CT builds its budget reserve — as post-election deficits loom large

After three consecutive years of draining its emergency reserves, state government is on pace to deposit nearly $780 million in its rainy day fund.

And for Gov. Dannel P. Malloy, who has struggled with deficits for most of his second term in office, it means a chance to leave a nearly $1 billion fiscal cushion for his successor, who is projected to face shortfalls more than double that size.

In his final monthly report for the 2017-18 fiscal year — which officially ended Saturday — Comptroller Kevin P. Lembo estimated the state will deposit $779.4 million in the budget reserve after closing the books. Coupled with existing funds, that would elevate the reserve to $992.3 million, or 5.25 percent of annual operating expenses.

“When I became governor we had no rainy day fund,” Malloy said Tuesday, adding that while Connecticut has drawn down its reserves during his tenure, it never depleted them entirely.

State finances, unless adjusted, were on pace to run an unprecedented $3.67 billion deficit in the 2011-12 fiscal year — a problem Malloy inherited during his first year in office from former Gov. M. Jodi Rell and from the 2010 General Assembly.

The growing reserves are crucial because the  legislature’s nonpartisan Office of Fiscal Analysis warns the next governor will face another big deficit,  about two-thirds of the size Malloy encountered. State spending is projected to outpace existing revenue sources by $2.1 billion during the first new fiscal year after the November elections, and the potential gap grows to $2.6 billion one year after that.

The nearly $780 million deposit Connecticut will make in September — when Lembo officially closes the books — is due largely to surging income tax receipts tied to investment earnings. And analysts for both the legislature and the Malloy administration have warned that two key factors behind that surge are unlikely to repeat next fiscal year:

• Many households inflated their quarterly state income tax payments this past winter to take advantage of favorable federal income tax rules that expired after the 2017 calendar year.
• And a federal income tax loophole that for years allowed hedge-fund managers to accumulate offshore gains without paying federal and and state income taxes closed this year, leading to a one-time surge in payments.

Lembo also urged caution despite the growing reserve, noting that while Connecticut has recovered all of the private-sector jobs it lost during the last recession, job recovery stands at just 81 percent when public-sector jobs are considered.

“Recent indicators show that the state of Connecticut continues to lag behind the nation’s economic recovery in key areas,” including wage growth and consumer debt, he said.

The budget reserve is state government’s chief defense against a recession or other major economic downturn, which can cause tax receipts to drop by hundreds of millions of dollars in one fiscal year. 

Connecticut’s income tax is particularly volatile because of the high concentration of wealth tied to Wall Street and the financial services sector. 

About 35 percent of income tax receipts come from quarterly payments, not payroll withholding. And most of the quarterly payments involve earnings from capital gains, dividends and other investment income, which traditionally grows – or shrinks –by double-digit percentages from year to year.

Lembo recommends a reserve of 15 percent. Connecticut legislatures and governors have never saved that much at one time. The largest rainy day fund ever stood at just under $1.4 billion in 2008, an amount equal to 8 percent of operating costs at that time.

Malloy, who insisted throughout his successful 2014 re-election campaign that state deficit forecasts were wrong, closed the first three fiscal years after that win with budget shortfalls — albeit modest ones.

Connecticut had $519 million in its emergency reserves in July 2014. 

That cushion was depleted to around $213 million after the state closed the 2015, 2016 and 2017 fiscal years with deficits of $113.2 million, $170.4 million and $22.7 million, respectively.

Technically, the just-completed fiscal year also ended in the red, with preliminary estimates showing a gap of $594.5 million.

But that deficit is a technicality. A new state law prohibits the comptroller from considering a percentage of income tax receipts tied to quarterly filings until after the fiscal year has closed. Once that revenue stream is considered, the state has sufficient funds to cover the shortfall and make the nearly $780 million deposit into its reserves.