Ensure Adequate Financial Reserves
Sound fiscal management requires state government to accumulate and maintain cash reserves to protect against economic downturns or other strains on the state’s finances. Automatic repayment of any spending financed from the Texas Economic Stabilization Fund, or “Rainy Day Fund,” would allow the state to ride out economic fluctuations and improve its cash management and credit rating.
Texas has a reputation for conservative fiscal management. This philosophy is manifest in the state’s “pay-as-you-go” approach to state spending. Before the Legislature can pass an appropriations bill, the Comptroller’s office must certify that the proposed appropriations can be covered by available revenue anticipated over the next biennium.
In 1986 and 1987, however, a severe and unanticipated economic downturn put the Texas approach to the test, when actual revenues proved to be far less than expected. In 1986, the governor called a special session of the Legislature to reduce appropriations to meet the fiscal crisis. The state’s bond rating dropped from AAA to AA, resulting in higher borrowing costs for the state.
Rainy Day Fund
In response to the economic upheaval of the late 1980s, the Legislature considered various measures to improve the state’s ability to respond to fluctuating revenues. One mechanism included increasing reserve balances as a safety net against future cash shortages. In 1988, Texas voters approved a constitutional amendment that required periodic transfers into a new Economic Stabilization Fund, or “Rainy Day Fund,” as a cushion against unexpected revenue shortages.
Deposits into the fund consist of transfers of half of any General Revenue Fund surplus in each biennium and 75 percent of any oil and natural gas production taxes exceeding 1987 levels. The Legislature’s intent was to avoid cash flow shortages by saving “extra cash” during positive economic times.
Despite economic growth and occasional deposits, the Rainy Day Fund’s cash balances remained low during the late 1990s, since the Legislature chose to spend down the fund balances as soon as they became available. Only after two large transfers of natural gas tax collections in fiscal 2002 and 2003 has the balance begun to approach $1 billion.
In recent years, the management of the state’s cash flow has become increasingly difficult.
The receipt of state revenue does not match the timing of its expenditures. This timing mismatch is the result of substantial distributions to the Foundation School Fund made early in each fiscal year, as well as various tax relief initiatives that also affect cash flows early in the year. These early, annual expenditures require the state to “borrow” funds on a short-term basis.
The state uses short-term tax and revenue anticipation notes to manage its annual cash flow requirements. These notes are short-term debt instruments issued by states to finance current operations, with repayment from expected revenues and tax receipts. This short-term borrowing does not constitute debt under the state’s “pay-as-you-go” system because the notes are paid back during the same year. Note proceeds meet cash flow needs during the first part of the year and are paid back at the end of the year after the receipt of taxes and revenue.
But the cash flow mismatch is growing rapidly. In fiscal 2003, the state issued $5.9 billion in tax and revenue anticipation notes, and this amount seems certain to continue rising. Possible solutions to the problem include earlier payment of taxes by taxpayers, later distributions to schools or the use of reserve funds to manage cash flow.
The Texas Constitution already allows for the temporary use of Rainy Day Fund balances for interfund borrowing. These sums can be borrowed to meet cash flow needs as long as the loan is returned to the fund, with interest, before the end of the fiscal year.
Reserve balances are an important factor that rating agencies use to evaluate states’ credit quality. Credit ratings, in turn, are important to states because higher ratings translate into lower borrowing costs. Considering that bonds are essentially loans for millions of dollars, lower ratings can cost states significant amounts of money.
The major rating agencies, Moody’s Investor Service, Standard and Poor’s and Fitch IBCA, rate the Texas general obligation debt at Aa1, AA, AA+, respectively. The ratings indicate good-quality credit, but not the highest rating of AAA, which the state held before 1987.
In 1999, Moody’s upgraded Texas’ general obligation debt from Aa2 to Aa1, citing the state’s strong economy and anticipated reserves in the Stabilization Fund as a factor. Standard and Poor’s, on the other hand, moved the state’s outlook from “positive” to “stable,” citing the state’s modest reserve levels and the expenditure of the state’s accumulated surplus.
A. Texas should increase balances in the Rainy Day Fund to 5 percent of the general revenue budget.Building the balance in this way would allow Texas to accumulate a financial reserve and help manage the state’s cash flow needs. This percentage is consistent with Standard and Poor’s benchmark ratios and implies a balance of about $3 billion at current budget levels.
B. State law should require the Legislature to repay any spending from the Rainy Day Fund.Until recently, Texas has spent its Rainy Day Fund balances almost as quickly as they accumulate, undermining the fund’s potential benefits as a tool for handling cash flow and boosting the state’s credit rating. The state’s present financial challenges make the fund a tempting target once again, just as the balance is beginning to build. Constitutional and statutory references to the Rainy Day Fund should be expanded to require that any appropriations financed by the fund be repaid in the following fiscal biennium, and that these amounts be withheld from the Comptroller’s estimates of available revenue until the repayment is complete. Sound financial management requires appropriate levels of reserves for economic downturns. Deposits should accumulate to the maximum allowed by the state constitution.
This recommendation would have no direct fiscal impact on the state.
Tex. Const. art. III, §49a.
Tex. H.J.R. 2, 70th Leg., R.S. (1987).
House Research Organization, Analyses of Proposed Constitutional Amendments (Austin, Tx, July 15, 1988), p. 14.
Moody’s Investors Service, Municipal Credit Research, New Issue Report (August 10, 2000).
Barron’s Business Guides, Dictionary of Banking Terms (Hauppauge, New York, 1990).
Tex. Const. art. III, §49a.
Bond Review Board, 2001 Annual Report (November, 2001), pp. 2-3.
Moody’s Investors, Municipal Credit Research: State of Texas Rating Update (June 18, 1999).
Standard & Poor’s, CreditWeek Municipal, Outlook Revised (August 30, 1999), p. 83.