Many states struggle with how much to save because their purpose for doing so is unclear, according to a new report from The Pew Charitable Trusts. Why States Save: Using Evidence to Inform How Large Rainy Day Funds Should Grow examines budget stabilization funds—often called rainy day funds—and offers recommendations to determine optimal savings goals and create enhanced budgetary flexibility over the course of the ups and downs of economic activity. The research found that:
- More than half of the 46 states with rainy day funds—27—do not clearly express the purpose of their funds in state law.
- During the growth years of the mid-2000s, rainy day funds in 21 states were prevented from growing because they reached their maximum levels. As a result, most of those states relied on spending cuts and tax increases to balance their budgets during and after the Great Recession.
- Only five states—Connecticut, Minnesota, Nebraska, Oregon, and Utah—currently require regular, periodic evaluations of revenue volatility patterns to inform the size of their rainy day funds.
“It is critical for states to establish a purpose for saving, and to define that purpose as clearly as possible,” said Brenna Erford, manager of state budget policy research at Pew. “Clarity around the objective of the fund—the reason states save rather than spend—is necessary to determine how much states should hold in reserves and when they should consider tapping them.”
The volatility of state revenue and the level of coverage that legislators wish to provide for their state’s budget are also key factors for policymakers to consider. Without understanding revenue fluctuations or the budgetary risk that the state wants to offset, policymakers will continue to struggle to determine how much to save.
The study presents three recommendations for states seeking to identify an optimal savings target:
- Explicitly define, in law, the purpose of a rainy day fund. A clearly defined and narrowly drawn purpose will enable policymakers to identify under what conditions a fund can be used, which will facilitate accurate estimates for a savings target.
- Align savings targets with the fund’s purpose as well as the state’s tax volatility. States should examine the fluctuations of their revenue; while some experience little volatility in their revenue streams, others rely on sources that are more prone to variations.
- Determine and clearly express the level of coverage—similar to an insurance policy—that the state seeks to provide for its budget. A maximum savings cap should be based on how much risk the state is willing to offset or tolerate. Some state rainy day funds are meant to address only current-year shortfalls; others are designed to cover all expected shortfalls over two years.
Setting and meeting targets for rainy day fund savings entail trade-offs. Every dollar directed to a rainy day fund is one that cannot be spent on public programs or tax reductions, or used to pay down long-term debt. But these savings can allay tough decisions during recessions and help make state budgets more consistent and predictable.
Historically, many states have saved too little in their rainy day funds, requiring painful service cuts and tax increases during economic downturns. Other states have saved more than they need, unnecessarily diverting funds from public programs and investment opportunities. Taking steps to set practical, thoughtful policies and savings targets for rainy day funds can ensure the correct size of funds and enhance states’ fiscal health over the long term.
The Pew Charitable Trusts is driven by the power of knowledge to solve today’s most challenging problems. Learn more at www.pewtrusts.org.