How Minnesota Rebuilt Its Rainy Day Fund and Created Its Largest Budget Reserve in History

The figure marked a sharp contrast to where it once stood. Last week, Minnesota released a budget forecast showing that the state had nearly $1.6 billion in a reserve account—or “rainy day” fund.

About seven years ago, at the height of the Great Recession, that reserve fund balance had hit zero after state lawmakers drained the last $155 million from the account in order to fill a budget deficit.

“Minnesota now has its largest budget reserve in state history,” Lt. Governor Tina Smith said in a statement on Tuesday. This helps, Smith added, with it comes to protecting “priorities like schools and health care during periods of economic downturn.”

Matthew Schoeppner, an economist with the Minnesota Management and Budget Office, noted during a phone interview on Tuesday that another recession would eventually arrive.

“Unfortunately, for economists, we have a difficult time forecasting when those turning points happen,” he said. “That’s the point of these savings.”

‘What Exactly Constitutes Rain’

On Tuesday, The Pew Charitable Trusts released a report that pointed to Minnesota as the state that follows the most rigorous process for determining the ideal level of reserve fund savings. In that report, the Pew researchers were looking to provide some guidance on a tricky question: How much money should states save?

Entering into a recession with a pithy rainy day fund is undesirable. But Brenna Erford, Pew’s manager of state fiscal health and economic growth, notes that there are also downsides to stashing too much money away. This is because cash set aside in reserve accounts might otherwise be used for paying important expenses like education costs, infrastructure maintenance, or outstanding debt.

From the perspective of the Pew researchers, there was another question that needed to be posed before considering how much money states should keep in reserve.

“We asked: why do states save?” Erford said during a conference call with reporters on Monday. “In order to create an outstanding rainy day fund policy,” she added, “lawmakers need to determine what exactly constitutes rain.”

While that determination may sound straightforward, the Pew researchers found that out of 46 states with rainy day funds, 27 do not clearly explain in state law the goal of the reserve accounts.

There were two other key findings as well.

One was that during the mid-2000s, when the U.S. economy was thriving, and tax revenue was flowing strong, 21 states had policies in place that prevented their rainy day funds from growing any larger than they did. For many of these places, this meant relying more heavily on tax hikes and spending cuts during and after the recession.

The other finding was that only five states currently have laws that require regular evaluations of revenue volatility patterns in order to set maximum, or targeted, levels for their reserve accounts.

Volatility in this context refers to economic ups and downs that can cause tax collections to surge or fall flat.

Based on the report’s findings, Pew makes three recommendations for policymakers to take into account when trying to decide on a rainy day fund savings target.

The first is to identify the state’s reason for saving. This means clearly defining what reserve funds are meant to accomplish, as well as how and when they can be tapped. The second recommendation is to study volatility, specifically by looking at historical data, when setting savings goals. And the third is to decide on the degree of risk the state wants to offset. For instance: do policymakers want to stave off some cuts during a recession? Or all of them?

Setting and Meeting a Target

Minnesota’s reserves are intended to provide a cushion against unexpected fiscal stress caused by sudden changes in the economy, according to the state’s Management and Budget Office. The state’s reserve target is a percentage of forecast tax revenues and is based on an annual analysis of volatility in the general fund tax system.

The Pew report points out that Minnesota also sets a hard standard in terms of how much risk it is trying to offset, aiming to have enough rainy day money on hand to totally cover 90 percent of expected shortfalls over a two-year budget cycle.

Minnesota lawmakers enacted two significant policy changes in 2014 that affected the state’s savings regimen.

One change had to do with setting the target level for the amount of money that gets salted away in the budget reserve fund.

That level used to have a dollar-amount cap: $653 million. This standard was abandoned in favor of the new system that takes into account revenue and volatility. By basing the reserve's target balance on a percentage, rather than a dollar amount, Schoeppner pointed out that: “as government changes, grows, or shrinks over time, this target value will grow or shrink.”

In fiscal year 2016-2017, the recommended level for the reserve is 4.8 percent of the budget cycle's "non-dedicated" general fund revenues. This works out to just over $2 billion. Non-dedicated revenues include the state's major tax sources, like those levied on income and sales. 

The other policy change in 2014 involved the creation of an automatic mechanism to set aside rainy day funds. It works like this: The state issues a budget forecast in November, which provides an update on the difference between revenues and expenditures. If forecasted revenues exceed expenditures, 33 percent of the surplus amount is funneled into the reserve, until the account hits its target.

The latest allocation under this guideline, announced last week, totaled $594 million.

It was back around 2009, when Schoeppner, working with long-time state economist Tom Stinson, began to look at different statistical techniques that could be used to capture and show increased volatility they’d noticed in Minnesota’s tax base since the mid-to-late 1990s.

Their work yielded the statistical method that is now used to guide the reserve fund targets, by estimating volatility in both components of the state’s tax base, and in the state as a whole.

“We’re looking at volatility over time,” Schoeppner said. “And taking what we believe to be the last, or most recent period of volatility and putting risk parameters around that, and converting that into a target for our state budget reserve.”

‘No One Way of Doing This’

Earlier this year, Wyoming turned to Minnesota’s statistical method to help inform its savings policies.

But Schoeppner cautions: “No state is the same.”

“There really is no one way of doing this, I would argue,” he said, as he discussed the method. Policymakers outside of Minnesota looking to implement something similar, he added, should “gather the ideas of what other states have done and tailor it to their own tax base.”

Pew’s Erford took a similar view when discussing the target amount that state’s should be looking to squirrel away in their reserve accounts. Echoing the findings of the report, she explained that this sum would vary depending on the state’s preferences, the characteristics of its economy and the volatility of its revenues.

“What we have really found," Erford said, "is that there is no right amount for a rainy day fund.”