Federal budget crisis puts Virginia’s fiscal future in peril

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Print this page By John B. Montoro, CPA

Gov. Bob McDonnell’s has proposed an $84.9 billion 2012-2014 state budget, with $34.5 billion coming from the commonwealths’ general fund and $50.3 billion from other sources, including federal grants and contracts.

While much of the public and media focus is on spending, it’s important to identify the major sources of general and non-general fund revenues, and the inherent risks and assumptions used to forecast key revenue sources that support the proposed expenditures.

Perhaps the biggest risk facing Virginia’s budget and the economy as a whole is that the impact and risks associated with federal policy are not discussed in any detail in the proposed budget document. The assumptions made regarding federal policy are not even mentioned. For example, what assumptions have been made with regard to the impact of potential mandatory defense budget cuts resulting from the failure of the “super committee?” While the cuts would not officially take effect until January 2013, a recent article in The Washington Post noted that some lawmakers fear an earlier impact due to potential preemptive action by the Department of Defense to slow or cancel contracts.

The budget document

The budget document is 483 pages — an imposing document, to say the least. However, if one considers each of the four parts at a time, it becomes more manageable. I recommend starting with Part A, which checks in at only 18 pages. It provides highlights of the governor’s proposed recommendations for the 2012–2014 biennium, an economic forecast on the state of Virginia’s economy and a revenue forecast that specific projected revenues on which the proposed operating budgets and amendments are based. 

Economic outlook and revenue estimates

The economic forecast goes through a formal process of review, which started with a meeting of the Joint Advisory Board of Economists (JABE) in October. Their recommendation was then considered at the November meeting of the Governor’s Advisory Council on Revenue Estimates (GACRE). Finally, their recommendation was adjusted slightly based on December revisions to the fiscal year 2012 forecast. Overall, the forecast anticipates that the U.S. economic recovery is on firmer ground as economic data have been somewhat more optimistic. The GACRE consensus for key economic assumptions was as follows:

• Real GDP is projected to grow 1.7 percent in FY 2012, 1.8 percent in 2013 and 3.2 percent in FY 2014.
• Employment is expected to be sluggish with growth of 1 percent over the next two years.
• Real consumer spending is expected to grow by 2 percent per year.
• Inflation is expected to be slightly higher for 2012, but will be less than 2 percent for FY 2013 and 2014.
• The Federal Reserve is expected to maintain the federal funds rate at zero through FY2013.

The total revenue for the biennium is $83.5 billion, and the governor’s proposed spending appropriation is $84.9 billion. Is the apparent $1.5 million gap between revenues and expenditures a case of deficit spending? Not exactly. It appears revenue estimates do not include the net proceeds from the Virginia Lottery of approximately $870 million over two years. In fact, the lottery is not mentioned in the revenue section of the budget. Add to that the estimated available carryover balance of $515 million from fiscal year 2012, and total revenue and resources reconcile to the $84.9 billion proposed appropriation amount.

Federal impact

In fiscal year 2011, revenue from federal grants was $10.3 billion — the largest single source of revenue. While the forecast shows a decrease in 2012 and 2013 as stimulus funds are used up, federal revenues still make up 37 percent of nonfederal revenue and 22 percent of the total for 2013–2014.

The economic assumptions noted above can be found in Part A of the proposed budget. What will not be found in the budget document are the significant assumptions relating to federal government policy. For that information one must refer to the economic outlook, a separate document prepared by Secretary of Finance Ric Brown. His Dec. 19 report notes the following assumptions built into the revenue forecast:

• The 2 percent payroll tax cut and emergency unemployment insurance benefits are extended for 2012 then phased out over several years.
• The automatic cuts beginning in 2013, predicated by the failure of the “super committee”, will not occur. Instead, a new package of spending cuts and tax increases will be approved and won’t begin until January 2014.
• The Bush tax cuts will be extended in 2013.

These are very significant assumptions. While we might agree or disagree whether these assumptions are the “best guess” today, it is worth examining how significant the risk is if these assumptions prove inaccurate.

Virginia’s dependence on federal spending goes far beyond the $10 billion in direct aid. When federal contracts and direct payments to employees and retirees are taken into consideration, the federal government accounts for more than one-third of the commonwealth’s GDP.  Even a small reduction in federal spending and support could have a devastating impact on revenues. In addition to the direct impact on federal grant funding, the decline in federal outflows will have a significant impact on the commonwealth’s other major revenue sources, mainly individual and corporate income tax and state sales and use tax.

Virginia response to the risk posed by the federal budget crisis

In his budget presentation, McDonnell pointed out the risk posed to the commonwealth and its AAA bond rating by the current political uncertainty created by the federal budget crisis. He noted that, while currently our AAA bond rating has been reaffirmed, it was placed on “negative outlook” by the rating agencies — primarily due to the commonwealth’s dependence on the gederal government.

In response to this risk, McDonnell proposes to replenish the “rainy day” fund by $440 million, bringing the balance to $600 million by the end of FY 2014. The rainy day fund was at its highest level at $1.19 billion in 2007, and has dropped to $299 million as of June 30, 2011.

The governor also has proposed creating a new Federal Action Contingency Fund (FACT) to be used to mitigate a variety of negative impacts on Virginia related to likely future federal actions. This appears to be a great first step by recognizing the risk posed by dependency on the federal government. Unfortunately, the proposed $50 million dollar funding by 2014 is just a drop in the bucket compared to the potential risk.

The citizens of the commonwealth and the business community at large would be better served if the risks and potential impact associated with federal budgetary policy decisions were described in more detail in its revenue forecast. Clearly-quantified estimated impacts of policy decisions would lead to a more informed voting public in a better position to evaluate the actions of our federal leaders.

John B. Montoro, CPA, is a partner at Cherry, Bekaert & Holland LLP, where he serves as the director of the firm’s Government Services Group. He currently serves on the executive committees of the American Institute of CPAs (AICPA) Governmental Audit Quality Center and the Virginia Society of CPAs (VSCPA) while also serving as a reviewer for the Association of Government Accountants (AGA) Certificate of Achievement in Service Efforts and Accomplishments Reporting program.

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