Rainy-Day Funds Protect Government, Cost Private Jobs

In light of the European crisis, it is fair to ask how much better America is doing. We know, e.g., that California, New York and Illinois are in really bad shape, but they are not the only states with agonizing budget problems:

Even when the debate is leaning toward tax cuts, as in Ohio, there is fierce resistance from friends of big government.

These examples illustrate well how our state governments are still on the wrong side of history. They are making the same mistake as national governments in Europe, struggling hard to maintain their big, costly welfare states.

This does not mean that they don’t recognize the risks of budget deficits and debt pile-up. While it is extremely unlikely that our state legislators in general have realized that Europe’s fiscal mess is on its way Stateside, they have taken some precautions that, they hope, will help when their budgets go into the red. These measures are often referred to as “rainy day funds” and supposed to provide cash when tax revenues fall short of what government wants in order to keep spending.  

The entire idea of a rainy day fund is wrong. It is based on false fiscal theory and only serves to preserve an inherently unsustainable welfare state. But before we elaborate on these points, let’s get a bit more acquainted with the rainy-day fund phenomenon. A new report from the Tax Foundation has this to say:

Most states have created budget stabilization, or “rainy day,” funds to draw upon when economic conditions create a severe or sudden drop in tax revenues. However, these cash reserves were for the most part inadequate in coping with the recent economic downturn. For all intents and purposes, only Alaska and Texas have sizable rainy day fund amounts remaining, although many states have begun to rebuild their balances.

Herein lies a clue to what is wrong with the very concept of a rainy day fund: maintaining it takes precedence over reforming away spending. In order to build up a rainy day fund, government needs to charge us more than $100 in taxes for every $100 it spends. After several years of paying, say, $105 to get $100 worth of government services, we hit a recession during which government covers lost tax revenues with rainy-day fund money. Once the recession is over government resumes charging us, e.g., $105 for every $100 it spends.

In other words: the rainy day fund builds in excessive taxation into the government budget. This has very important consequences for our economy.

More on that in a moment. For now, let’s get back to the Tax Foundation report.

Generally, U.S. states are required by their constitutions or by statute to contribute to their rainy day funds according to a formula or rule up to a preset limit or cap. At a minimum, most are required to deposit some portion of year-end surpluses into their rainy day funds during good years. … The size of rainy day funds is typically benchmarked against annual appropriations or general revenues. … According to the National Conference of State Legislatures (NCSL), 16 states require a legislative supermajority (three-fourths, two-thirds, or three-fifths) to withdraw from their funds. Other states permit drawing on the fund only after an economic trigger, such as a drop in personal income or an increase in unemployment. While there is currently no consensus on how large a state rainy day fund should aim to be, bonding agencies and state budget officials generally target 5 percent as the appropriate amount. If the fund is too large, there are opportunity costs with the funds being tied up in reserve, as well as a worry that it would reduce incentives for careful expenditure planning.

Again, the rainy day fund forces excessive taxation – one example is a budget surplus that is not returned to taxpayers – but even more importantly, the fund protects the very spending that causes the need for the rainy-day fund in the first place.

The reason why a government runs a deficit in a recession is simple. Tax revenues depend on how well taxpayers are doing, primarily in terms of personal income (which pays for income, sales, use and addiction taxes; even property taxes, actually). Government spending, on the other hand, depends on formulas for entitlement programs that are entirely politically determined. There are no ties between government spending and the ability of taxpayers to pay for that same spending; if taxpayers are suffering in a recession, the people who are entitled to government handouts and services are not going to give up any of their goodies.

When was the last time you heard Medicaid enrollees say “Hey, it’s a recession, go right ahead and cut away some of our health benefits that you’re paying for”?

Furthermore, many government spending programs by design cost more in a recession.

Because of this discord between tax revenues and government spending there will inevitably be deficits in recessions. A rainy-day fund protects that spending and thereby serves as a validation of the entitlements that cause the need for that same fund in the first place.

Back to the Tax Foundation report:

Recent scholarly research has studied past recessions to develop rainy day fund rules of thumb based on the average revenue shortfalls during an economic downturn. Wagner & Elder, for example, found that “the typical state can expect a revenue shortfall equal to 13 to 18 percent of revenue during a normal downturn.  To achieve this during a typical period of economic expansion, states would need to save between 2.4 percent and 2.8 percent of each year’s revenues during good economic times.

In other words, you have to pay $102.80 for every $100 worth of services you get back from government. In a state like Ohio, this means that taxpayers have to dole out $660 million per year that they get nothing for, other than the maintenance of already big, bloated government spending programs during a recession.

Nationwide, a 2.8-percent rainy-day fund annual deposit would cost American taxpayers $19.7 billion in excessive taxation. This is a net drainage of money from the private sector that maintains government spending and protects government employees while costing the private sector 142,000 jobs every year.

Rather than being concerned with government’s ability to maintain spending that is already too big, too costly and too intrusive on the economy, our state lawmakers (and my peers at other free-market think tanks) should focus their efforts on developing models for permanently dismantling the welfare state. No other economic issue is even close in importance to this one. For every day we keep trying to save our welfare state, we draw one day closer to the day when Greek-style austerity comes down on us, with all its disastrous consequences.