When to Use State Rainy Day Funds

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Overview

When the Great Recession hit in 2008, it put enormous pressure on state budgets. Tax revenue dropped precipitously and mandatory costs—particularly for health and human services—rose. Delaware, for example, entered fiscal year 2010 facing a $750 million budget shortfall because of declining revenue from personal and corporate income taxes.

One tool the state had to balance its budget was the Budget Reserve Account, a rainy day fund dedicated to helping address unanticipated deficits. At  the time, the fund’s balance totaled $186 million—equivalent to 5 percent of general fund revenue, the statutory maximum level. But policymakers did not tap it. Instead they relied on a combination of budget cuts and tax increases to make up for the deficit, reducing state employees’ salaries by 2.5 percent and raising the top individual income tax rate from 5.95 percent to 6.95 percent. In fact, since creating the account in 1977, the state has never made a single withdrawal.

Delaware has not used its Budget Reserve Account in part because the law does not clearly define what budget conditions meet the acceptable criteria. As former Delaware Secretary of State Glenn Kenton explained, “The fund wasn’t used because [some people feel] it’s only for true emergencies. They characterize it as an emergency fund rather than a budget reserve fund.” So while state statute lays out its purpose as being to fund unexpected deficits, there is no further guidance that defines what meets that criterion. One way to solve this confusion, he said, would be to amend the statute to make the fund’s purpose clearer.

Delaware is not the only state that has struggled to use its rainy day fund effectively. Between fiscal years 2003 and 2007, most states experienced strong tax revenue growth, which rose more than 7 percent on average annually across the 50 states. While this would suggest an opportunity for states to make deposits to their rainy day funds, 22 states did the opposite and made withdrawals at least once. Conversely, from 2008 to 2010, many states experienced their worst recession-driven revenue downturn in decades—a perfect time for withdrawals— and yet eight did not use any of their rainy day funds. In some states, like New York, repayment provisions probably discouraged their use. In others, clear conditions for withdrawal were absent, as was the case in Delaware.

A robust and well-designed rainy day fund can give a state the flexibility it needs to weather the revenue impact of economic downturns. For this to work, states need to also have clear policies that ensure the funds are used   in a way that is aligned with how their revenues respond to the business cycle. Pew’s examination of states’ rainy day fund withdrawal policies found that in some cases, those policies either fail to adequately safeguard savings from inappropriate use during times of economic and revenue growth or do not provide enough flexibility or accessibility in times of greatest need. States with flawed policies may find that their rainy day funds do not fulfill their primary intent: to keep their budgets stable regardless of how well the economy is performing.

Pew’s examination of state policies governing withdrawals from the 47 states with budget stabilization funds found that:

• Six states have no legal conditions for when funds should be  withdrawn.
• Ten  states have unclear conditions for when they can make withdrawals.
• Twenty-nine states do not include revenue or economic fluctuations as criteria for determining when withdrawals from these funds are appropriate.

Pew identified three elements that state policymakers should consider when designing budget stabilization funds:

1. The fund’s usage should be aligned with its purpose. Not all withdrawals from rainy day funds are consistent with the objective that the funds were created to meet. States should examine whether funds are meeting their statutory and/or  constitutional purpose.
2. There should be a connection between fund withdrawal conditions and volatility. Ideally, guidelines should tie withdrawals to economic or revenue fluctuations in a clear and measurable way. Such guidance gives policymakers a clear signal on whether the time is right to use reserves.
3. The requirements for rebuilding the fund should be clear and achievable. Some states require that any money withdrawn from a rainy day fund be reimbursed within a specific time frame, which is intended to ensure that the state rebuilds its reserves. However, such requirements often fail to take the business cycle into consideration, and in some cases are so stringent that state leaders rarely authorize withdrawals—even in dire economic circumstances.