Statement of Principles on Sound Rainy Day Fund Practices

Summary

During the first twenty years of this century, there have been three devastating economic recessions occurring in 2001, 2008, and 2020. There are clear differences in how states withstood these recessions. One important difference is states with prudent spending practices that include appropriately designed and utilized stabilization funds, more commonly known as Rainy Day funds, weather the storms of recessions much better than those that do not. More importantly, states that have prudent spending practices better cope with economic downturns than high spending states. The following tenets should be considered as states seek to establish an ideal Rainy Day fund or take the necessary steps of reforming existing funds and spending practices into an ideal Rainy Day fund to be prepared for the next downturn.

Statement of Principles on Sound Rainy Day Fund Practices

Guiding Principles of State Rainy Day Funds

The American Legislative Exchange Council (ALEC) is committed to developing state budgetary policies that foster an economy that works for all, empowering people to earn success and realize their potential. One way that a legislature can ensure this goal is by preparing for economic downturns. During good economic times lawmakers should not spend all of the state’s revenues and place some portion into a well-structured stabilization fund. When revenues decrease because of an economic downturn, lawmakers can use stabilization funds to help continue essential services and those that tend to be more utilized during times of high unemployment.

 

Implement Non-Partisan Stress Testing

States that do not have an adequate picture of the volatility of revenues could be at risk of reserving too little money. Likewise, states could also have too much in reserve, therefore taking more from taxpayers than necessary to run government. It is important for states to perform a non-partisan stress test, including a volatility analysis, to determine the adequate level for the Rainy Day fund.

Additional factors that should go into the target size of the fund should be the length of time a state should plan to operate with reserves, the severity of the downturn and an honest, unbiased assessment of which programs are essential for the state to fund during the downturn.

 

Require Specific Deposit Rules

Ideal Rainy Day funds should be enshrined in the state constitution. A constitutional amendment is the best way to keep it from being altered to allow for the funds to be used for nonessential politically popular or special interest expenditures. This includes rules for deposits into the fund.

Once states have identified the percentage of expenditures needed to withstand economic downturns, they should establish specific, regular revenue contribution requirements into the stabilization fund. When the Rainy Day fund is sufficiently filled, all excess funds should automatically be returned to taxpayers and used to pay down debt as appropriate for the individual state. The mechanism would vary by state, but any excess revenues should be returned directly to taxpayers during the next fiscal year or used to reduce unfunded government pensions and state bonded debt.

Any interest should accrue to the fund and should not be used for any purposes outside of the fund.

 

Require Specific Withdrawal Rules

During good economic times, all tax revenue that is collected tends to be spent thus ignoring the reality that an economic downturn is somewhere in the future. This unsound fiscal behavior has left many states completely unprepared for economic downturns, even when three major recessions have hit in the past 20 years. Rainy Day funds allow for essential services to be provided for in true emergencies when tax revenue is decreased. Specific macroeconomic indicators, such as a defined increase in the unemployment rate, should be used to determine whether stabilization funds may be used.

The impacts from economic downturns are not always confined to one fiscal year, therefore stabilization funds should not be drained completely in one fiscal year. States could benefit from specific withdrawal percentages that provide a phased withdrawal over one to three fiscal years allocating more funding when the downturn is at its worst and less funding as the revenues begin to recover. This should be considered in the stress and volatility test and should not create artificial barriers to using these funds when they are needed. As with deposits, all rules or indicators should be explained in the Constitutional amendment so that Rainy Day funds aren’t used or restricted inappropriately in the future.

 

Require a Super Majority to Withdraw Funds

Some states have accessed stabilization funds during good economic years in order to increase politically popular line items. This is a perverse use of a Rainy Day fund and would be less likely to occur if a supermajority, either two-thirds or three-fourths of the state legislature, were required to access the fund. However, this high bar would not be difficult to meet when needed. Even the most prudent fiscal hawks in the legislature would recognize the need to use stabilization funds when truly necessary.

 

Rainy Day Funds Should not be used for Unnecessary or Wasteful Spending

Stabilization funds should only be used for essential spending not covered by recurring tax revenue. Economic downturns present an opportunity for governors and legislators to work together to ensure unnecessary spending is eliminated before Rainy Day funding is used. Stabilization funds should not be used for corporate welfare line items, tourism, arts councils, or other quasi-government boards, agencies, or similar unnecessary spending.

It should be clear that an emergency is not simply defined as a budget shortfall or the desire for increased spending. There should be no other circumstances that the funds should be used other than what is contained in the constitutional amendment.