Connecticut's fiscal guardrails face criticism

Connecticut's "fiscal guardrails," a 2017 set of budget reforms, have a pretty big reputation, as budget policies go.

The guardrails, placed in the state's bond covenants, forced the state to pay down billions of dollars of unfunded pension liabilities, saving hundreds of millions annually. They added predictability to a perennially painful budgeting process. And they gave the state a huge boost in its bond ratings.

"As someone who chairs a finance committee," said Connecticut State Rep. Maria Horn, D-Salisbury, "it means that when I go to conferences, Connecticut's no longer at the bottom of the list, and in fact, often gets noticed for being a 'most improved player.'"

But seven years after the guardrails' creation, the limits embedded in the policy are starting to emerge. Critics point to artificial revenue shortfalls and underfunded social services as signs the guardrails are overly strict and based on miscalculations.

The impact of the fiscal guardrails has been undeniable. But critics and some supporters argue it's time to revise the policy.

Before the fiscal guardrails were erected, Connecticut was the fiscal equivalent of a reckless driver. The state's neglect of its pension obligations 'was decades old, but its fiscal problems intensified in the wake of the Great Recession. Lawmakers have described the decade after 2008 as a "."

Connecticut's revenue varied wildly from year to year, and raising income and sales taxes twice in the span of five years, the state endured frequent budget cuts and mid-year recissions.

The guardrails emerged as a bipartisan agreement to solve a budget impasse.

They consisted of four caps: a bonding cap; a revenue cap, which only allows the budget to spend 98.75% of projected revenues, guaranteeing a surplus which must be allocated toward the budget reserve fund; a spending cap, which essentially limits the budget to the size of the previous year's budget, adjusted for inflation or increase in personal income; and a volatility cap.

The volatility cap applies to revenue from the personal income tax and pass-through tax, which usually vary more than most revenue streams. The cap takes the amount of those taxes deemed "volatile" ? billions of dollars ? and directs it toward the budget reserve fund. It also caps that reserve fund and directs anything over the threshold to the state's unfunded pension liabilities.

Thanks to the guardrails, Connecticut is poised to have its sixth straight surplus. It meets its actuarially determined pension contributions and has paid down around $8.6 billion of unfunded pension liabilities.

But this year, Connecticut got a demonstration of the guardrails' downsides. In October, Gov. Ned Lamont's office projected nearly $400 million of cost overruns. Some sections of the budget, including Medicaid, had shortfalls, while others raised more revenue than projected, Horn said.

Lamont has curbed spending in state agencies, refusing to approve most new hires, and last month announced cuts to higher education.

But these cuts come as Connecticut has a surplus. Between the revenue cap and the volatility cap, Connecticut will deposit $1.6 billion into its reserve fund at the end of the fiscal year.

"It's hard for Connecticut to say with a straight face that we are in this extreme position and we need to make all these drastic cuts to agencies when we have that kind of money that's being saved," Horn said. "You can't really say it's volatile."

Moreover, as Connecticut's reserves and pension funds have increased, its social services have lagged behind neighboring states', according to Patrick Murphy, who authored a recent study on the guardrails with Yale University and the Connecticut Project.

Higher education institutions, K-12 schools, Medicare recipients, and nonprofits that provide social services for the state are all in need of more funding, Murphy and Horn said.

"Connecticut probably has the second toughest set of constraints on what the state can do in its budget in the country," Murphy said, behind only Colorado.

The tight restrictions that legislators intended in 2017 are compounded, Murphy said, by errors in the guardrails' design.

The volatility cap, for instance, initially restricted $3.15 billion of revenue and has increased every year. Depending on how you calculate volatility, up to half of that revenue isn't volatile, Murphy found. Revenue has exceeded that threshold by more than half a billion dollars every year since it was implemented.

The cap was calculated based on 2017 tax revenues, Murphy said. A more accurate cap would be based on a five or ten-year rolling average of revenues.

"There was no magic, and arguably little science, behind the guardrails' initial design," the study said.

The spending cap creates further problems. It creates a "ratcheting effect," Murphy said, where appropriations are based on the previous year's appropriations.

Between 2017 and 2019, the state had revenue shortfalls and spent less than what the cap allowed. Those shortfalls are now baked into the spending cap, Murphy found.

"The amount of spending allowable under the cap was approximately $1.8 billion lower in FY25 than it would have been if the General Assembly had appropriated funds up to the allowable cap in earlier years," the study said.

The restrictions on spending will become more obvious next fiscal year when federal stimulus funds run out, said Christopher Trombly, interim dean of the College of Education at Southern Connecticut State University. The aid was funding programs that lawmakers might wish to continue, but they simply can't afford to without cuts to other areas.

"We are paying down the debts of generations past at the expense of kids and families who are hurting now," Trombly said.

Murphy said the state has options for adjusting the guardrails. The legislature could change where the caps lie or how they're calculated. It could also leave the caps in place but direct the surplus funds toward other priorities, like capital projects, higher education or healthcare.

Carol Platt Liebau, the president of the Yankee Institute, a conservative think tank, said the guardrails should stay as they are. They save Connecticut hundreds of millions of dollars a year, she said, and any adjustment could be a slippery slope back toward the destructive budgeting habits of the past.

"We are just beginning to get a foothold, just beginning to get our arms around this problem," Liebau said. "Now is not the time to start eroding the progress we've made and return ? to a failed model of governance."

Adjusting the guardrails would be complicated.

Under Connecticut's bond covenants, the state must continue the guardrails into 2028 unless the governor declares a state of emergency. Plus, the spending cap is enshrined in the state constitution.

Tinkering with bond covenants could have implications for Connecticut's recently burnished reputation with investors.

Moody's, in lifting its outlook on Connecticut's Aa3 rating to positive in May, cited the governance improvements embodied in the guardrails, "that have led to significant budgetary reserves, strong financial performance, stable debt levels and significant pension contributions."

But even after years of supplemental pension contributions, Connecticut's fixed costs for debt, pensions and other post-employment benefits remain among the highest in the nation, the rating agency said.

The unfunded pension obligations still top $37 billion, according to Kroll Bond Rating Agency.

In 2018, three of Connecticut's bond ratings were in the single-A category, with KBRA at AA-minus.

Today, the state and its general obligation bonds carry ratings of AA-plus from KBRA, with a stable outlook, and AA-minus from Fitch Ratings and S&P Global Ratings, with a positive outlook from Fitch.

The legislature renewed the guardrails almost unanimously last year, but criticism has grown louder since then. Horn said her colleagues are hearing from people and organizations that need funding for social services.

Horn believes in the guardrails, she said, and she thinks adjusting calculations and adding flexibility will help keep the policy in place long-term.

"A brick wall does not make a good guardrail," Horn said.