Recent scholarly research has studied past recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. s to develop rainy day fund rules of thumb based on the average revenue shortfalls during an economic downturn. Wagner & Elder, for example, found that “the typical state can expect a revenue shortfall equal to 13 to 18 percent of revenue during a normal downturn." To achieve this during a typical period of economic expansion, states would need to save between 2.4 percent and 2.8 percent of each year’s revenues during good economic times.
In 2006, the peak year for state rainy day funds between 2001 and 2012, only Alaska and Wyoming had accumulated at least 13 percent of their annual general fund spending level in reserve funds (see Table 2). Aside from those two states, North Dakota, and Oklahoma, all states had accumulated less than 10 percent of their annual general fund spending amount in a reserve fund.
Admittedly, developing a rule of thumb is difficult, as state revenue systems vary in reliance on different types of taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. es. States with highly progressive income-based tax systems tend to experience more volatility and should therefore have larger reserves to weather economic downturns. States that rely more on consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. es, which tend to be more stable, need not have as much in reserves to smooth over revenue declines.
Having a well-funded rainy day fund may not obviate the need for making difficult programmatic cuts during an economic downturn but it can cushion the fiscal system in the short-term. Well-designed rainy day funds should have set rules for filling and withdrawing the funds, a targeted amount to save that takes into account the state’s historical revenue volatility, and good transparency to ensure that citizens are informed about how the fund operates and is used.
- Having a rainy day fund is critical.
- States should loosen caps on the size of rainy day funds so they can build them up to adequate levels. Rainy day funds would have been even more effective in the most recent downturn if they had been larger; part of the reason they weren’t larger is that thirty-three states and the District of Columbia cap them at inadequate levels. If rainy day funds are capped at an inadequate level, such as 10 percent of the budget or less, states will have difficulty accumulating sufficient reserves. States with overly restrictive caps could either remove the cap or increase it to a more adequate level, such as 15 percent of the budget.
- States should ease rainy day fund rules that make it difficult to make deposits in good times.