentially, this projection is meant for internal evaluation — to inform the governor and the Legislature how much money would be needed if one funded all these “needs.” In fact, we never can and the governor and the Legislature have to make difficult choices.
Another confusing aspect of baseline budgeting is when the Appropriation Act (the authority to spend) is finally enacted it may be viewed by some as containing substantial reductions when in fact the result may very well be an increase from the prior year — but simply a reduction from “projected” baseline needs. These budget exercises are good for planning and policy development reasons, but they must be used very carefully — otherwise, the data can be manipulated for political purposes and confuse the public.
Budget wonks also use other terms describing how a budget is developed and reviewed — continuation budget, zero-based budget, and performance budget. But in the final analysis, the only budget that counts is the one the governor submits, the Legislature reviews and approves, and which ultimately becomes the Appropriation Act that the governor signs into law.
One final but important point. Several times during the course of the year revenues fall short of projections (aka the Recession of 2008) and an actual deficit is developing. So, to end with a balanced budget the state must take extraordinary actions to reduce spending in midstream. These actions are taken because the New Jersey Constitution prohibits the state from ending in a deficit and thus the governor is required to take whatever actions are necessary to balance the budget — not on a cash basis, but in accordance with proper accounting standards. New Jersey has always followed this directive and sometimes the reductions can be quite severe and have negative implications for those entities that were expecting payments from the state but will not receive them. Remember — in this instance — I am viewing the pensions as separate funds.
Gimmicks and other nonrecurring resources
In almost every budget year for the past 35 years, one-time or nonrecurring transactions, or a series of gimmicks, were used to balance the budget. In some instances, the transactions have been minimal (1.7 percent); in other instances significant (14 percent) in terms of the percentage of the budget.
Usually, these actions are taken to avoid unpleasant budget reductions with the expectation or at least the “hope” that there will be a better economic climate next year and the state can eliminate these gimmicks. Unfortunately, in most instances, the economic climate either does not improve or other budgetary needs require policymakers to use other nonrecurring devices to maintain current service levels or expand politically popular programs.
Every state uses "gimmicks" or non-recurring transactions to balance its budget — it is not unique to New Jersey. The real issue is the magnitude of these transactions. Extraordinary use of nonrecurring actions or gimmicks or both will ultimately lead to big tax increases or significant program reductions.
Over the years, New Jersey has used many of these techniques to balance its budget — ranging from changing a payment date, to deferring pension contributions, selling assets, and transferring fund balances from dedicated unds. The largest and arguably most egregious was selling long-term, noncallable bonds for operating purposes — a very big no-no in the world of public finance.
The cumulative impact of the above actions, especially the deferral of pension appropriations, has placed the state’s long-range budget projections in significant difficulties.
Rainy day fund
Many states establish a rainy-day fund — New Jersey has such a requirement. The intent is to save monies that can only be used for emergencies. Some people confuse a rainy-day fund with surplus — they are not the same. Surplus (undesignated fund balance) is the sum remaining at the end of the year; that is, the positive difference between revenues and expenditures. Surplus can be used in the next year’s budget as a resource, per the example in the first section above. Monies in the rainy-day fund cannot be used as a resource.
Under New Jersey statute, rainy-day funds are developed in one of two ways: 1) make a direct appropriation to the fund or 2) if final revenue collections exceed the original estimate in the Appropriation Act, one-half must be transferred into the fund. The use of the rainy-day fund must be requested by the governor and approved by the Legislature for emergency purposes.
Building a rainy-day fund is good budget policy. The intent is to have funds available to offset unexpected recessions, or extraordinary declines in revenues, or unexpected disasters — especially in the middle of a budget year. New Jersey exhausted its rainy-day fund during the most recent recession (fiscal 2008/2009) when it utilized $734 million.
Any monies placed in any rainy-day fund in effect reduce the regular surplus account and therefore limit money available for current spending purposes.
Since 2008, no monies have been placed in the rainy-day fund. In each year, language has been inserted into the annual Appropriation Act that has overridden the statutory requirement to place any excess revenues into the fund. In effect, as a matter of policy, the Legislature and the governor did not wish to limit the use of any monies for current spending needs at the expense of future emergencies.
As important as current spending issues are, the state must return to the practice of saving money for a rainy day — because it will come again.