Pew Comments: Montana Bill to Create State Rainy Day Fund

Robert Zahradnik, director of The Pew Charitable Trusts’ state fiscal health and economic growth project, testified March 23 before the Montana House Committee on Appropriations about S.B. 261, an act that would create a rainy day fund for the state and set guidelines for the fund’s use.

Zahradnik discussed provisions in the bill that reflect best practices identified in Pew’s research for saving, withdrawing, and determining the optimal size of state rainy day funds. He also noted that enacting the bill would improve the state’s ability to manage revenue volatility and weather future economic uncertainty.  

Full text of the testimony is below.

Testimony in Support of Senate Bill 261

Montana House Committee on Appropriations
March 23, 2017
Robert Zahradnik, director
State Fiscal Health Project, The Pew Charitable Trusts

Chairwoman Ballance, Vice Chair Brodehl and members of the Committee:

Thank you for the opportunity to speak today regarding Senate Bill 261. My name is Robert Zahradnik, and I am a director on the State and Local Fiscal Health team at The Pew Charitable Trusts. Pew applies a rigorous, analytical approach to a number of issues with the goal of improving public policy. One focus of our work is helping states manage their long-term fiscal health by conducting research on common fiscal and economic challenges. We work across the 50 states, highlighting solutions for lawmakers to consider and offering customized research and technical assistance.

Pew has been providing research assistance to the Legislative Fiscal Division over the past several months on the issue of rainy day fund policy. Over the past four years, The Pew Charitable Trusts has extensively researched the policies that govern budget stabilization funds, commonly referred to as “rainy day funds.” Through an evidence-based assessment of all 50 states, Pew has determined the best policies for saving, withdrawing, and determining the optimal size of such funds.

Based on Pew’s definition, Montana is currently one of three states—including Colorado and Illinois—that does not have a separate rainy day fund to manage unexpected shortfalls over multiple budget years. The proposed legislation—Senate Bill 261—includes several of the best practices identified in Pew’s research, including the creation of a separate rainy day fund to help manage volatility.

Pew has found that revenue volatility has become a more significant challenge over the past two decades and presents challenges for state officials and policymakers to accurately forecast revenue and keep budgets in balance. Montana’s budget stabilization plan—that establishes a separate Budget Stabilization Reserve Fund—will help smooth state finances over shifts in the business cycle. The plan is a key budget management policy that may reduce the need for difficult budget choices, including spending cuts and tax increases during periods of decline, and help identify the best use of surplus dollars when tax collections are flush.

Montana’s budget stabilization plan, to build a financial cushion to help the state weather revenue shortfalls over multiple years, includes several best practices identified in Pew’s research. Specifically, the plan proposes a deposit rule for the budget stabilization reserve that sets aside 50 percent of the excess revenue in the annual general fund forecast as a hedge against future downturns. This approach, known as forecast error, can be a successful means for saving the surplus revenue collected. However, an alternative method—which is more in line with best practices—is linking deposit rules directly to extraordinary or unexpected revenue growth, such as when revenue collections exceed an historical average. For example, Virginia sets aside 50 percent of growth in revenue that exceeds the 6-year growth average.

Montana’s withdrawal condition for its budget stabilization reserve is also in step with best practices. Withdrawals are triggered when the projected ending balance for the current biennium is projected to fall below a specified benchmark. This type of withdrawal condition is based off budget balance, a rule currently found in 19 states. Conditions based on budget balance offer the most flexibility for using the funds.

Consistent with Pew’s research, the state’s budget reserve also includes an evidenced-based determination of the amount of reserves needed to offset expected revenue declines. The savings target, based on a statistical analysis of revenue trends conducted by the Legislative Fiscal Division (LFD), is consistent with Pew’s recommendation for states to rigorously analyze historical revenue volatility to establish the optimal fund balance. The LFD analysis found that an ending fund balance of 8.3 percent of expenditures was sufficient to avoid statutory budget reduction triggers in four out of five biennia. In the one out of five biennia event, a combination of spending reductions and short term transfers would be available to cover shortfalls, without calling the legislature into special session to make more difficult reductions.  In normal budget times, the 8.3 percent ending fund balance is sufficient to meet cash flow needs without issuing short-term debt.

In addition to following best practices for reserve policy, the state’s plan establishes clear conditions and prioritization for borrowing resources from other state funds in the event of a more severe downturn in revenues, including clear repayment provisions. Accessing balances from state funds, often referred to as “fund sweeps,” is a common practice during an economic downturn. However, these funds sweeps are often conducted without clear guidelines and can result in negative consequences if replenishment of the funds is delayed or does not occur.

Finally, Montana’s budget stabilization plan also creates a mechanism to shift the state’s debt ratio over the course of the business cycle. This is notable because it will afford the state additional budget flexibility when it is needed most. During good times, more capital is funded on a pay-as-you-go basis, while during downturns more capital is funded through debt. This practice has a several advantages:

1. Can sustain the level of capital spending across a recession;
2. Helps manage volatility, easing pressure on the operating budget by shifting cash from the capital budget to the operating budget when the economy slows;
3. Takes advantage of issuing debt at a time when interest rates are traditionally lower.

Overall, based on Pew’s extensive research, Montana’s proposed budget stabilization plan includes a set of policies that will help to strengthen Montana’s long-term fiscal health.