Tax Reform

Rainy Day Funds for the COVID-19 Era

A budget stabilization fund, commonly known as a rainy day fund, is a state-managed savings account designed to offset budget gaps during crises such as economic recessions or natural disasters. During the current COVID-19 economic crisis, states with well-structured rainy day funds have been better prepared to stabilize their budget. For example, North Carolina’s $1.2 billion Savings Reserve has played a major role in stabilizing the budget without tax increases or a federal bailout.

There are two leading factors in building a strong rainy day fund: limiting withdrawals to times of true crisis and depositing funds regularly. Several states have implemented effective methods of withdrawing and depositing, and these implementations can be used as a guide to strengthen any rainy day fund.

Starting with withdrawal practices, many states leave withdrawing funds to the discretion of a simple legislative majority, which can lead to the unnecessary depletion of a rainy day fund. Responsible withdrawals should happen only during a true rainy day. Indiana’s Counter Cyclical Revenue Fund allows fund withdrawals only when the growth rate of adjusted personal income in Indiana is less than -2%. The fund is then used to stabilize budget gaps or finance disaster recovery. North Carolina’s Savings Reserve requires a supermajority vote in the General Assembly for fund withdrawals. This ensures legislators have access to funds only when a true crisis surfaces.

Depositing practices for rainy day funds are equally as important as restrictions on withdrawals. A state savings account is not effective if it is not large enough to offset serious emergencies. A common way to measure the health of a rainy day fund is to compare it to the state’s general fund. If a rainy day fund can cover a higher percentage of a state’s general fund, then the state has a wider safety net for when budget gaps occur. Research by Bo Zhao, a senior economist for the Federal Reserve Bank of Boston, shows the average rainy day fund should be between 6.9-21.4% of the general fund. This range is based on the income and spending balance of each state and varies due to factors unique to each state, such as reliance on volatile revenue sources or economic reliance on a certain industry. Other research by Erick Elder of the Mercatus Center recommends that funds should reach the expected revenue loss of an average recession. Note that these recommendations are targets, not minimums, so funds are not excessively withholding money from the economy.

To reach recommended funding levels, several states automatically deposit portions of their yearly surpluses into their rainy day fund. For instance, Georgia requires a portion of its yearly surplus to go into their Revenue Shortfall Reserve. According to data from 2019, Georgia’s rainy day fund has reached 11% of the general fund balance, which is in the healthy range. This preparedness has enabled Georgia to use $100 million in funds from this reserve to aid in COVID relief.

Pro-active replenishing ensures a rainy day fund is not left empty or too small after it is used.  South Carolina’s General Reserve Fund requires the state to replenish the fund after it is used within three fiscal years by replenishing at a rate of no less than 1% of general fund revenue of latest completed fiscal year. This policy ensures the fund does not run out after helping abate a fiscal crisis. Because of this, SC has kept its fund over 6% of its general fund balance for a decade and has used $200 million for COVID relief to date.

Similarly, Indiana’s Counter Cyclical Revenue Fund has seen automatic deposits via a multi-step evaluation of economic growth. This has enabled Indiana’s rainy day fund to cover 8.6% of its General Fund with over $2 billion in reserve before the economic shutdown.

States without sufficient funds in reserve will have more difficulties filling budget gaps. For example,  Illinois is unprepared to deal with the COVID-19 fiscal crisis. With only $4.9 Million in reserve, and a refusal to cut spending in a meaningful way, Illinois policymakers requested a federal bailout to close its budget gap, and the state budget now relies on $5 billion borrowed from the Federal Reserve’s Municipal Liquidity Facility (MLF).

Budget stabilization funds can greatly reduce the negative impact of a downturn or disaster. They are a vital policy in a state’s toolkit to combat the negative effects of any disaster, even a pandemic and economic shutdown.It is important for states to save for the rainy day that no one wants, and, most of the time, no one expects.

In Depth: Tax Reform

Mainstream economists, small business owners and taxpayers across the country understand that growth-oriented reforms mean increased opportunity for all. As demonstrated by the annual Rich States, Poor States: ALEC-Laffer State Economic Competitiveness Index, sound tax and fiscal policies are critical to economic health, allowing businesses and households to flourish. A…

+ Tax Reform In Depth