Why Rainy Day Funds Can’t Always Be Used on Rainy Days

Louisiana faced a dual fiscal problem this spring: a mid-year gap in its 2010 budget and a shortfall in the 2011 budget it was trying to write. So, like states around the country, it went to its reserves, accessing $198 million from its rainy day fund. To supporters, this looked like a prudent step. The 2011 budget ended up $3 billion smaller than the 2010 budget, with significant cuts to health care and higher education. If the state had kept its reserves fully funded, those cuts would have been even more severe.

Ron Gomez doesn’t see it that way. Gomez, a former legislator, says the move was not only bad policy but also was illegal. Louisiana’s budget problems were linked to a post-Katrina reduction in federal funding. Gomez says the constitution allows the Budget Stabilization Fund to be accessed only when state tax revenue drops. Plus, he argues, even if lawmakers could have spent the money legally, they would have been required to put it back in almost immediately, since fund deposits are linked to mineral taxes. He’s suing the state to get his views heard.

Gomez’s suit reflects the peculiarities of Louisiana, but it also reflects a broader truth: If you want to know why a state is spending money from its rainy day fund or why it isn’t, it helps to look at the rules. States have set up a variety of restrictions on how large rainy day funds can be, under what circumstances they can be tapped and how quickly they must be replenished. These rules create a balancing act. If the rules for using the fund are too loose, states lack any guarantee that the money will be there when they require it. If the rules are too tough, lawmakers won’t be able to use the money when and how they need to stabilize the budget. After going through a period of fiscal tumult during which rainy day funds were more important than ever, lawmakers are starting to reassess whether they’ve gotten that balance right.

This reassessment is occurring even though most observers say that state rainy day funds worked in the current fiscal crisis – or at least worked as well as could have been hoped. States entered the current downturn with larger reserves than in other recent recessions. Faced with large budget shortfalls, many states used the money to blunt cuts to services and to reduce the need for tax increases.  Today, according to the National Association of State Budget Officers, the reserves largely are gone. Just two states, Alaska and Texas, hold around $19 billion of the $29.5 billion total that states still have in their rainy day accounts.

Precious reserves

Still, even beyond Alaska and Texas, some states stand out for their reluctance to tap reserves. Missouri, for example, made a variety of painful cuts this year after the budget Governor Jay Nixon proposed in January proved to be $500 million out of balance only months later. Yet Missouri lawmakers haven’t touched the state’s Budget Reserve Fund, which holds more than $500 million. New York lawmakers have creatively used one-time money to paper over structural budget problems for years, but they haven’t actually tapped the billion-dollar Tax Stabilization Reserve Fund, one of their two rainy day funds.

The rules help explain why. In New York, money taken out of the reserve fund must be repaid in three equal payments over six years. For a state with structural problems, tapping the reserve would offer the state only a relatively brief respite from its fiscal pain. New York lawmakers haven’t taken money out of the Tax Stabilization Reserve Fund in 20 years.

In Missouri, money removed from the Budget Reserve Fund must be repaid in equal payments over the next three years, with interest. That requirement makes it useful for responding to costly natural disasters, but less suitable as a counter-cyclical force in prolonged fiscal downturns. “Right now, in the current revenue situation we’re in, obviously it would do us no good,” says Linda Luebbering, Missouri’s budget director. Missouri can’t use the fund without a two-thirds vote of the Legislature and an emergency declaration from the governor. As a result, the Budget Reserve Fund has been used only once in state history, for a literal rainy day: the Great Flood of 1993.

The question with these stringent rules – like the ones Gomez is trying to uphold in Louisiana – is whether they’re discouraging lawmakers from spending reserves at precisely the time when they ought to be spent. If states aren’t going to tap their rainy day funds during the worst fiscal crisis since the Great Depression, when are they going to use them? Once the money has been spent, it’s an open question whether it makes sense to require lawmakers to repay it on a predetermined schedule, regardless of fiscal conditions. “If you can’t balance your current budget and you’re furloughing your workers and you’re trying to figure out how to meet your current payroll,” says Kim Rueben, a public finance expert at the Tax Policy Center, “the ability to sock money away for the next recession is hard to do.”

In part to give themselves more flexibility, New York lawmakers created a second fund in 2007, the Rainy Day Reserve Fund, that doesn’t have the same replenishment requirement. Last year, the Missouri House approved a constitutional amendment to allow lawmakers to use the rainy day fund without having to begin repaying money until four years later. It died in the state Senate.

But not everyone is clamoring for changes. Budget officials in New York and Missouri note that the reserves send at least a small positive signal to credit rating agencies. The states also routinely borrow from the reserves to balance out cash flow throughout the year. Those uses come with real financial benefits, even if it appears at first blush that the money is just sitting around in an account. “Some states have to go out and borrow from someone else,” Luebbering says. “We just borrow from ourselves…I don’t see a problem with the current restrictions.”

Gomez wishes Louisiana lawmakers had the same mentality. His legal argument is that the rules are the rules. But he also says that the rules make sense. They were designed to preserve the rainy day fund for periods of fiscal distress tied to a decline in the price of the natural resources on which Louisiana’s economy depends. “Being a former legislator and knowing what we were intending to do when we passed it,” Gomez says, “I think the current legislators have been totally irresponsible and need to be brought back to reality.” For their part, legislators who support using the rainy day fund argue that fiscal distress is just as real when it comes from a decline in federal funding.

Learning from Wisconsin

Still, Gomez’s view isn’t unique. After all, restrictions are a big part of preserving the money for a rainy day. States generally can keep money in reserve by carrying over a balance from year to year, without the need to place money in a special account. When such money simply sits unspent in the general fund, though, it’s a constant source of temptation for legislators interested in funding new programs or cutting taxes. When rainy day funds are as easy to spend as the general fund, they’re equally great sources of temptation.

In this regard, Wisconsin represents a cautionary tale. The state spent nearly all the money in its rainy day fund when it wrote its budget in early 2008, before the worst of the economic downturn even had hit. In Wisconsin, spending money from the rainy day fund is as easy as any other appropriation.

Today, Wisconsin legislators are looking to change that. A proposed constitutional amendment would bar lawmakers from using the rainy day fund unless the economy was in recession and, even then, require a two-thirds vote in the Legislature to do it. The amendment also would force legislators to put a half-percent of tax collections into the fund each year.

California is attempting something similar. This year’s budget deal there included a variety of new rules designed to make the state’s reserves bigger and more difficult to access. The changes, which California voters still must approve at the polls in 2012, include provisions that would require annual payments into the fund in good times and prevent the fund from being used for increases in per capita spending beyond the rate of inflation. Along the same lines, South Carolina voters approved a ballot measure earlier this month to require the state to place more money in its rainy day fund, while voters in Virginia and Oklahoma approved measures increasing the maximum sizes of their funds.

If California voters support the changes in that state in 2012, lawmakers will, for better or worse, have less flexibility to use reserves as they please. But Philip Joyce, a George Washington University professor who has written about rainy day funds, points out that there are natural impediments to keeping reserves off-limits. Politicians aren’t the only ones tempted by them, he notes. Voters are, too. “You have to convince people in the state that they should have to be overtaxed in good times so that you don’t have to raise taxes or cut spending in bad times,” he says. “It becomes difficult to justify politically. It can be a hard case to make.”