Socking Away Money for the Bad Times Requires Strategic State Practices

From requiring specific financial conditions be met in order to withdraw money from a rainy day fund to setting a replenishment plan to pay back those drawdowns, a new report outlines some best practices for state governments to save money for an economic downturn.

The Volcker Alliance report, released Thursday, examined the practices of all 50 states and makes 10 best-practice recommendations that states can borrow from to strengthen their own fiscal stability.

The report details best practices in three areas: making withdrawals from rainy day funds, replenishing of funds, and addressing revenue volatility. It also grades states based on their reserve fund balances and policies.

Many states made significant drawdowns of their rainy day funds during the economic downturns of the early and mid-2000s. In the years since the Great Recession, many have reworked their savings plans to make them more resilient when the economy turns sour.

Rainy day funds, which dipped to $27 billion in 2010, are now expected to hit $68.2 billion in 2019 and $74.7 billion in 2020, according to the National Association of State Budget Directors.

The first step in strengthening a state’s savings policy is to define rules governing when reserve funds can be spent, according to the Volcker report. Setting rules about usage and requiring some form of legislative approval “can help guard against frivolous use of taxpayer dollars while directing reserve funds toward the most pressing needs,” the report said.

The report identifies seven states—Illinois, Kansas, Kentucky, Maryland, Nebraska, Ohio, and Wyoming—as lacking or having limited policies that govern tapping of rainy day funds.

“Whether the purpose of a withdrawal is to cover a revenue shortfall in the current fiscal year, reduce deficits from previous periods, or help pay for reconstruction after natural disasters, states should clearly define the economic or fiscal indicators that may justify drawdowns, as well as acceptable uses for the money,” the report said.

The report identified Indiana as one state exemplifying a best practice for rainy day fund use. The state has set conditions that make decisions to transfer rainy day funds to the state’s general fund reliant on a formula rather than action by lawmakers. Transfers are permitted only when revenues have decreased by more than 2％ in a fiscal year.

Other best practices include enacting rules that require budget cuts in conjunction with reserve fund withdrawals and requiring supermajority approval from the state if money is to be used for reasons other than an economic downturn, health or safety emergency, or an unexpected revenue shortfall.

After states spend money from rainy day funds, the Volcker report emphasizes it is important to require that funds be replenished and to have a plan in place to pay back the spent funds.

The report highlights Florida as one state that has established best practices on this returning the money. The state is required to pay back rainy day fund drawdowns through equal payments made over a five-year-period beginning three years after the money is spent.  

Other best practices include requiring a portion of surplus revenue to be set aside for rainy day funds and identifying specific revenue sources that will provide automatic funding for the reserve funds. Hawaii does this in part by putting 15％ of the annual proceeds it receives from the 1998 Tobacco Master Settlement Agreement in the fund.

The Volcker report’s final recommendations address questions regarding the right amount of money states should put away for the future.

Many states cap their rainy day funds at between 5 and 15 percent of their general revenues, according to the National Conference of State Legislatures.

Rather than prescribe a dollar figure or percentage states should set aside, the Volcker report recommends states factor in the volatility of their revenue sources when devising a savings plan.

“The more volatile a state’s revenue streams, the more likely it is that unexpected downturns will occur,” said the report, highlighting income taxes and capital gains as drivers of volatility. “Formally considering this volatility when calculating the ideal amount of cash in a rainy day fund may help prevent tax increases or program cuts.”

To compensate for revenue volatility, the report highlights California’s practice of depositing excess cash in its rainy day fund when revenues exceed a certain amount. The state deposits 1.5 percent of its general fund revenues and capital gains tax proceeds into its reserve fund when those proceeds exceed 8 percent of the state’s general fund revenue for the year.

Finally, the report recommends that states should examine historical revenue patterns to find the right balance for rainy day fund savings.

Seventeen states received A’s for their rainy day fund balances and policies, 23 received B’s, eight received C’s and two received D’s.