Pew: States Can Strengthen Reserves by Linking Savings to Volatility

A report released today by The Pew Charitable Trusts illustrates how states can save enough during economic boom years to better weather future recessions. Building State Rainy Day Funds: Policies to Harness Revenue Volatility, Stabilize Budgets, and Strengthen Reserves identifies the limitations of current rainy day funds, formally known as budget stabilization funds.  It also contains three strategies to help states make saving a reliable and predictable practice in times of growth.

These funds are intended to smooth state finances over the ups and downs of the business cycle. The 50-state assessment reveals that only 12 states connect the rules for when, how, and how much to deposit into their funds with underlying revenue or economic fluctuation. Further, caps on the size of funds often are set too low, preventing states from saving enough to substantially offset revenue losses during economic downturns.

“Unanticipated peaks and valleys in revenue collection are unavoidable, and increasingly common,” said Brenna Erford, who manages Pew’s state budget policy research. “States with rainy day fund deposit rules tied to observed volatility are able to more reliably harness growth when times are good, prioritize saving during the budget process, and prepare for future downturns.”

The study identifies three best practices that can help policymakers manage volatility by designing responsive budget stabilization funds. 

1. Require regular studies to identify major sources of volatility and present appropriate policy solutions. These studies should determine which areas of the tax system are volatile, recommend ways to align budget stabilization fund policies with that volatility, and be revisited on a recurring basis. For example, every three years Utah produces a comprehensive report, which analyzes economic changes that affect state tax revenue, the interaction between the tax base and tax rate, and policy changes that modify the tax system. These reports have directly informed the rules governing how and how much the state saves. In 2014, Utah expanded its volatility study to consider automatic deposit mechanisms for reserve funds.
2. Tie budget stabilization fund deposits to observed volatility. To ensure that policymakers set aside a portion of one-time or temporary revenue growth, rainy day fund deposits should be tied to extraordinary or unexpected revenue increases. This can allow states to save more in high-growth years, when funds are available, and to set aside less in leaner years. Because each state’s economic and fiscal characteristics are unique, the ideal rule will vary from state to state. Virginia ties deposits to growth in all major taxes; Massachusetts captures high capital gains collections; and Texas sets aside oil and gas revenue above a certain level.
3. Set fund size targets that match the state’s experience with volatility. The amount of money states need to have on hand for downturns depends on their susceptibility to sudden swings. Even when deposits are linked to volatility, if the fund’s cap is too low, it can hinder creation of an adequate financial cushion. Recently, states have begun to address this problem through legislation. For example, Minnesota law requires the state to examine economic patterns to determine the ideal size of its budget stabilization fund.

The report notes that setting aside money for the future requires tradeoffs. Although many state leaders have emphasized the need to rebuild savings, each dollar directed to a budget stabilization fund is a dollar that cannot be spent on public programs or tax reductions or used to pay down long-term debt. But these savings can mitigate tough decisions during recessions and help make state budgets more consistent and predictable throughout the business cycle. As the economy expands and states continue to see their revenue increase, policymakers have both a fiscal responsibility to rebuild budget stabilization funds and a rare opportunity to significantly improve them.

Pew examined the mechanisms for depositing money into budget stabilization funds and compared these rules to tax volatility patterns and drivers in all 50 states. State budget policy researchers at Pew adjusted U.S. Census Bureau data to remove the effect of tax policy changes from 1994 to 2012, which revealed the underlying cyclical volatility in these tax sources.

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The Pew Charitable Trusts is driven by the power of knowledge to solve today’s most challenging problems. Learn more at www.pewtrusts.org.