Fixing DC’s Rainy Day Fund

PDF of this report (17pp.)

In 2000, the District established two new fiscal reserves, an “emergency reserve” and a “contingency reserve,” as required by Congress in that year’s appropriations legislation.  These reserves are similar to the “rainy day” funds that most states use as a cushion against major crises that could disrupt the budget ‘ such as a natural disaster or a rapid drop in revenues during an economic downturn.

When the reserves were established, it was assumed that it would take the District up to seven years to reach the target level, which was set at seven percent of the local budget. The District’s strong finances in 2000 and 2001, however, allowed it to meet this level in just two years.  By the end of fiscal year 2002, the District had set aside more than $250 million of local revenues in the emergency and contingency reserves.

Rainy day funds can play a significant role in helping states and cities manage a fiscal crisis.  In particular, they can help maintain public services during an economic downturn, when rising unemployment and falling incomes lead to increasing need for government services.  Rainy day funds also limit the need to raise revenues at a time when families and businesses are least able to afford tax increases.  Finally, spending rainy day reserves provides a stimulus to the local economy that can help mitigate the effects of a recession.

The federal law governing DC’s rainy day reserves, however, includes several restrictions that make it difficult for the District to take advantage of this important strategy.  Partly as a result of these restrictions, Mayor Williams and the DC Council chose not to use the rainy day funds to address a $323 million shortfall identified in September 2002.  Instead, the deficit was eliminated entirely through substantial spending cuts and revenue increases.

This report compares the District’s reserve funds with the rainy day funds in other states.  Throughout this report, the DC emergency and contingency reserves are described as the District’s “rainy day fund.”  This review finds that the rules governing DC’s rainy day fund are more restrictive than in almost any other state.

  • Most significantly, funds withdrawn from the DC rainy day fund in a given year must be replenished in full in the following year.  Because a fiscal crisis can last more than one year, this rule could require the District to repay a withdrawal before its finances have recovered.  As a result, District officials are unlikely to ever consider making more than a modest withdrawal from the rainy day funds.
  • Of 45 states with a rainy day fund, 39 have no replenishment requirement.  In these states, contributions to the rainy day fund typically are not required until fiscal conditions recover ‘ such as when the state returns to budget surpluses or when revenues begin to grow at a healthy rate.  Among the six states with a replenishment rule, no state requires repayment as rapidly as in the District.

While the rapid replenishment rule is the most significant barrier to using the District’s rainy day fund, other rules limit access in ways that are more restrictive than in most state rainy day funds.

  • Both components of DC’s rainy day fund ‘ the emergency reserve and the contingency reserve ‘ can be used to address a natural disaster or other emergencies.  But only the contingency reserve ‘ which totals roughly $100 million ‘ can be used in response to a revenue shortfall.  In effect, this means that the District has a $250 million rainy day fund to respond to natural disasters, but only a $100 million reserve to respond to an economic downturn.
  • Moreover, the $100 million contingency reserve can be accessed only if revenue collections fall more than five percent below the level projected when the budget was enacted.  This means that the District can use these funds when it faces an unexpected revenue shortfall, but not when weak revenue collections are anticipated in advance.  If, for example, revenues are projected to fall 10 percent from one year to the next ‘ and this projection proves to be accurate ‘ the District could not use its rainy day fund to address the decline.  Even if the District does face an unexpected revenue shortfall, it must exceed five percent before the rainy day fund can be accessed.  This means that rainy day funds could be used only if there is an unanticipated shortfall that exceeds $175 million.

By contrast, most state rainy day funds give policy makers great flexibility to determine when to use the reserves.

  • In 21 states, the rainy day fund can be used when the state faces a deficit for any reason.  In another 18 states, the rainy day fund can be tapped when a budget deficit results from a revenue shortfall ‘ that is, when actual revenue collections in a given year are less than the revenue projection upon which the budget was based.
  • Most states allow use of the rainy day fund for natural disasters or other emergencies, but no state restricts a portion of its rainy day fund for this purpose as the District does.  Only six states require that economic or revenue conditions decline by a specified amount before the rainy day fund can be used.
  • While policy makers in most states have discretion to determine when fiscal conditions are weak enough to necessitate using the rainy day fund, some state rainy day funds include rules designed to limit access.  Ten states require a super-majority vote of the legislature, such as three-fifths, to make a withdrawal from their rainy day fund.  And 10 states limit the amount that can be withdrawn at one time.  In Idaho, for example, no more than half of the fund’s full balance can be used in a given year.

In short, most state rainy day funds are designed to be built up when budget conditions are strong and to give policy makers flexibility to use the rainy day fund when fiscal conditions deteriorate.  Most states with rainy day funds ‘ 32 of 45, including Maryland and Virginia ‘ have used this flexibility to make one or more rainy day fund withdrawals to address the current budget crisis.  The withdrawals total nearly $14 billion nationwide, more than half of the aggregate rainy day fund balances.<

This review suggests that the District’s rainy day fund should be modified to adopt the best features of other state rainy day funds.  Without these changes, the District may never be able to make significant use of this valuable fiscal tool.  Because the District is in the midst of a fiscal downturn that is expected to continue through at least 2004 ‘ and because significant spending reductions and revenue increases already have been implemented in response to these fiscal problems ‘ it is important to consider these modifications now.

Since DC’s rainy day fund was established under federal law, changes must be made by the U.S. Congress.  Among the changes that should be considered are:

The replenishment rule should be replaced.  Any rule requiring replenishment of rainy day fund withdrawals within a specified time period ‘ even a period of several years ‘ could require repayments at a time when fiscal conditions remain weak.  As a result, the replenishment rule in the District’s rainy day fund should be replaced with rules requiring contributions when fiscal conditions are healthy.

One option is to require a contribution to the rainy day fund to be included in the District’s budget in any year when revenues are projected to exceed the costs of maintaining existing programs and services.  A second option is to require a contribution when the District ends the year with a budget surplus.  Alternatively, both of these provisions could be required.

District policy makers should have more discretion over when to use the rainy day fund.  Rather than maintaining two separate reserves, DC’s two rainy day funds should be combined into one fund that can be used for either a natural disaster or a revenue shortfall.

In addition, Congress should consider several modifications to give greater flexibility to the mayor and Council to use the rainy day fund to address a revenue shortfall.  In general, use of the rainy fund should be allowed whenever worsening revenue collections lead to a deficit ‘ as is the case in most state rainy day funds.  This means that District officials should be able to appropriate funds from the rainy day reserve in the annual budget if projected revenues are not sufficient to maintain existing programs and services.  Withdrawals also should be allowed after the budget is enacted when revenue collections fall by any amount below the level assumed in the budget, rather than the five percent threshold in current law.

While these changes would improve the rainy day fund, they could raise concerns that the rainy day fund would be relied upon too readily to address budget shortfalls.  One possibility for addressing that concern is to limit the amount of the rainy day fund that could be withdrawn in a given year.  Limiting withdrawals to half of the fund’s target level, for example, would allow the District to use no more than $125 million in a given year.

The structure of rainy day funds in other states and recommendations for improving DC’s rainy day funds are discussed in more detail below.

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