How Budget Rules Shape State Rainy Day Funds
When downturns hit, lawmakers face a painful choice: raise taxes, issue debt, or cut public services. Budget stabilization funds, often called rainy day funds, are designed to cushion that blow.
Researchers Eunjoo Choi and Yonghong Wu examined why some states enter recessions with healthy reserves while others arrive nearly empty-handed. Their study, Impact of Stringent Budget Stabilization Fund Rules on US State Savings: Generalized Synthetic Control Method and Panel Data Analysis, finds that states tend to build stronger reserves when they adopt well-designed, more stringent deposit rules.
Wyoming and Alaska could manage well over six months using only rainy day funds, according to Pew. Indiana, by contrast, could cover barely a month. New Jersey is in even worse shape; its budget stabilization fund is empty.
However, Choi says the findings do not support a simple “stricter is always better” story.
“What surprised us most is that rules don’t work in isolation,” Choi says. “Their effects depend on how they’re combined, and on economic conditions.”
What Makes a Rainy Day Fund Rule Stringent?
Choi and Wu asked a deceptively simple question: Do stricter rules lead to higher savings? To answer it, they first had to define what “strict” means.
The study defines stringency around two ideas: precision and obligation. Do the rules actually require officials to do something? And are they written clearly enough to limit discretion?
For example:
A rule saying lawmakers may deposit money when they choose is not very stringent.
A rule requiring that a share of surplus revenue be saved is more stringent.
A rule that uses an economic volatility formula is more stringent still, because it reduces discretion by tying deposits to objective conditions.
From there, the researchers examined how 14 budget stabilization fund features interacted with saving levels, including deposit requirements, withdrawal rules, repayment provisions, caps, limits, and discretionary authority.
What Matters Most?
If the goal is to build reserves before a downturn, automatic deposit rules may be the most important place to start.
Choi and Wu report several statistically significant findings. Interpreted simply, a 1% increase in each rule feature is associated with the following change in budget stabilization fund levels as a share of general fund expenditures:
“Automatic deposit rules can reduce political discretion and improve consistency,” Choi says. “In particular, governments should ensure mandatory saving mechanisms are paired with sufficiently high caps, so funds can grow over time.”
When states rely on legislative or executive discretion, saving can compete with other priorities. Mandatory rules change the default. Deposits tied to economic conditions also help move money into reserves before it can be used elsewhere.
The Problem With Rules That Are Too Strict
Choi cautions against reading the results as a blanket argument for tightening every rule. Budget stabilization funds are meant to be used during downturns, and some withdrawal or repayment rules can get in the way of that purpose.
“We find the relationship between repayment provisions and BSF levels varies with economic conditions. At low unemployment (around 2%), the relationship is negative, but as unemployment rises (up to about 13%), it becomes positive, meaning that states with more stringent repayment provisions tend to have higher BSF levels during downturns.”
That does not necessarily make stringent repayment provisions desirable. They may keep fund balances high, but if states are not willing or able to use those funds in a crisis, the policy design may be working against the fund’s purpose.
Takeaways for Policymakers
Choi highlights four broad lessons for policymakers.
First, implement automatic deposit mechanisms to minimize legislative discretion.
“Varying results depend on the formula used, legislative adherence, and political interference, underscoring the need for a well-designed formula and the consistent application of systematic rules.”
Second, pair mandatory surplus deposit rules with adequate budget stabilization fund caps.
“If caps are low, the effect of surplus deposits is limited; as caps increase, their positive impact becomes substantially stronger.”
Third, strengthen withdrawal rules while preserving budget flexibility.
“While stringent withdrawal conditions help preserve BSF reserves for genuine emergencies, overly rigid rules can create unintended consequences. It’s not just about having a rainy-day fund, but about designing a set of rules that encourages saving in good times, and allows effective use in bad times.”
Finally, maintain transparency and public oversight.
“Some states may resort to budgetary maneuvers rather than adhering to BSF policies. Transparent reporting and withdrawal calculations, and the intended purposes of each fund, can foster public trust and prevent misuse.”
The research appeared in issue 45(3) of Public Budgeting & Finance.
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