Top 10 State Tax Trends #8: Insufficient Rainy Day Funds

June 6, 2012

We’ve identified the top ten key tax trends among the states in recent years. We’re sharing them with a short report each weekday with data and analysis on each trend. We hope this information will help you learn how states responded to the recession, how they’re faring now, and how prepared they are for the future. The series kicked off last week with an overview of state budgets and state tax changes during 2011.

Our #8 trend, released in today’s report (PDF), is that state rainy day funds fell far short of the 13 to 18 percent of general fund appropriations level suggested by the economic literature. Some highlights from the report:

  • Most states have created budget stabilization, or “rainy day,” funds to draw upon when economic conditions create a sudden drop in tax revenues. Generally, U.S. states are required by their constitutions or by statute to contribute to their rainy day funds according to a formula and up to a preset limit.
  • Having a well-funded rainy day fund may not eliminate the need to make difficult cuts during an economic downturn, but it can cushion the fiscal system in the short-term. These cash reserves, however, were for the most part inadequate in coping with the recent economic downturn.
  • Research has found that states on average suffer a 13 to 18 percent revenue decline during a normal downturn, meaning that states would need to save between 2.4 percent and 2.8 percent of each year’s revenues during good economic times.
  • 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 taxes, which tend to be more stable, need not have as much in reserves to smooth over revenue declines.
  • 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. 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. (View all states in Table 1 here.)
  • 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 sufficient transparency to ensure that citizens are informed about how the fund is used.

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