Learning from the crisis (2): Strengthening our reserve funds

As state leaders struggle to find solutions to this year’s revenue shortfalls and funding gaps, it is not too soon to draw lessons from the current state fiscal crisis to design policies that will allow us to respond better the next time the economy falters. This post, the second in a four-part series that will recommend changes to our budget and tax system, looks at options for strengthening our budget reserve funds.  Our first post recommended enhanced and expanded budget forecasting; subsequent pieces will consider multi-year revenue commitments and tax expenditures. Together, our proposals are designed to improve the Legislature’s ability to manage budget downturns.

Like most every state, Oklahoma has established a budget reserve fund to put money aside during times of robust growth that is then made available to cushion the impact of economic downturns.  Oklahoma’s Constitutional Reserve Fund, known as the Rainy Day Fund (RDF), was created by a vote of the people in 1985. Under the Constitution, deposits are made into the Rainy Day Fund of all General Revenue (GR) collections that exceed 100 percent of the final certified estimate made by the State Board of Equalization for a given year. Deposits are capped at 10 percent of the General Revenue Fund certification for the preceding year.  If the RDF is already at its cap, additional surpluses spill over to the General Revenue Fund.

Since adoption of constitutional amendment SQ 708 in 2004, the RDF can be accessed as follows:

• Up to 3/8ths of the Fund may be appropriated to make up for a shortfall in the current year’s collections;
• Up to 3/8ths of the Fund may be appropriated in the budget for the forthcoming year if General Revenue collections are forecast to be less than the amount originally projected for the current year;
• Up to 1/4 of the Fund, or $149 million, may be appropriated upon the declaration of an emergency.

There are two changes to the Rainy Day Fund that would allow it to work better. The first, as has been proposed recently by Treasurer Scott Meacham and Senators John Ford and Andrew Rice, is to raise the maximum amount the RDF can hold, from 10 percent of the annual General Revenue Fund budget to 15 percent. The current limit is too low to sustain state services through even a mild recession, much less a major economic dislocation. If a 15 percent cap had been in effect prior to the current downturn, the RDF would have been allowed to grow to close to $900 million, rather than the roughly $600 million the Fund currently holds.

A second worthwhile reform aims to keep the RDF available over the course of a prolonged downturn. Under current rules, 3/8ths of the fund may be used to make up for a deficit in the next budget year, but only if revenues are expected to fall from the current year’s estimate. That means we we will likely be able to access the fund in the coming year, FY ‘11, but probably not in FY ‘12, because revenues will in all likelihood be growing again. However, we might well need the Rainy Day Fund more that year than ever. Our forecasts suggest that FY ‘12, and possibly FY ‘13 revenues will remain below those of FY ‘08. With federal stimulus dollars having been spent, the state will have to make up for the loss of over $600 million in federal funds that are sustaining services during the initial phases of the downturn. It would be advisable to change the Constitution to allow the 3/8ths to be appropriated in any year that revenues are expected to remain below their peak of any of the four previous years.

At the same time, an additional means of easing the volatility of Oklahoma’s revenue collections would be to create a reserve fund specific to gross production tax (GPT) revenues, our most volatile and unpredictable revenue source. Under one possible scenario, a Gross Production Tax Reserve would collect revenues whenever GPT collections increased beyond a certain limit – say 12 percent – and would automatically disperse revenues back to General Revenue when gross production taxes fall.  Our calculations suggest that had such a Gross Production Tax Reserve been in effect over the past decade, it would have accumulated a balance of over $1 billion by FY ’09. This reserve  would have been disbursed to make up for plummeting gas revenues in FY ’10 and the remainder of the downturn, thereby greatly cushioning the severity of the downturn.

Together, increasing the cap on the Rainy Day Fund and creating a specific Gross Production Tax Reserve would greatly increase available reserves heading into a downturn and cushion the magnitude of budget cuts once revenues fall. Increasing the size of our reserve funds would involve accepting more modest spending growth during the peak years of growing revenues. That is a trade-off most Oklahomans are likely to endorse.