Rainy Day Funds: Opportunities for Reform
States are in considerably better fiscal shape than they have been since 2001. State revenues have grown rapidly over the last few years, in marked contrast to the sluggish growth or declines in revenues between 2001 and 2004. This is good news. However, a return to budget deficits is inevitable at some point. In general, states have used the better times to prepare for this eventuality by rebuilding their reserves. But many states could do more.
The state experience coping with the fiscal crisis of the early part of the decade showed the importance of reserve funds but also highlighted the need for larger reserves than most states have traditionally kept on hand and for more flexible policies governing their use. Between 2001 and 2004 states struggled to close cumulative deficits of over $250 billion. The first place they turned to close these gaps were rainy day funds and budget reserves. At the end of 2000, state balances stood at $49 billion — 10.4 percent of spending. This was more than double the size of the reserves on hand prior to the last recession of the early 1990s. But even these significant reserves represented less than one-fifth of the cumulative deficits that states faced.
This experience reinforced the conclusions of a 1999 study by the Center on Budget and Policy Priorities as well as recommendations from the Government Finance Officer’s Association that an adequate level of total reserves is 15 percent of a year’s expenditures — or more.
Over the last few years, states have replenished their reserves more rapidly than they did after the downturn of the early 1990s. In aggregate, state budget reserves totaled more than 10 percent by the end of fiscal year 2006 — just two years after the end of the fiscal crisis. However, there are indications that rather than continuing to grow, this level may represent the peak for this expansion. In some states, the amount that can be deposited into a Rainy Day Fund is capped. Other states are considering or have adopted tax cuts or are considering new spending initiatives without ongoing funding. And there are some signs that state tax growth rates are leveling off. The combination of these factors are likely to reduce rather than increase state reserve levels at a time when reserves in many states are still well below the amount suggested by the Center’s earlier paper. Only nine states — Alaska, Wyoming, North Dakota, Nebraska, Montana, Delaware, Louisiana, Alabama, and Idaho — ended fiscal year 2006 with reserves greater than the 18 percent that the Center’s report determined was necessary on average to maintain services during a moderate recession.
Both the level of reserves and the policies states use to manage rainy day funds determine the effectiveness of these budget “cushions.” In addition to increasing the level of their reserves, state policymakers can adopt some critical policy changes to improve their reserve policies so that they are better prepared for the next fiscal crisis. These steps include the following.
Create rainy day funds.Arkansas, Colorado, Illinois, Kansas and Montana do not have separate rainy day funds. These states should create separate funds dedicated to saving resources during good times to cushion the blow of a recession.
Increase or remove rainy day fund caps. Rainy day fund caps place a limit on how large the fund can grow, typically measured as a percent of the budget. If rainy day funds are statutorily or constitutionally capped at an inadequate level, such as 10 percent of the budget or less, then states are going to have difficulty accumulating adequate reserve balances. The first step states could take to improve their rainy day funds is either to remove the cap — perhaps substituting targets for a fixed cap — or to increase it to a more adequate level such as 15 percent of the budget.
Improve rainy day fund deposit rules. Most states place a low priority on saving by only depositing year-end surpluses into their rainy day funds. States could develop a process to integrate rainy day fund transfers into the budget as part of an overall reserve policy that places a high priority on saving.
Eliminate onerous replenishment rules. Six states — Alabama, Florida, Missouri, New York, Rhode Island and South Carolina — and the District of Columbia have created rules that require rainy day funds, after they are used, to be quickly replenished even if economic conditions have not improved. These replenishment rules both create a disincentive for using the fund and place the rainy day fund in competition with other programs for scarce resources during an economic downturn. These replenishment rules can be removed.
Remove limits on legitimate use. Some states have reduced the effectiveness of rainy day funds in addressing budget deficits by requiring a super-majority of legislators to release the fund or by placing an arbitrary limit on how much of the fund can be released at any one time. These restrictions can be repealed.
 Former Center on Budget and Policy Priorities staff member Robert Zahradnik wrote an earlier version of this report.