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State Rainy Day Funds and the State Budget Crisis of 2002-?

Christian Gonzalez, Arik Levinson
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Document date: August 11, 2003
Released online: August 11, 2003

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Note: This report is available in its entirety in the Portable Document Format (PDF).

1. Introduction

On paper, states entered the recession that began in March 2001 well-prepared. Forty-seven states had established budget stabilization or "rainy day" funds. The funds contained over 5 percent of annual total state expenditures, which when added to general fund balances amounted to more than 12 percent of annual expenditures. By comparison, when the recession of 1990-91 began, only 35 states had rainy day funds, their rainy day balances amounted to less than 1 percent of expenditures, and total balances amounted to less than 5 percent of expenditures. During the recessions of 1980 and 1981, fewer than half of the states had rainy day funds.

Figures 1a and 1b (next page) depict the states' preparedness for the current fiscal contraction. Figure 1a plots the growing number of states with rainy day funds, from fewer than half in 1984 to virtually all today. Figure 1b plots rainy day fund balances and total general fund balances as a percent of annual expenditures. Both figures grew sharply during the latter half of the 1990s to unprecedented levels, both in absolute terms and as a percent of state expenditures.

Despite these preparations, state budgets appear to be in serious trouble. The National Governors' Association (NGA) and the National Association of State Budget Officers (NASBO) issued a press release last November saying that "states face the most dire fiscal situation since World War II" (NGA, 2002a). The story, and that quote in particular, have been carried widely and motivate this conference on "State Fiscal Crises."

What accounts for the discrepancy between the historic levels of state fiscal preparedness and the state budget crisis we face today? We can think of several explanations:

  1. The claim that current state budget difficulties are unusual may be overstated.
  2. There may have been structural changes in state finances related to education, Medicaid, homeland security, or tax receipts.
  3. The rainy day savings may represent fungible transfers from accounts that existed before the establishment of the rainy day funds, and not "new" savings.
  4. State savings, even with the added rainy day fund balances, may simply be insufficient to cover the recent revenue decline.
  5. The crisis may merely represent the reversal of an unusual tax revenue bubble of the late 1990s.

In this report, we focus on the last three of these explanations, but let us begin by briefly discussing the first two.

First, has this crisis been exaggerated relative to previous state budget crises? States are, to varying degrees, required to balance their budgets. This means that every time there is a national recession, states are supposed to raise tax rates or decrease spending. A quick scan of headlines from 1991 or 1982 exposes the consequences of these balanced budget rules.1 In both previous national recessions, state budgets were squeezed by revenue shortfalls and increases in necessary entitlement expenditures.

The national recession of 2001 was not unusually severe. National unemployment rates have not risen above 6 percent, compared with rates over 7 percent for the early 1990s, over 8 percent for the mid-70s, and over 10 percent for 1982-83. Real gross domestic product fell in three successive quarters in 2001, by 0.15 percent, 0.4 percent, and 0.07 percent. By contrast, the early 1990s saw real GDP declines of 0.18, 0.82, and 0.49 percent, and the "double-dip" recession of the early 1980s saw quarterly declines as high as 1.18, 1.66, and 2.04 percent. State budgets reflect the relative mildness of the recession. State general fund spending was budgeted to grow by 0.4 percent in real terms during fiscal 2003. While this is a drastic slowdown, real general fund spending shrank by 6.3 percent in 1983, by 1.1 percent in 1982, and by 0.6 percent in 1980. Moreover, some states are relatively unaffected. Eighteen states projected to end fiscal 2002 with year-end balances greater than 5 percent of expenditures (NGA, 2002b). Some states have continued to add to their rainy day funds or have refrained from drawing them down—Texas's fund contained nearly $1 billion in 2002, 3 percent of annual expenditures.

Nevertheless, many states are slashing discretionary spending and enacting tax rate increases. Even if the current state budget crisis is not worse than during previous recessions, it remains an open question whether the states' unprecedented rainy day fund and general fund surpluses have ameliorated those states' problems, and if not why not.

What about the structural changes? The NGA report cites the costs of Medicaid, homeland security, the unfunded mandates regarding education ("No Child Left Behind"), and the changing tax base of states from easily administered sales tax receipts to elusive Internet and service-sector activities. While Medicaid expenses do increase during a recession, and they did increase 13.2 percent during 2002, that is a slower rate of growth than during 1992. In 1991, states faced increased costs of new prison construction and growing welfare rolls, neither of which seem severe this time around. During the recessions of the early 1980s, states confronted the "new federalism" policies of the Reagan administration, which shifted responsibility for funding many programs from Washington to the states. The new issues facing states—homeland security, education mandates, and changing tax structures—may not be so unusual from this historical perspective.

That leaves the last three explanations for why the states' balances as of 2001 may have been insufficient preparation for the current downturn: that they are merely relabeled funds that were typically saved in other accounts, that even the new savings are small relative to state budget cycles, and that the crisis is a return to normalcy after a revenue bubble.

Notes from This Section

1. See, for example, "Bad Year for States' Budgets Expected to Lead to Worse One: Mandated Medicaid, Prison Construction Costs Cited," Washington Post, Oct. 30, 1991, and "Recession Giving States Nightmares: Taxes Are Raised, Payrolls Slashed," Washington Post, May 13, 1982.

Note: This report is available in its entirety in the Portable Document Format (PDF).


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