The commonwealth’s structural deficit could exceed $7 billion by 2030 unless state lawmakers can cut spending or find new sources of reliable revenue, according to a new report from the Independent Fiscal Office. That’s up from more than $4.5 billion in the last fiscal year.
The structural deficit is a measure of how much more money the state is spending than it’s bringing in.
While lawmakers have found ways to balance recent budgets, next year, Democrats in Harrisburg could face tough decisions ahead of their first budget negotiations with majorities in both chambers of the general assembly.
“Permanent policy changes need to be enacted,” IFO Director Matthew Knittel said during a presentation of the office’s findings Thursday. “Especially if the Rainy Day Fund is to be maintained.”
Spokespeople for Gov. Josh Shapiro and Democratic leaders in the House and Senate did not respond to requests for comment. Neither did spokespeople for the Republican caucuses’ leaders.
Here are some of the topline takeaways from the IFO’s latest annual budget outlook report.
Temporary bandaids may no longer cut it
While some temporary measures have helped to balance past budgets on paper, the IFO warns that lawmakers may be running out of wiggle room.
For example, during negotiations earlier this year, lawmakers agreed to balance the most recent state budget using an accounting trick called a “cycle roll.”
Two months of payments to managed care organizations that provide services for Medicaid patients were delayed into the next budget cycle. At least on paper, that brought down the state’s projected spending in relation to its revenue by $2.6 billion.
Lawmakers can continue making those monthly payments on that delayed schedule, but they won’t be able to claim the same savings in the future.
Residual COVID-19 funds have also helped to balance recent budgets, but Knittel warned that well has likely run dry.
“At this point, we think those are largely used up, as are most of the larger one-time measures that can be used,” he said. “For that reason we do think that permanent revenue changes or spending changes are needed to address the structural deficit.”
IFO expects booming economic growth to ease, demographic changes to rack up costs
A booming stock market, driven in large part by tech and artificial intelligence companies, has been a boon to the state’s revenues. Corporate profits have been high for the last three years, allowing the state’s corporate net income tax collections to beat estimates.
But the IFO, while it isn’t projecting a recession, is predicting that those gains will level out.
“Right now, an important question is, ‘are those revenues permanent going forward, since much of it was driven by one sector of the economy?’” Knittel said. “Currently, we are treating them as permanent, however we do have a modest slowdown built in for next calendar year.”
There was also a large boost to corporate net income tax revenues during this budget cycle due to taxable tariff refunds, netting the state around $230 million.
Demographic changes also present a challenge. Pennsylvania’s population is getting older. The IFO predicts that retirees will make up a greater portion of the population, while the school-age and working-age cohorts shrink.
That can mean increased spending on services like healthcare.
The risks of relying on cannabis and skill games to close the gap
For the last several years, Republicans have blocked Democratic efforts to tax and legalize marijuana and skill games. In his last budget, Shapiro estimated those efforts could bring in $2 billion annually.
With majorities in both chambers of the general assembly, Democrats may finally be able to make those policies reality. But the IFO is warning lawmakers not to rely on projections of how much they will earn the state to balance their budget.
”The downside of these estimates is there’s a lot of uncertainty and variability associated with them,” Knittel said. “One reason for that is that oftentimes we have little or no data.”
As an example, he pointed to how a 2013 law legalizing small games of chance or “tavern games” in some establishments was estimated to bring in around $156 million annually, but actual collections in the latest year were a mere $1 million.
In lieu of relying solely on these projections, the IFO has recommended lawmakers budget estimated revenues from more predictable sources, like 0.5% increases to the personal income tax or sales tax. Those could be quickly implemented if projected revenue from new sources falls short.
But that could be a hard pill to swallow, as lawmakers in both parties have said they’d like to lower taxes.
And Democrats have long been averse to cutting spending on services like education and healthcare.
There are other taxes Democrats have proposed increasing, which target corporations.
Earlier this year, some Democrats pushed to implement a 5% gross receipts tax on digital advertising platforms, targeting big tech companies like Meta and Google. The proposal was estimated at the time to bring in as much as $500 million.
And Shapiro has proposed a change to corporate tax policy that require what’s called “combined reporting,” meaning parent companies and their subsidiaries would have to file their taxes like a collective organization. The goal is to close what’s known as the “Delaware loophole” that allows companies to shift profits to related businesses in other states.
Shapiro’s office projected the measure could net the state up to $1.1 billion annually.
Keeping the rainy day fund for a rainy day
In the past, Shapiro has called for transferring money from the state’s rainy day fund to cover deficit spending. But the IFO says lawmakers should hold onto that money for a crisis, instead of using it to cover recurring expenditures.
Pennsylvania’s rainy day fund currently has around $8 billion.
A Pew Charitable Trusts report found that leaving rainy day funds intact can help states navigate downturns and emergencies like recessions. (As a note of disclosure, the Pennsylvania Capital-Star is part of the States Newsroom network, which has received funding from the Pew Charitable Trusts.) It’s also a finite account, meaning that the funds can only close a deficit gap for so long.
The IFO has been warning about Pennsylvania’s structural deficit for years, but so far the state has managed to stay afloat and keep its budgets balanced, even improving its credit rating, according to Moody’s, in 2024.
Knittel says he’s often asked about this, and what’s different now.
“The difference is the deficits are real, and they’re large,” he said, noting that recent boons like COVID-19 funds or tobacco settlement money have helped to stabilize past budgets. “But right now, as we discussed, the one time transfers and the delays and shifts have been largely used up … and the general fund surplus is exhausted. So this time it is different, and we do feel that permanent changes will be required.”