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January 29, 2024

A question of volatility: Are Connecticut’s fiscal guardrails in the right place?

KYLE CONSTABLE / CT MIRROR 2017 legislative leaders Senate President Pro Tem Martin M. Looney, House Speaker Joe Aresimowicz, House Minority Leader Themis Klarides, and Senate Republican leader Len Fasano in 2017, before they reached an agreement on a “volatility adjustment” that would be key to the state’s now-burgeoning rainy day fund.

It’s been hailed as Connecticut’s fiscal miracle.

Following a decade riddled with deficits and huge tax increases, lawmakers embraced new restraints in 2017 that changed everything.

Billions of dollars in pension debt was wiped out in a few years.

The all-but-empty rainy day fund swelled and broke records year after year. 

Motorists enjoyed a 13-month state gas tax holiday, while income and other tax cuts were ordered to save households and businesses more than $800 million next fiscal year.

Even a once-in-a-century pandemic couldn’t derail the budget comeback.

Or so the narrative goes.

The full story, though, is more complex. A Connecticut Mirror examination of the state’s policies found that fiscal guardrails imposed by state lawmakers over the last seven years have resulted in what could be described as a de facto “tax” on core programs, such as education, health care and social services, some of which are eroding at the same time the state’s coffers have swelled.

A few of the casualties: 

Public colleges and universities, facing shrinking funding, have raised tuition and fees sharply while preparing to shed staff and trim course offerings.

Nonprofit social service agencies, already losing hundreds of millions of dollars annually from stagnating state payments, watched the gap worsen, even as demand grew.

Medicaid rates that hadn’t been adjusted in a decade or longer left some poor patients insured in name only — unable to find a doctor willing to treat them for minimal compensation.

And when federal funding for winter heating assistance shrank, Connecticut spent none of its windfall to offset the problem last year and committed nothing to start this winter — when the poorest households stand to lose nearly $1,000 each. And while lawmakers say they will add funds for this in mid-February, the addition will be modest.

Critics say these and other problems developed, in part, because those 2017 budget restraints — dubbed “fiscal guardrails” by supporters — were crafted hurriedly under extreme pressure toward the end of a fierce nine-month budget battle.

Many of the debates in the legislature over the next few months will be set against that backdrop: whether the guardrail parameters, put in place at a desperate moment, are too constraining — or necessary, in their current configuration, to keep Connecticut on the road to recovery.

The debate is about revision, not repeal, of these budget controls.

The guardrails

While those guardrails played a big role in the state’s fiscal comeback, a robust stock market and higher tax rates — ordered in the early 2010s by former Gov. Dannel P. Malloy and the legislature — also did a lot of the heavy lifting.

These budget controls hinge on a formula that bars legislators from spending “volatile” tax receipts. But critics call it an over-correction, forcing lawmakers to save hundreds of millions in revenues — badly needed by core programs — that they describe as more stable than volatile.

Roughly $3 billion in federal pandemic relief helped mask any flaws in the guardrails system during the past two years, but those funds are nearly exhausted.

The debate — whether to spend more on critical programs or continue to save at unprecedented levels — will come into sharp relief during the upcoming legislative session.

“It’s a false dichotomy. It’s not one or the other. We can do both,” said Rep. Josh Elliott, a Hamden Democrat and founder of the progressive House Tax Equity Caucus.

By rapidly slashing pension debt that will be formidable regardless into the 2040s, Connecticut is creating “a lost generation,” short-changed in education, health care and job development, he added.

“I’m not confident that it’s working,” said Senate President Pro Tem Martin M. Looney, D-New Haven. “It’s siphoning, certainly, more money than we ever intended.”

But the guardrails’ chief defender, Gov. Ned Lamont, insists the system is working fine, reducing debt while still investing in programs, albeit not as quickly as everyone wants.

Connecticut has more than $37 billion in unfunded pension debt, one of the highest per-capita burdens in the nation. According to the American Legislative Exchange Council, it’s more than $40,000 per person. But had officials not poured $7.7 billion in surpluses into pensions since 2020, Connecticut’s mandatory $3.5 billion in annual contributions would be $650 million more.

“I think we've gone from a state of permanent fiscal crisis to a lot more stability,” the governor said. “Because we've done this, we're saving the taxpayers $500-$600 million a year, for the rest of my lifetime. … Tell me what that would have done to our social services if that continued.”

A double-barreled approach to saving

The guardrails debate is not a binary question of repealing or retaining the guardrails.

It’s an issue of precision. Do they save too much and thereby starve programs, or do they work just fine as is?

For those like Looney, who argue these controls are “siphoning” funds out of government’s most important functions, the debate centers on a program created less than seven years ago, when the government was mired in a painful cycle of deficits and tax hikes.

Labeled the “volatility adjustment,” it targets tax receipts from two sources that, historically, varied greatly from year to year: Quarterly income tax payments from wealthy households on their capital gains, dividends and other investment earnings; and quarterly filings by certain partnerships, limited liability corporations and other business entities that don’t have to pay the state’s corporation tax.

The concept is simple. In any year that total revenues from these sources top a predetermined limit, they are considered “volatile” and the overage cannot be spent — unless the governor and three-fifths of the legislature agree. After the fiscal year ends, those captured dollars must cover any deficit. Whatever is left goes into the rainy day fund. If that is full, the surplus is used to pay down pension debt.

In theory, the “volatility adjustment” will capture lots of money some years and none in others.

In reality, it has never failed to capture funds during its first six years, and never less than $530 million.

The average take during the program’s first seven years — including this year’s projected grab of $478 million — is almost $1.3 billion.

That’s not the only savings program Connecticut created in 2017. 

A second one ensures legislators build a financial cushion into each budget. The “revenue cap” stipulates that annual appropriations cannot exceed 98.75% of projected revenues.

In other words, there must be a 1.25% cushion to offset cost overruns. This year, that translated into a built-in surplus of at least $281 million — in addition to whatever is saved via the “volatility adjustment.”

One dollar out of every five goes to pension debt

Since the revenue cap took effect in 2020, these two programs have saved an average of nearly $1.6 billion per year.

That annual savings is equal to 7% of this year’s General Fund and almost half of the entire budget reserve.

Before these savings programs were established, Connecticut’s entire budget reserve was $212 million, or just over 1% of the General Fund.

Before 2017, the largest reserve in state history was the nearly $1.4 billion Connecticut held entering the Great Recession in 2008, a cushion equal to about 8% of the General Fund at that time.

With Connecticut’s new budget controls and a robust stock market, it took the state just two years to set a new rainy day fund record. And it took just three years — by 2020 — to reach the maximum reserve allowed by law, which is 15% of the General Fund or slightly more than $3 billion at that time.

But the huge push toward savings becomes even more clear when looking at the primary beneficiaries: Connecticut’s pension funds for state employees and municipal teachers.

State government fell under a national spotlight in the early 2010s as pension debt run amok for 70 years was revealed as one of the chief culprits behind enormous tax hikes, deep program cuts and labor concessions.

Just before the worst of the Great Recession struck Connecticut in 2008, about 6% of General Fund revenues were used to make mandatory annual contributions to pensions.

When Malloy took office, he reformed a system that had allowed the state to short-change pensions by contributing less per year than fund analysts said was needed to cover obligations.

Not surprisingly, pension contributions ate up between 10.6% and 12.5% of General Fund revenues during Malloy’s eight years in office. 

Since the rainy day fund hit its legal maximum in 2020, due partly to the guardrails, 21% of all revenues — excluding those assigned to special budget funds — have gone into the pensions.

Taking one out of every five dollars from the Connecticut economy and investing it in pensions goes beyond an over-correction for the fiscal sins of the past, said University of Connecticut economist Fred Carstensen.

“This is a self-inflicted wound,” he said, noting that many pension fund assets are invested in out-of-state entities. “We have an economy that is flatlining. … It means we are not investing in ourselves.”

And Connecticut can’t wait until its pension woes have been resolved to dramatically increase spending on economic development, Carstensen added. 

Even given the billions of surplus dollars deposited into the pension funds since 2020, Connecticut isn’t projected to retire all the unfunded obligations it amassed over decades in the pension funds until 2051, according to actuarial tables from the state Treasurer Erick Russell’s office.

Has Connecticut forgotten the deficits of the past?

Supporters of the new system reject that argument and point to overall spending.

The $22.1 billion General Fund legislators approved for this fiscal year is 24% greater than what Connecticut spent in 2017, just before the new guardrails were first adopted, according to budget records. That’s not record-setting growth over seven years but hardly paltry either.

More importantly, they say, it’s a huge leap from what Connecticut went through during most of the 2010s.

Between 2010 and 2017, state finances closed in the red five times while the legislature ordered two of the largest tax increases in state history.

Lamont increased taxes — but not the income tax — during his first year in 2019 but offset all of that and then some with big tax relief programs that passed in 2022 and 2023.

And the governor recently urged people not to forget that success, nor the problems of the prior decade, in the coming years, when analysts forecast budget surpluses will be smaller yet still healthy. “We’re going to have a lean budget” in 2024, Lamont said during a pre-Christmas press conference. “We’re going to stay true to our north star and keep this state moving forward for everybody.”

Between 2011 and 2018, Malloy and the General Assembly shrank the Executive Branch workforce by about 10%, scaled back public sector benefits through two major concessions packages and routinely withheld hundreds of millions of dollars in approved appropriations to stave off deficits.

“What you don't want … is over-promising, which is what we've done for the last 50 years,” Lamont said, “over-promising then pulling back, over-promising and pulling back. We've had consistent increases in our core commitments, which I think is really important.”

“We don’t want to go back to the bad old days,” said Lamont’s budget director, Office of Policy and Management Secretary Jeffrey Beckham, adding that predictable spending and declining taxes bodes well for Connecticut’s economic future. “If you care about programming, “you ought to care about [the budget’s] stability.” 

And that’s not just the Lamont administration’s message.

House Minority Leader Vincent J. Candelora, R-North Branford, who spent much of his career on the tax-writing Finance, Revenue and Bonding Committee, remembers the deficits and tax hikes of the 2010s — and the bad habits that triggered them.

Legislatures and governors for decades increased spending too quickly while saving too little for pensions and other retirement benefits, he said. And by not saving, they effectively forfeited billions of dollars in potential investment earnings, according to a 2015 analysis from the nationally recognized Center for Retirement Research at Boston College.

Candelora said majority Democrats in the state House and Senate have forgotten the past and are focused only on “the insatiable need to spend money. … It has very little to do with good fiscal policy.”

The North Branford lawmaker conceded many human service programs aren’t coming close to meeting the full need. But rather than disassembling fiscal guardrails, he said, legislators should be more open to finding other ways to cut spending. Reforming an arbitration system that contributed to state workers receiving annual raises topping 4% and $3,000 in bonuses two years ago, he said, would be a good place to start.

Were guardrails crafted on a hunch?

But others say a better place to start would be revisiting the marathon 2017 budget debate that produced the guardrails.

Slim Democratic majorities in the House and Senate couldn’t reach consensus on a new budget that spring and turned to the GOP to develop a bipartisan plan. Republicans wouldn’t participate unless Malloy — a lame duck Democrat who had bumped heads plenty with lawmakers in his second term — was excluded from the talks.

But with finances again in deficit and tax hikes off the table, bipartisan negotiations didn’t deliver a deal before the session ended in early June, before the next fiscal year began July 1, or even before autumn arrived.

With finances in chaos and Malloy threatening to withhold municipal aid payments, Republicans played hardball.

The state spending cap, which had been effectively nullified by a 2015 opinion from then-Attorney General George Jepsen, would be rewritten. Prior exemptions for aid to poor cities and for pension contributions would be eliminated or phased out.

A new borrowing cap limiting state bond issuances would be established.

Democratic Sen. John Fonfara of Hartford, co-chair of the finance committee, had been arguing for years for new rules to help Connecticut better save its volatile revenues. The GOP insisted on this as well.

“I had been frustrated with the boom-and-bust effects for some time,” he said.

But the state was reeling then from deficits and tax hikes, and no one foresaw the huge revenue explosion that would begin half a year later.

Pressed for time, Fonfara and others who negotiated the guardrails provisions didn’t request a detailed revenue analysis of the prior decade or economic models of the years to come. They simply asked fiscal analysts a question: How much did the volatile revenue sources generate last year?

The answer was roughly $3.15 billion, and that became the magic number. Anything above that would be considered volatile and could not be spent.

Lawmakers would later add a mechanism increasing the threshold annually based upon the statewide growth in personal income.

But if everything hinges on that initial threshold of $3.15 billion, was it a typical year? 

A CT Mirror review of revenues from these volatile sources, after adjustments for inflation, shows the 2017 threshold was the third-lowest. And the nearly $4 billion they generated was about $640 million below the average yield for the past 15 years.

“You can fuss whether you should have had a four-year average,” rather than just using 2017 tax receipts as the standard, Lamont said. “But it's, you know, eight years later. So, I think we're OK.”

But if the initial threshold was atypically low, could Connecticut be treating millions of stable, recurring tax dollars as too volatile to spend? And if surging pension contributions stripped resources from programs for two decades before the coronavirus pandemic made needs even greater, are some key services breaking down now, even as budget surpluses pile up?

Fonfara has argued frequently that the state government does too little to reverse Connecticut’s deep pockets of urban poverty. In 2021, a frustrated Fonfara likened impacts — or lack thereof — of the state budget on the Black community to the killing of George Floyd by Minneapolis police, the May 2020 crime that set off a national debate over criminal and economic justice.

“Our policies are a knee on the neck of the Black community and other underserved communities of our state,” the Hartford lawmaker said then. “We can do better, and we must do better.”

But the man hailed as one of the chief architects of Connecticut’s savings program refuses to see it as written in stone. If lawmakers want to repeal it outright, Fonfara has a problem. Reasonable adjustments, though, to ensure better balance, could be discussed, he said.

“I’m open to that conversation, but not in a vacuum,” Fonfara added.

Last year, he publicly questioned whether Connecticut even needed its secondary savings program, the revenue cap. Repealing it would free close to $300 million next fiscal year.

Fonfara and every other legislator voted unanimously last February — barely one month into the regular session — to renew the guardrails for at least five more years. And like the first approval, the state also pledged in contracts with its bond holders not to tamper severely with these provisions. The process, commonly referred to as “bond-lock,” relies on these contractual guarantees to prevent future legislatures from repealing the system outright before mid-2028.

But almost immediately after last February’s vote, majority Democrats — both leaders and rank-and-file — began to express fears that there would be complications.

“There is absolutely an appetite to make these changes,” Elliott said, adding that some wary lawmakers were afraid to appear fiscally irresponsible as Lamont trumpeted the guardrails’ many successes.

Given that reversing decades of pension debt will be a long, steady process, regardless of savings programs, some legislators say it’s time to get a better handle on these guardrails.

Rep. Kerry Wood, D-Rocky Hill, a leader of the House moderate caucus, isn’t ready to propose changes but said lawmakers need to better understand how much revenue is being saved and whether all of it is truly unstable.

Education, health care, social services and town aid had been struggling well before 2017 due to Connecticut’s longstanding debt problems but were challenged even more severely when the coronavirus struck in 2020. Are they getting what they need now?

“I don’t think we should ever be afraid to look at the data,” Wood said. “I never want to be sitting on my hands and say we didn’t see that coming.”

Rep. Maria Horn, D-Salisbury, the House chair of the finance committee, also wants a more detailed review of the savings programs.

“This is not some sacred text,” she said. “Who has benefited? … Who has lost out overall?"

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