The States Struggle to Save for Rainy Days. p e w t r u s t s. o r g / f i s c a l - h e a l t h

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1 The States Struggle to Save for Rainy Days FEBRUARY 19, 2016

2 Session Experts Bo Zhao, Ph.D. Senior Economist in the New England Public Policy Center (NEPPC) at the Federal Reserve Bank of Boston Barry Bluestone, Ph.D. Northeastern University: Senior Research Associate, Kitty and Michael Dukakis Center for Urban and Regional Policy; Professor of Public Policy and Urban Affairs; Russell B. and Andree B. Stearns Trustee Professor of Political Economy

3 Days Atlantic States Could Run on Reserves Alone FY 2015 (Estimated) Days state median Atlantic state median FY2007: 35.1 days FY2015: 21.7 days R E C E S S I O N R E C E S S I O N FY 2001 FY 2003 FY 2005 FY 2007 FY 2009 FY 2011 FY 2013 FY 2015 (estimate)

4 State tax collections are becoming more volatile Atlantic State Total Tax Revenue Changes 7% FY2011: 6.4 Volatility Score 6% 5% 4% 3% 2% 1% 0% FY1999: 1.4 Volatility Score

5 Best Practice: Saving During Periods of Revenue Growth Virginia's Tax Collections, , Year-Over -Year Growth 15% 10% 5% 0% -5% -10% -15%

6 Most Atlantic states don t link deposits to volatility Tied to Volatility

7 Most Atlantic states don t link deposits to volatility Tied to Volatility Tied to Budget Surplus

8 Most Atlantic states don t link deposits to volatility Tied to Volatility Tied to Budget Surplus Tied to Forecast Error

9 Most Atlantic states don t link deposits to volatility Tied to Volatility Tied to Budget Surplus Tied to Forecast Error Static or Required

10 Atlantic States with Savings Deposits Linked to Volatility MA CT Effective 2010 Deposit annual capital gains revenue above one billion dollars Effective 2019 Will deposit capital gains and corporate income above a 10- year average threshold

11 Rainy Day Fund Caps 43 States Have a Maximum Balance or Savings Target for their Rainy Day Fund

12 Rainy Day Fund Caps Are Often Set Too Low 21 States with Maximum Balances Hit Their Caps in the Years Before the Last Recession

13 Pew s Questions to Ask to Determine Savings Size Why are we saving? What is our desired level of coverage? How many years do we want to be covered for?

14 Minnesota decided to evaluate why it saves and began to assess coverage goals Minnesota s Savings Target Purpose: Cover entire revenue shortfall during a recession Length: Two years Risk: Want coverage for 9 out of 10 possible recessions

15 In Summary Steps for Improving Savings in the Atlantic Region Identify your most volatile revenues Explore options for saving above-trend revenue growth Determine the purpose of your fund Calculate how much it would take to cover that purpose

16 Stephen Bailey pewstates.org/fiscal-health

17 How Large Should State Rainy Day Funds Be? The Case of Atlantic States Presented at the Fiscal Leaders Meeting February 19, 2016 Bo Zhao New England Public Policy Center Federal Reserve Bank of Boston Disclaimer: The views expressed here are those of the author and do not necessarily represent the views of the Federal Reserve Bank of Boston or the Federal Reserve System.

18 Why do states need rainy day funds? State revenue is cyclical. Purposes of rainy day funds: Address revenue shortfalls associated with economic downturns Smooth state budgets over the business cycle States face tradeoffs in setting the size of their rainy day funds. Question: How large should state rainy day funds be?

19 Rules of thumb Rules of thumb: relative to annual general fund 5% (National Conference of State Legislatures 1983) 15% (Center on Budget and Policy Priorities 2011) 17% (Government Finance Officers Association 2009) Criticisms: Arbitrary One-size-fits-all Ignore states having different degrees of revenue cyclicality and different desires for tax rate and spending stability

20 Preview of main findings There is no one-size-fits-all optimal rainy day fund size. We develop each state s target rainy day fund level based on: magnitude of its revenue dips below trend its preference for having stable tax rate and spending. Except for Massachusetts, Atlantic states rainy day fund caps are low relative to the needed rainy day funds. Atlantic states frequently lacked sufficient rainy day funds over the past 25 years.

21 Data and methodology Data for FY 1988-FY 2012: Census Bureau National Association of State Budget Officers Methodology: Divide each state s revenue figures into two parts Long-term revenue trend Deviation from trend induced by business cycles

22 Estimated deviation from the revenue trend (as a % of state average general expenditure from 1988 to 2012) Note: The shaded areas indicate national recession periods.

23 Estimated deviation from the revenue trend (as a % of state average general expenditure from 1988 to 2012) Note: The shaded areas indicate national recession periods.

24 Estimated deviation from the revenue trend (as a % of state average general expenditure from 1988 to 2012) Note: The shaded areas indicate national recession periods.

25 Potential target rainy day fund levels (as a % of the Census Bureau-defined state general expenditure) State Needed rainy day fund for the worst-case scenario Needed rainy day fund for the middle-case scenario Connecticut Massachusetts Delaware Maryland Rhode Island Maine New Hampshire Vermont U.S. as a whole

26 Are state rainy day fund caps high enough? (as a % of state-reported general fund revenue or expenditure) State Rainy day fund cap Needed rainy day fund for the worst-case scenario Needed rainy day fund for the middle-case scenario Massachusetts Maine New Hampshire Connecticut 10.0 (15.0) Maryland Rhode Island Vermont Delaware

27 How often have states lacked sufficient rainy day funds for ? State # of periods with below-trend revenue (1) # of periods with below-trend revenue in which state rainy day funds were insufficient (2) % of periods with below-trend revenue in which state rainy day funds were insufficient (3)=100 (2) (1) Connecticut Massachusetts New Hampshire Maine Rhode Island Vermont Delaware Maryland U.S. as a whole

28 Conclusion and policy recommendations Atlantic states experienced some periods with below-trend revenue in the last 25 years, especially during the two recent recessions. Needed rainy day funds differ across states. States might consider a target level closer to the needed rainy day fund for the worst-case scenario. Many states have a low cap relative to the needed rainy day fund for the worst-case scenario and may consider raising the cap. Many states often did not save enough in the last 25 years. They should consider saving more moving forward.

29 The States Struggle to Save for Rainy Days Barry Bluestone, Ph.D.