Rainy Day Funds Help States Weather Fiscal Downturns

When states face budget shortfalls, rainy day funds are their best line of defense. Every dollar that policymakers use from their rainy day funds to close budget shortfalls means they have to find one less dollar in spending cuts or tax increases.

Building reserves is the second of four steps identified in research by The Pew Charitable Trusts that state governments can take to prepare for temporary budget difficulties caused by economic downturns or other adverse events such as the coronavirus pandemic.

During the Great Recession, which started in late 2007, rainy day funds played a crucial role in softening the blow to state budgets. But they weren’t nearly large enough. As a result, states were forced to approve large spending cuts and tax increases, actions that harmed residents when they were most vulnerable and delayed the national economic recovery. As the economy eventually improved, many states redoubled their commitments to building strong reserves.

Today, states collectively have more money saved than they did at the start of the most recent recession, both in nominal terms and as a percentage of state expenditures. However, some states—such as Kansas, Kentucky, Illinois, New Jersey, and Pennsylvania—still have little in reserve. Others have better-stocked rainy day funds but haven’t conducted state budget stress tests to determine whether they will have enough to mitigate the impact of a downturn. That analysis is important because the right amount varies by state—tax collections in some states are more volatile than others and more sensitive to economic downturns.

Deposit rules, which are set by state legislatures, help ensure that policymakers save for a rainy day during good times. For instance, Virginia banks 50 percent of revenue growth that exceeds the state’s six-year revenue growth average into its fund.

Likewise, Massachusetts saves money from legal settlements and unusually high tax collections from capital gains to boost its reserves. “A lot of people see that as an important backstop to protect the state's budget from needing even more dramatic action than may be necessary if and when an economic downturn were to come,” Heath Fahle, director of policy and research at the Massachusetts Taxpayers Foundation, said in an interview earlier this year.

These rules and others like them not only help build reserves, they also discourage policymakers from using one-time or unsustainable revenue to make ongoing commitments that they would struggle to afford when tax collections fall.

To make sure the dollars in rainy day funds are available when needed, states should use care when designing rules for withdrawal and repayment as well. Some rainy day funds have restrictive repayment requirements that make the accounts ill-suited for dealing with significant downturns.

Missouri, for example, hardly touched its rainy day fund during the Great Recession because the state constitution requires that any funds withdrawn be repaid with interest in three equal payments over the next three fiscal years. If Missouri had withdrawn money from its fund in fiscal year 2009, it would have had to repay those dollars at the same time that revenues fell an additional 5 percent.

In addition to their formal rainy day funds, states often have other reserves that they can tap when facing budget troubles—albeit with varying degrees of legal and political ease. For example, states often have some dollars left over in the general fund at the end of the fiscal year. They also may have a variety of accounts that policymakers created for specific purposes but that they can potentially use to help balance the budget if needed. That, however, requires reducing the dollars available to achieve the accounts’ original goals.

As part of Utah’s stress testing analysis, the state took the valuable step of cataloging these types of informal reserves and rating how difficult they would be to access. This type of analysis can show where policymakers could turn to close a budget gap if the formal rainy day fund isn’t large enough to solve the problem on its own or if state leaders prefer to consider other options first.

Josh Goodman researches state fiscal and economic policy as part of The Pew Charitable Trusts’ state fiscal health initiative.