Revised May 13, 2003
ARE STATE RAINY DAY FUNDS WORKING?
by Bob Zahradnik and Rose Ribeiro
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SummaryStates are experiencing widespread and severe fiscal difficulties as a result of the recent economic slowdown. To balance their budgets, states are cutting spending, raising taxes and using reserve funds. Both tax increases and spending cuts have negative economic consequences to varying degrees for a state because they reduce demand for goods and services, thereby dampening sales, profits, and job growth. Using reserve funds, however, helps reduce the negative economic consequences of budget cuts and tax increases.
States have used a significant portion of their total reserve funds to help close budget gaps in 2002 and 2003. During 2002, total ending balances — which includes both general fund balances and rainy day fund balances — declined from $41 billion to $22 billion. Some 16 states addressed a third or more of their 2002 deficit with rainy day fund withdrawals. Enacted fiscal year 2003 budgets further reduced reserve balances to $18 billion. Overall, reserve balances have declined from 10.4 percent of budgets at the end of 2000 to 3.4 percent of budgets in 2003.
The remaining balance of $18 billion
is heavily concentrated in a few states. In fact five states hold over half
of the remaining total balance —
For most states, the use of reserves can no longer be a significant part of budget balancing plans for the remainder of 2003 and 2004. Nevertheless, now is an excellent time for states to restructure their rainy day funds so that they can be more effective during the next downturn.
The effectiveness of state rainy day funds as a fiscal policy tool has been compromised by a number of factors:
States should take a common sense approach to designing or restructuring rainy day funds. This approach involves four elements:
Rainy Day Funds Have Ameliorated the State Fiscal Crisis and Benefited the Economy — But Not As Much as They Could
Over the course of the 1990s, states increased total reserves to their highest level in twenty years. By the end of fiscal year 2000, states had total year-end balances (which includes both general fund balances and rainy day funds) of almost $48.8 billion, or 10.4 percent of expenditures. Prior to the last recession of the early 1990s, states had total balances of only $12.5 billion or 4.8 percent of expenditures. As a result, states were better prepared for this economic downturn than they were for the recession of the early 1990s.
Reserve balances began to
decline in 2001, falling from $49 billion at the end of 2000 to $41
billion at the end of 2001. This decline accelerated during 2002 as
reserve balances fell to $22 billion at the end of 2002. Based on
appropriated 2003 budgets, states are estimated to have reserve
balances of $18 billion by the end of 2003 (see Appendix Table A for
state-by-state figures on total reserves). Put another way, states
had total reserve balances that equaled 10.4 percent of expenditures
at the end of 2000 and now have reserve balances that equal 3.4
percent of expenditures (see Figure 1). While reserve balances in
aggregate are quite low, several states have significant reserve
balances available to help close 2003 and 2004 budget deficits.
Some nine states and DC have reserve balances in excess of five
percent of expenditures including, for example:
Total reserve balances include both general fund balances and rainy day fund balances. Rainy day funds are reserve accounts funded during the recent economic expansion for the express purpose of assisting states in getting through an economic downturn. Several states drew heavily from their rainy day funds to help reduce the amount of counter-productive spending cuts or tax increases they otherwise would have had to make (see Appendix Table B for state-by-state data on rainy day fund balances). Some 16 states addressed a third or more of their 2002 deficit with rainy day fund withdrawals. For example,
While states have been heavily drawing down on rainy day funds and other reserves, these funds are proving inadequate to balance state budgets. According to the National Conference of State Legislators (NCSL), states had total budget deficits of $37.2 billion or 7.2 percent expenditures in 2002 and estimated 2003 budget gaps of $79.0 billion or 15.1 percent of expenditures. The latest estimates of 2004 budget gaps indicate that states are facing deficits of at least $78.4 billion or 15.0 percent of expenditures. These figures demonstrate the magnitude of the multi-year budget problems that states are facing. As indicated earlier, state total reserves peaked at $50 billion, or 10.4 percent of expenditures — less than one-third the amount needed to fund three years of budget gaps.
Why are State Rainy Day Funds Inadequate?
In any given year, elected officials generally would prefer to cut taxes or boost spending — measures that directly and immediately benefit constituents — than to save money for the future. And, indeed, in the mid to late 1990s, when many states were running surpluses, spending rose and taxes were cut. States also saved significant resources in rainy day funds, but they did not save enough. But how much is enough?
The experience of this fiscal downturn confirms a previous Center on Budget and Policy Priorities analysis, which found that the common benchmark of five percent for reserve balances is not adequate. A 1999 study showed that on average states would need balances of about 18 percent to weather a three-year fiscal downturn, similar to the downturn of the early 1990s, without cutting spending or raising taxes. At the time, these estimates seemed high to many state policymakers. However, given the severity of the current downturn, these previous estimates now appear conservative.
The Government Finance Officers Association (GFOA) has also questioned the five percent reserve benchmark. In a statement of recommended practices released in 2002, GFOA stated that:
The adequacy of unreserved fund balance [which includes rainy day funds] in the general fund should be assessed based upon a government’s own specific circumstances. Nevertheless, GFOA recommends, at a minimum, that general-purpose governments, regardless of size, maintain unreserved fund balance in their general fund of no less than five to 15 percent of regular general fund operating revenues, or of no less than one to two months [that is, eight to 16 percent] of regular general fund operating expenditures. A government’s particular situation may require levels of unreserved fund balance in the general fund significantly in excess of these recommended minimum levels. [italics added]
Clearly the data discussed above indicate that in the future states should plan on targeting the upper bound of GFOA’s recommendation — reserves of 15 percent of operating expenditures. Somewhat surprisingly, many states have structured their rainy day funds in ways that prevent accumulations of more than even the minimum recommended by GFOA, five percent of revenue or eight percent of spending, much less the higher target, 15 percent of revenue or 16 percent of spending.
Bond rating agencies have also questioned the adequacy of the 5 percent benchmark level. Standard and Poor’s considers total general fund balances (including rainy day funds) of 15 percent or more to be “strong,” while balances of 5 percent or less to be “low” for local government tax-backed general obligation bond ratings. Standard and Poor’s notes that the “approach to rating GO bonds of states is similar to that of local government units.”
Rainy Day Fund Caps Should be Raised
One structural feature of rainy day funds that plays an important role in the size of the fund is whether or not there is a cap on the size of the fund. Rainy day fund caps place a limit on how large the fund can grow, typically measured as a percent of the budget. Clearly if the size of state rainy day funds are statutorily or constitutionally limited to an inadequate level, such as 5 percent of the budget or even less in some cases, then states are going to have difficulty accumulating adequate rainy day fund balances. While this may seem like an obvious point, this is exactly the case in over 40 percent of the states with rainy day funds. Specifically, 19 states have capped their rainy day funds at 5 percent or less (see Figure 2). These states are virtually guaranteed to find their rainy day funds inadequate. On the other end of the spectrum, 10 states have no cap and nine states have a cap set at 10 percent of the budget. (For a state-by-state summary of rainy day fund caps see Appendix Table C. For a summary of all the major rainy day fund provisions including: caps, super-majority requirements, limits on use, source of deposits and replenishment rules see Appendix Table D).
Rainy day fund caps clearly restricted rainy day fund growth since the end of the last recession. The rainy day funds in states with caps of five percent or less grew from 1.0 percent of expenditures at the end of 1993 to only 3.7 percent of expenditures at the end of 2000. The rainy day funds in states without caps or with caps of 10 percent or greater grew from 2.3 percent of expenditures at the end of 1993 to 9.0 percent of expenditure at the end of 2000. This indicates that raising rainy day fund caps is a critical policy option that states should pursue. The first step states should take to improve their rainy day funds is either remove the cap or increase it to a more adequate level such as 10 or 15 percent of the budget.
Contribution Rules May Place Low Priority on Saving
A second structural reason contributing to the inadequacy of rainy day funds is that the rules for contributions do not give states much encouragement to save. The most common contribution rule — used in 30 out of 46 states with a rainy day fund — is that a portion of the state’s year-end surplus must be placed in the rainy day fund. This rule has the advantage of ensuring that the state is truly not in need of the funds before the deposit is made. The disadvantage is that the rainy day fund is last in line for receiving state resources. During the 1990s, for example, states moderately increased spending and cut taxes extensively when they enacted their budgets. In states with a year-end surplus deposit rule, rainy day fund deposits were made at the end of the fiscal year, long after the decisions to raise spending or cut taxes were made. States are now paying the price for placing such a low priority on saving.
Other types of deposit rules
can have the opposite effect; they may lead to required deposits
when the state cannot afford to make them.
Other states have rules intended to
assure that rainy day fund contributions will be made when fiscal
conditions are healthy. Some seven states — Arizona, Florida,
Idaho, Indiana, Michigan, Tennessee, and Virginia — require deposits
into the rainy day fund when growth in tax revenues or state
economic growth is expected to exceed specified levels.
In some states, however,
these rules can require states to make contributions when state
finances are not particularly strong. In
Why Haven’t States Spent Money in their Rainy Day Funds?
While aggregate total reserve and rainy day fund balances have declined dramatically over the last two years, some states did not aggressively use rainy day funds to reduce the need for budget cuts or tax increases. This failure not only led to unneeded spending cuts, but also slowed the nation’s economic recovery by holding funds out of the economy at a time when they were needed to boost demand thru additional spending. There are a number of reasons why states may choose not to use rainy day funds. In some cases, the failure to withdraw funds resulted from onerous rules requiring replenishment of withdrawn funds in an unrealistically short time frame. Other barriers to timely withdrawals included supermajority requirements and artificial limits on the amount of funds that may be withdrawn.
Six states — Alabama, Florida, Missouri, New York, Rhode Island and South Carolina — and the District of Columbia require that withdrawals from the rainy day fund be replenished over a specified period. Replenishment rules can be problematic for two reasons. In some cases they provide a disincentive to using the fund. When replenishment must occur soon after the drawdown, rainy day deposits may compete with critical government programs and services for scarce resources during a time of fiscal strain.
Of the states that require
replenishment of withdrawals from their rainy day fund, three —
Claims about Impact of Using Rainy Day Fund on Bond Rating Are Overstated
A few state officials appear to believe that using Rainy Day Funds at this time would be seen negatively by bond rating agencies and result in a downgrade to a state’s bond rating. Most recently, legislative budget leaders in Maryland expressed concern over former Governor Glendening’s proposal to use $200 million of the state’s $500 million rainy day fund to help close a FY 2003 budget gap of about $500 million. News accounts indicated that legislators were fearful that drawing down reserves would harm the state’s AAA bond rating. This does not appear to be the case. For example, a recent Standard and Poor’s publication indicated that prudent use of reserves would not affect a state’s credit rating.
Some policymakers are fearful of allowing the rainy day fund balance to drop below the arbitrary level of five percent of spending — even when the state is still battling the fiscal storm. Rainy day fund balance targets are intended to indicate the level of funding needed prior to the start of the economic downturn, not the level of funding the state must maintain throughout the crisis. In fact, seven of the 10 states with an AAA bond rating used one-third or more of their rainy day fund in 2002. Three of these top-rated states — Minnesota, North Carolina and South Carolina — used their entire rainy day fund in 2002.b
a Robin Prunty, Alexander M Fraser, Steven J Murphy. Commentary: The State of the States. Standard and Poor’s, October 18, 2001.
b Robin Prunty, Alexander M Fraser. U.S. State Ratings and Outlooks: Current List. Standard and Poor’s, January 29, 2003.
Shorter time periods,
however, are problematic. In
States Should Not Hesitate to Use Remaining Rainy Day Fund Balancesa
While states used rainy day funds extensively to balance 2002 and 2003 budgets, a number of states still have some money left in rainy day funds. States should not hesitate to use those remaining balances for a number of reasons:
Rainy Day Fund Rules Limit Use of Funds
Ten states have super-majority requirements governing the release of rainy day fund resources to address budget deficits. Super-majority rules create an unnecessary political hurdle to accessing the funds. These rules allow a minority of lawmakers to block the sensible use of rainy day funds in times of fiscal crisis.
Some 13 states set a limit
on the amount of the rainy day fund that can be used at one time.
Several states did not use their rainy day funds, or their use was limited, as result of replenishment rules, super-majority requirements and direct limits on use.
, the super-majority requirement was also a factor in limiting the use of the fund. The Senate easily approved the governor’s proposal by a vote of 31-2. The House, however, was unable to garner the necessary two-thirds vote to authorize the use of the fund. The bill did gain a simple majority of votes in the House. In the absence of the super-majority requirement, Missouri would have been able to tap its rainy day fund and offset some of the budget cuts that were eventually implemented to balance the budget. Missouri
Common Sense Approach to Designing a Rainy Day Fund
Rainy day funds, if properly designed, are an
important policy option for state policymakers. But there is room
for improvement in the design of rainy day funds. Most state rainy
day funds have not been adequate to close budget gaps during the
current fiscal crisis. A few states still do not have separate
rainy day funds (
There are four common sense steps states can take to design or restructure rainy day funds to make them more effective: use funding targets instead of caps and set the targets at levels that are in line with needs; develop an appropriate process for making deposits into the fund that lessons the probability that tax cuts or new spending programs will preempt saving in rainy day funds; allow flexibility in accessing the funds during a downturn; and avoid including onerous replenishment rules and eliminating those rules where they now exist.
First, the notion of a cap on the size of rainy day funds is problematic because the caps have prevented the funds from reaching an adequate level of funding. Instead of restricting the size of rainy day funds to an inadequate standard of five percent of the budget, states should set a target level for the size of the fund that is at least 10 to 15 percent of the budget. Once that target is met, policymakers should give serious consideration to making additional deposits into the fund above the 15 percent level.
Second, states could develop a more rational process for making rainy day fund contributions that would incorporate deposits into the budget development process prior to the beginning of the fiscal year in the following manner:
This process would ensure that all necessary spending needs are being met, that funds are being deposited into the rainy day fund and that funds are available to meet additional needs.
The third element to a common sense approach to rainy day funds is that states should have flexibility in using the funds once there is an economic downturn. The most straightforward method for accessing rainy day funds is through the normal appropriation process. This makes sense because state legislatures typically address shortfalls in the current budget when they are developing the budget for the upcoming fiscal year. Placing a super-majority requirement on accessing the funds does not make sense because it creates an unnecessary political hurdle to making a withdrawal from the fund. Super-majority requirements also give additional leverage to a minority of legislators that can distort priority-setting and policymaking.
Using rainy day funds should be a state’s first response to fiscal stress because other policy options, such as tax increases or budget cuts, require time for thoughtful consideration. A rainy day fund withdrawal provides a quick infusion of funds to keep the budget on track while other options are considered. Consequently there should be no artificial hurdles, such as a super majority requirement, to accessing the funds.
One option that makes sense
is allowing the governor the discretion to use a portion of the
rainy day fund without legislative approval. For example, the
In addition to avoiding
super-majority requirements, state rainy day fund policies should
not place other hurdles on accessing the funds. Some states place a
limit on how much states can withdraw from the rainy day fund in a
given year or limit how the funds can be used. For example,
Finally, state rainy day fund policies should not include a replenishment rule. These rules create a disincentive for using the fund and may lead to rainy day fund deposits competing with other programs for scarce resources. If states appropriate deposits when the budget is developed, the need for replenishment rules would be greatly diminished. Overall, the funding targets and the deposit process described above should be utilized to ensure that once a state fiscal crisis ends, a state begins to plan for the next one.
Click here to view full report.
 National Association of State Budget Officers (NASBO), Fiscal Survey of the States, November 2002.
National Conference of State Legislators (NCSL), State Budget
and Tax Actions 2002,
See Elizabeth C. McNichol and Kevin Carey, Did States Overspend
During the 1990s,
Standard & Poor’s. Public Finance Criteria 2000.
 Some states define year-end surplus as revenues in excess of expenditures, while others define it as actual revenues in excess of projected revenues. The 46 states with a rainy day fund include DC.
“Hanaway takes heat for opposing use of rainy day fund to fix