Thomas A. Garrett

English

Research Papers in Economics

April 2004
NationalEconomicTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
S
tates are facing the most severe budget crises in the
post-World War II era. Recent data suggest, however,
that the budget crises may be abating, despite some
dire predictions last year. Back in April 2003, the National
Conference of State Legislatures (NCSL) reported that
aggregate state budget deficits would be in the range of
$20 to $30 billion for fiscal year (FY) 2003, and possibly
as large as $78 billion in FY 2004. More than half of the
states were projecting a budget deficit in excess of 5 percent
of general fund revenue for FY 2004, and one in four states
was forecasting a deficit greater than 10 percent.
Reports seven months later, in November 2003, con-
trasted with the April 2003 figures: The NCSL reported
that state budget deficits totaled $17.5 billion for FY 2003,
and ten states projected an aggregate deficit of $2.8 billion
for FY 2004. This improvement was due in part to stronger
than expected growth of gross domestic product in the
second half of 2003.
In an effort to be less reliant on expenditure reductions
and/or tax increases to mitigate periods of fiscal stress,
states typically save surplus revenue during good years
for use during lean years when revenue growth is below
average. While such surplus funds have historically been
maintained as a general fund surplus, nearly all states have
supplemented this practice with the use of a rainy day
fund. This fund is nothing more than a separate account
in state budgets where surplus monies are retained. 
Of the 46 states that currently have a rainy day fund,
only eight were in place before 1980. States with rainy
day funds generally deposit some fraction of a general
fund surplus into the rainy day fund (short-term savings)
and retain the remainder in the general fund (long-term
savings). Both general fund and rainy day fund balances
typically earn interest according to a state’s investment
policies regarding surplus funds. The total funds available
to correct unexpected shortfalls at any given time equal
the sum of the state’s general fund and rainy day fund
balance. 
According to the NCSL, states’rainy day fund balances
have dropped significantly in the past two years as states
attempted to mitigate their budget crises. In January 2002,
total rainy day fund balances topped $17 billion. Aggregate
balances dropped to $11.4 billion at the end of FY 2002
and fell further to $8.5 billion at the end of FY 2003. In
FY 2004, 13 states are expected to tap their rainy day funds
to minimize budget shortfalls. However, many states are
reluctant to reduce rainy day fund balances further, and
many states (Arizona, Idaho, and Oklahoma, for example)
have depleted their balances altogether.
Of course, rainy day funds can assist states in easing
recessionary pressures only to the extent that these funds
supplement the general fund. If monies saved in rainy day
funds are simply replacing monies saved in the general
fund, then there is little benefit. Since rainy day funds are
nothing more than separate accounts in state budgets,
policymakers may decide simply to reduce the size of
the general fund surplus by $1 for every $1 deposited in
the rainy day fund. In fact, for every dollar that a state
does deposit into its rainy day fund, total savings (the sum
of the state’s rainy day fund plus general fund balance)
increases by only $0.44 to $0.49.1 This suggests that the
average state’s use of rainy day funds has not significantly
improved its fiscal health.
Apart from the issue of substitutability with the general
fund, the most important point regarding rainy day funds
and savings is not how the funds are saved, but whether
sufficient funds are saved. Research finds that states having
strict rules that force policymakers to save and limit how
rainy day funds may be spent will improve a state’s ability
to weather downturns.2 The same research reveals, how-
ever, that the typical state’s rainy day fund is grossly insuf-
ficient to mitigate a severe fiscal crisis and substantially
lessen the need for expenditure reductions and/or tax
increases. This is evident from the massive budget short-
falls faced by most states in the past three years.
—Thomas A. Garrett
1 Wagner, Gary A. “Are State Budget Stabilization Funds Only the Illusion of
Savings? Evidence from Stationary Panel Data.” Quarterly Review of Economics
and Finance, Summer 2003, 43(2), pp. 213-38.
2 Holcombe, Randall G. and Sobel, Russell S. Growth and Variability in State
Tax Revenue: An Anatomy of State Fiscal Crises. Westport, CT: Greenwood
Press, 1997.
Available on the web at research.stlouisfed.org
Saving for a Rainy Day?

Saving for a rainy day?

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Saving for a rainy day?

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