Saving for a rainy day: Estimating the needed size of U.S. state budget stabilization funds

Abstract

Rainy day funds (RDFs) are potentially an important countercyclical tool for states to stabilize their budgets and the overall economy during economic downturns. However, how much each state needs to save in its RDF has become an increasingly important yet unresolved policy question. To address this issue, this paper develops some potential target RDF levels for each U.S. state, based on both the estimated short-term revenue component associated with business cycles and the extent of states’ preferences for stable tax rates and expenditure. The analysis shows that, in the last 25 years, at least 21 states never saved enough in their RDFs to offset revenue shortfalls from trend for each downturn period. The paper also provides policy recommendations on reforming the RDF caps.