Rainy day funds (a.k.a. budget stabilization funds) offset state revenue volatility and shield BBR breaches

Literature suggests that, while it may be easier to evaluate budget practices one at a time, from budget cycle to budget cycle, institutions interact with one another over the long term. States should consider their institutions as tools that work together to promote long-term sustainability, not as singular institutions that function in isolation. Looking at fiscal institutions as toolkits, rather than as stand-alone practices, will help states understand where trade-offs occur over the long term. While some institutions may successfully change one fiscal metric, this may cause challenges elsewhere. Budget institutions that promote discipline in the short term may contribute to volatility and undermine long-term fiscal sustainability. Strict BBRs, for example, can rein in spending and reduce borrowing costs, but may force damaging program cuts or tax increases during economic recessions. The state may also trade away its long-term stability for a current balanced budget by closing gaps through either explicit or implicit borrowing. Tax limits may reduce growth in taxation and limit the size of government but restrict states’ ability to raise revenues to pay off debts or cover unexpected shortfalls. State TELs may also push responsibility to city or county agencies, which may be even less able to handle unexpected shortfalls. Focusing on single short-term metrics may obscure the trade-offs or long-term effects inherent in common budget practices. It would be important for us to have better information on the complementarity of these institutions and on their longer-term effects. Pair strict balance budget requirements with contributions to a BSF. Research suggests that BBRs have a beneficial disciplinary effect on state budget balances. States with strict BBRs respond more quickly to deficit shocks. However, some research also suggests that BBRs make it more difficult for states to respond to revenue shortfalls during a recession without exacerbating the business cycle and volatility. States are also more prone to cut services, rather than raise taxes, to meet BBR requirements, meaning that strict BBRs can result in cuts to school aid or restricted eligibility for optional Medicaid programs, for example. Contributing to a BSF during good times can offset such volatility effects during economic downturns. States would not have to immediately engage in deep program cuts or tax hikes to balance their budgets. BSFs also have their limitations and may not be able to prevent deep program cuts during multiyear recessions, but they can be designed to smooth the relationship between cyclical revenue streams and more constant spending needs.