RAINY DAY FUND . A sum of money set aside by a government during normal times, to be drawn down during periods of fiscal stress.
Rainy day funds are primarily a tool of state government finance, because most states are prevented from using deficit finance. Thus, in order to deal with unanticipated downturns in state revenues, states can build up a surplus of funds during normal times that can be drawn down when revenue growth declines.
The legal prohibitions on deficit finance vary in their details from state to state, but most states can simply build up a surplus of general revenues in one year that can then be spent in later years. Alternatively, they can set up explicit rainy day funds to be used to alleviate fiscal stress caused by recessions or other problems. Surplus balances built up in general revenues, outside of explicit rainy day funds, can be used to mitigate fiscal stress, but three factors work against a state's building up general revenues. First, a legislature has many pressures to spend money, making it difficult for a state to build up revenues to begin with and making the revenues it does build vulnerable to being drawn down in later years, whether or not the state faces any fiscal problems. Second, a state's prudent accumulation of general revenues may signal its taxpayers that taxes can be cut. (One of the factors leading to the passage of California's Proposition 13 in 1978 was the large balance of general revenue funds held by the state.) Third, many states have constitutional requirements limiting the amount by which general revenues can accumulate. Thus, states have an incentive to set up explicit rainy day funds, which are built up during normal years and drawn down when states experience fiscal stress.
The establishment of explicit rainy day funds is a relatively recent development in the United States, prompted in large part by fiscal crises that the states suffered during the 1982 and 1991 recessions. In 1982 only 12 states had rainy day funds, but the number increased to 44 states by 1994.
The provisions of these funds vary significantly from state to state. Some states require that money be deposited into their funds, but others have no requirement. Certain contingencies need to occur in some states before money can be withdrawn. Other states allow withdrawal of funds at any time, subject only to majority approval of the legislature. Some states have capped the amount that can be placed in their rainy day fund, and others have not.
The evidence suggests that, on one hand, states have been relatively prudent in not withdrawing rainy day funds until fiscal problems pushed them to do so, meaning that explicit withdrawal requirements have had little effect on the performance of the funds. On the other hand, states without an explicit requirement that money be deposited into their rainy day funds have been lax about building their funds up, so they have found themselves more underfunded than have states with explicit rainy day deposit requirements.
During the 1950s and 1960s state government budgets grew much faster than in the 1970s and 1980s, partly because states expanded their tax bases and partly because they increased tax rates on the bases they already taxed. Because of more rapidly growing revenues before the 1970s, states did not suffer widespread fiscal problems until the early 1970s. State fiscal problems during the 1970s might have been viewed as being a part of recessions and slow growth at the national level, but hindsight has shown that states have had significantly more severe fiscal problems in the 1970s and after, when compared to earlier decades. By the 1970s, state taxes had already risen significantly, and taxpayer resistance to new increases was beginning to grow. During the recessions of 1982 and 1991, many states ran into significant fiscal problems because their spending commitments exceeded their revenue growth during those recessions. It was in response to these fiscal crises during recessionary periods that many states established rainy day funds.
Even though states can set aside general revenues during good years and use those surplus general revenues to augment expenditures during recessions, explicit rainy day funds offer a number of advantages. First, because the money is set aside for budget stabilization purposes, it is insulated to a degree from demands for additional expenditures. There will always be a greater demand for government expenditures than there will be revenues to fund those expenditures, and an explicit rainy day fund helps to enforce the fiscal discipline to save during good years in order to help smooth expenditures over the business cycle. Second, a surplus of general revenue funds can lead to a call for lower taxes, which would defeat the purpose of setting the money aside as general revenue surpluses. Third, some states have explicit provisions to prevent the accumulation of excess general revenues, which in some cases require at least a partial refund of tax collections that exceed expenditures.
The cyclical nature of tax revenues is not the only reason states might want to set aside rainy day funds. Revenues might also be desired in the event of a bad revenue forecast, or as a result of changes in federal tax laws