By Erica MacKellar
After the Great Recession, states took measures to ensure they were better positioned for the next economic downturn by rebuilding their budget stabilization funds, or rainy day funds as they are often called.
The concept of a rainy day fund is straightforward: Save money when times are good to use when the economy takes a downturn.
Rainy day funds are viewed as an important component of state fiscal health. However, many states also carry forward excess general funds and other funds from year to year that can help address budget shortfalls. These funds combined with rainy day fund accounts make-up a state’s year-end balance, which is a better indicator of overall state fiscal health.
Lessons of the Great Recession
During the Great Recession, states used a combination of budget cuts, revenue enhancements and budget reserve funds to close significant budget gaps. As the effects of the recession continued, year-end balances dropped to a low of about 4.8% in state general fund spending in fiscal year 2009.
While the economic expansion that occurred after the Great Recession was characterized by slow, but steady growth, states recognized the importance of their rainy day fund safety nets and took steps to replenish those funds. Since FY 2013, year-end balances have on average hovered between 10% and 12% of general fund spending. This will provide states some flexibility as they grapple with the catastrophic revenue fallout of the COVID-19 pandemic.
However, rainy day funds and year-end balance amounts vary greatly by state, and no state likely has enough to cover the cost of the COVID-19 pandemic and resulting economic decline.
States with the largest year-end balances as a percentage of their general fund spending tend to be heavily reliant on volatile severance tax revenues. Alaska had a year-end balance of about 40% of general fund spending in FY 2019, North Dakota’s was 22% and New Mexico’s was nearly 20%. Wyoming has the largest year-end balances a percentage of its general fund spending at 109%. These states, however, are also dealing with low demand for oil in addition to revenue losses related to COVID-19. In some cases, oil prices per barrel are half of what states budgeted, so even states with the most robust rainy day funds may find them falling short.
While many severance-tax-reliant states tend to have the largest balances relative to their general funds, we’ve seen a number of other states build up above-average year-end balances. These balances will help many states cover short term costs as most state economies are shutdown, but they may not be nearly enough to address the longer-term effects of the expected economic decline.
Will Rainy Day Funds Be Enough to Weather the Storm?
There is a lot of uncertainty around the magnitude of revenue losses states will see for the remainder of FY 2020 and into FY 2021. Revenue estimators do not know when retail and restaurant businesses will reopen, or when states will welcome tourists back for conventions, sporting events and other large gatherings that generate significant revenue. But early estimates show states could face revenue losses of 15-20% between the beginning of March and the end of December, nearly double the average state year-end balance.
Those revenue losses are only part of the equation. As we saw during the Great Recession, the demand for health and social service programs increases during a recession, squeezing state budgets. States have already been working to expand access to unemployment benefits, food assistance programs and health care. They have also been providing grants to small businesses and other assistance to companies affected by the shutdown. These are important steps to protect citizens and businesses during an unprecedented time, but these actions also increase state budget shortfalls.
States also face challenges relating to the use of their rainy day fund reserves. Many states cannot access their reserve funds without an act of the legislature. That may not be a challenge during normal years, but these are extraordinary times.
Several legislatures have adjourned or suspended operations due to the COVID-19 pandemic. Other states have a cap on the amount that can be withdrawn in a fiscal year, or requirements that amounts withdrawn be replaced within the current or subsequent fiscal year, which could prove difficult if state revenues continue to decline. NCSL has more information on state rainy-day fund deposit and withdrawal requirements in our Rainy Day Fund Structures report.
State lawmakers wisely heeded the call to prepare themselves for another economic downturn after the last recession, but none could have predicted a decline with such immediate and drastic effects on state finances. Rainy day funds and other state reserves may help states soften the blow, but states will still face difficult budget choices in the coming months, and perhaps years.
Erica MacKellar is a program principal in NCSL’s Fiscal Affairs Program.