Ranking the States by Fiscal Condition

July 07, 2015

Does your state have its fiscal affairs in order? It’s not an easy question to answer, in part because the question can mean so many different things, including:

  • Can the state pay its current bills? (cash solvency)
  • Will annual revenues be sufficient to cover budgeted expenditures? (budget solvency)
  • Are the state’s long-term liabilities—think bonds and loans—sustainable? (long-run solvency)
  • How much room is there to raise additional revenue should the need arise? (service-level solvency)
  • Can the state meet its pension and health care obligations? (trust fund solvency)

These are questions that keep budget officers and legislative leaders up at night, and they can often be difficult to answer. Fortunately, Eileen Norcross at the Mercatus Center just came out with an invaluable comparative analysis, Ranking the States by Fiscal Condition. For policymakers, the publication ought to be prized for its comparison tables alone.

Alaska and North Dakota, with their abundant natural resources, unsurprisingly rank first and second, respectively, in overall fiscal condition; Prudhoe Bay and the Bakken Range all but assure that. Many other states, however, owe their strong rankings to prudent financial management and growth-oriented tax structures. Illinois, meanwhile, brings up the rear—unsurprisingly, given that the state has actually racked up billions of dollars in unpaid bills.

Comparing states is never an easy task, and sometimes it can be difficult to isolate the variable worth emphasizing. For that reason, I think that the figures Norcross provides on cash solvency are more interesting than the ranked summary measure.

Cash solvency is a measure of whether a state can meet its short-term spending obligations. A state can do that by drawing from cash reserves or by liquidating assets (typically invested funds). Ideally, a state has enough supply of ready cash—the cash ratio—to make its payments, or at least enough liquidity in the so-called quick ratio, the indicator of liquid current assets that can be converted and accessed quickly. If a state has a large current ratio (a broader measure of liquidity), however, it’s not necessarily the best policy to hold all reserves as cash. However, the Mercatus paper implicitly rewards such an approach by summing the cash ratio, quick ratio, and current ratio (the first two being subsets of the latter) to yield a ranking.

It’s undoubtedly a very bad thing that Illinois’ cash ratio is 0.49, meaning that its actual cash reserves are less than half the value of the next two months’ anticipated payments, and it’s deeply troubling that its current ratio is a mere 1.26. That’s a state that literally cannot pay its bills. But is it praiseworthy that Montana, with a current ratio of 5.4, has a 4.09 cash ratio, or might it make sense to invest more of it? For that matter, is the highest possible current ratio always the best thing, or might that sometimes be an indication that the state is bringing in more revenue than it needs?

Cash reserves are a very valuable thing for states and people alike, but we wouldn’t encourage an individual to keep her entire net worth in a savings account. The data table is an immensely valuable resource, but I’m still not sure I’d want my state to rank first—and I’m not convinced that the bulk of the current ratio showing up in the cash ratio is always a good thing. I don’t know of a better way to develop a single comparable figure on cash solvency, but the underlying table tells a much more interesting story.

Similarly, there’s no one “right” way to calculate unfunded pension liabilities. As Norcross notes, states often rely on aggressive estimates of the rate of return on trust fund investments. This “discount rate”—which “’backs out’ the interest from a future value to arrive at a present value,” as Norcross writes—can significantly understate unfunded liabilities and lead to crisis should expected returns fail to materialize. That’s why some studies disregard the state’s expected return in favor of a (typically lower) market-based discount rate. The Mercatus study discounts based on the yield on notional 15-year Treasury bonds at the time the actuarial valuation was performed. The current 15-year Treasury bond rate is 3.38 percent, less than half of what most states project for their investments.

This approach is certainly justifiable, and states’ high expectations have often done considerable harm, but the Mercatus methodology can also have the effect of emphasizing the amount of overall liabilities while somewhat deemphasizing current assets, since they are not assumed to appreciate nearly as much.

Under the state’s own discount rate assumptions, for instance, Washington State’s pension fund has $63.1 billion in assets and $67.5 billion in liabilities, for an enviable funding ratio of 94 percent. North Carolina is even better at 96 percent. Under the alternative Mercatus approach, however, Washington’s funded ratio drops to 49 percent and North Carolina to 55 percent (contractions of roughly half), while Alaska, which began at 55 percent funded, loses only a quarter of value under the new methodology.

Looking at any individual state, I’d probably want to take a conservative approach; comparing states, I might be inclined to accept assumptions which more strongly reward states with significant assets in their funds. Fortunately, Norcross provides the underlying tables in the appendices, allowing for comparisons across multiple metrics.

The whole publication is worth reading, as Norcross does an excellent job of breaking down different components of state fiscal health and putting data behind each indicator. Those chiefly interested in topline findings may wish to check out the executive summary and the maps illustrating key findings.

These measures matter. As Norcross writes, “Even states that appear to be fiscally robust—perhaps owing to large amounts of cash on hand or revenue streams from natural resources—must take stock of their long-term fiscal health before making future public policy decisions.”

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