As Budgets Tighten, States Weigh Whether to Tap Rainy Day Funds

After years of strong revenue growth, states nationwide have greatly increased their savings—rainy day fund balances are at record levels relative to state spending in 22 states. But revenues are declining and legislators and governors in several states are asking whether this is the right time to withdraw money from their rainy day funds.

These funds are reserve accounts in which states save money in good years to help balance their budgets in bad ones. Budget experts, including credit rating agencies, recommend using the reserves to limit painful service cuts or tax increases when states face budget shortfalls caused by temporary events such as recessions or natural disasters. But rainy day funds are not well suited for helping states close shortfalls caused by structural imbalances in which ongoing spending chronically exceeds ongoing revenue.

Although this maxim is easy to understand in theory—use the rainy day fund for temporary shortfalls, not structural ones—applying it can be more difficult. It’s not always obvious where and when temporary problems end and structural problems begin. Furthermore, rainy day funds have grown so much that some policymakers have begun to wonder whether their savings are larger than necessary. Some states continue to increase savings by raising caps on reserve funds or appropriating dollars to emergency funds, but others have started to discuss spending down rainy day funds even in the absence of a shortfall.

Proceeding cautiously

Overall, states are reluctant to move too quickly to use rainy day funds unless the circumstances warrant it. For example, even though Arizona faces a substantial budget shortfall this year, neither Governor Katie Hobbs, a Democrat, nor the Republican-led Legislature has proposed tapping the rainy day fund. The executive budget proposal explained: “While the State is facing a deficit, it is not due to an economic downturn.” As of May 2024, Hobbs and the Legislature were still discussing how to close the gap, but the governor started that process when she ordered state agencies to limit hiring and look for ways to cut costs this year and next.

Maryland started 2024 with similar caution. The state was facing “the largest structural gap … since back in the Great Recession,” according to David Romans, an analyst for the state Department of Legislative Services. Still, the General Assembly’s Spending Affordability Committee, which advises policymakers on the long-term fiscal health of the state, warned against drawing down rainy day funds when Maryland’s economy is relatively healthy. The committee recommended that the state maintain at least 8.5% of general fund revenues in reserves.

After the collapse of Baltimore’s Francis Scott Key Bridge in March, Maryland lawmakers quickly enacted legislation to allow tens of millions of dollars from the rainy day fund to be used to pay for costs associated with the disaster. But the budget that Governor Wes Moore (D) signed in May still kept the fund level above the amount recommended by the affordability committee—primarily relying on a mix of revenue increases and spending discipline to balance the budget.

Even in California, the state with perhaps the most serious immediate budget problems, policymakers are taking a measured approach. California’s fiscal year 2025 shortfall, which the office of Governor Gavin Newsom (D) estimated to be $45 billion as of May 2024, is partially driven by an economic downturn in the state, with technology companies and startups struggling. But even after the immediate budget year, policymakers are likely to face future fiscal challenges as projections indicate a lingering structural deficit.

The governor’s May budget plan proposes withdrawing only $3.3 billion from the state’s primary rainy day fund for fiscal 2025, reserving the bulk of money in the fund for fiscal 2026—the plan anticipates an $8.9 billion withdrawal for fiscal 2026—or subsequent years. By retaining substantial reserve balances, the plan acknowledges that relying too heavily on reserves this year could make future budget years more difficult.

Too much savings?

On the other hand, some lawmakers and governors are looking at swelling reserves and asking whether they have saved more than needed to balance their budgets in a potential downturn. In Kentucky, where the rainy day fund balance in fiscal 2023 was 12 times what it was in fiscal 2020, many legislators agreed that the savings level was too high, but debated what to do with the money instead of saving it. This spring, the General Assembly passed a budget that appropriated $2.7 billion from the savings account, mostly for one-time infrastructure projects.

One of the sharpest debates has been in Pennsylvania, where the rainy day fund grew from an amount equal to less than 1% of state spending in fiscal 2021 to 12.5% in fiscal 2023. Pennsylvania Governor Josh Shapiro (D) proposed using some of these savings, which he considers excessive, to close budget gaps by funding education, infrastructure, and safety net programs. This would require a two-thirds vote in the General Assembly, where Republican leadership opposes the governor’s plan and instead has called for tax cuts. Any budget compromise would need to recognize that either spending increases or tax cuts could worsen the state’s long-term structural deficit—and one-time money from the rainy day fund cannot pay for such commitments indefinitely.

Final thoughts

As lawmakers weigh how large rainy day funds should be and when to make withdrawals, proven policies and practices can help. Since 2018, more than a dozen states have used budget stress tests to determine savings goals. These analyses estimate the size of budget shortfalls during potential economic downturns and assess preparedness for such scenarios. And that helps policymakers determine how large rainy day funds need to be to close likely budget gaps. States such as Montana have increased the legal maximum sizes of their rainy day funds in recent years in part based on stress tests.

Stress tests can also help states identify when they have saved enough. Utah’s most recent stress test, for example, concluded that “even in a worst-case recession scenario” reserves “would be more than sufficient.” Likewise, New Mexico has reached the savings target recommended by recent stress tests (currently at slightly more than 30% of the state budget). The state also created new trust funds in addition to its traditional rainy day funds, leading both nonpartisan legislative staff and Representative Nathan Small, the Democrat who chairs the House Appropriations and Finance Committee, to say in April that the state should consider lowering its rainy day savings target.

In recent years, leaders in numerous states have rightly celebrated increased rainy day funds as an important step toward improving their preparedness for future recessions. Stress tests and effective rainy day fund policies can ensure that states do not squander this success—and that they have the right amount of savings to use at the right times.

Josh Goodman is a senior officer, John Hamman is a principal associate, and Sariah Toze is an associate with The Pew Charitable Trusts' state fiscal policy project.