Beyond Bailouts: Federal Tools for Preventing State Budget Crises

Abstract

More than two years after the official end of the Great Recession, state governments still face significant budget deficits that cannot be addressed without further drastic spending cuts or substantial revenue increases. The structural origins of the ongoing state fiscal crisis are well known. Excessively procyclical revenue structures, combined with spending obligations that increase with economic downturns, have resulted in a budget dynamic for the states that is not sustainable over the long term. The consensus solution to this problem is for states to save money during boom times (via budget stabilization or “rainy day” funds) and to draw on those savings during recessions. Unfortunately, numerous studies have shown that states do not save anywhere close to an adequate amount for this to be an effective strategy. As a result, during each of the past several downturns, states have turned to the federal government for fiscal assistance - often derisively termed “bailouts” - to address fiscal imbalances. Yet these bailouts have their own problems, including creating an incentive for states not to establish adequate rainy day funds, which in turn increases the likelihood of future bailout demands.

To escape from this vicious cycle, we propose a set of federal policy reforms to facilitate state savings. We offer a menu of policy options, rather than a single solution, because we argue that existing evidence does not clearly explain why states do not save. Therefore, we first analyze the possible sources of failure and then tailor a number of remedies for each; in nearly all cases, it is clear that states would be unable to overcome the problem on their own, making federal intervention particularly apt.

Keywords: rainy day fund, budget stabilization fund, intergovernmental transfers, behavioral finance, sovereign debt, fiscal federalism

JEL Classification: D72, H71, H72, H74, H77, I38