metadata: authors: 0: author: Gonzalez, Christian Y.
1: author: Paqueo, Vicente B.
docna: 0: docna: Social sector expenditures and rainy-day funds
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Theory & Research,Economic Adjustment and Lending,Industrial Economics,Primary Metals,Health Care Services Industry,Social Protections & Assistance,Public Sector Economics,Economic Growth,Public Finance Decentralization and
            Poverty Reduction
teratopic: Infrastructure Economics and Finance
abstracts: cdata!: Gonzalez and Paqueo examine the effects
            of budget stabilization funds--often called rainy-day
            funds--on the volatility of social spending and, for
            contrast, on nonsocial sector spending. They analyze the
            rainy-day funds of U.S. states. The authors find that
            rainy-day funds are ineffective in reducing the volatility
            of nonsocial sector expenditures but are effective in
            reducing the volatility of social sector expenditures. The
            authors also find that states that have stringent deposit
            and withdrawal rules have higher rainy-day fund balances,
            and thus are more effective in reducing the volatility of
            social sector expenditures. Finally, for long-term
            effectiveness, stabilization funds depend obviously on
            sustained economic growth.
repnme: repnme: Social sector expenditures and rainy-day funds
display_title: Social sector expenditures and
            rainy-day funds
listing_relative_url: /research/2003/09/2516827/social-sector-expenditures-rainy-day-funds
topicv3: Economic Growth m1326241 471,Fiscal Policy m1327144 445,Social Protection and Labor m1327194 697,Gold m1503518 2936,Health m1504661 3480
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Infrastructure Economics and Finance
origu: Development Research Group (DECRG)
no_of_pages: 24
model_extractions: I POLICY RESEARCH WORKING PAPER 3131

# Abstract

Gonzalez and Paqueo examine the effects of budget stabilization funds-often called rainy-day funds-on the volatility of social spending and, for contrast, on nonsocial sector spending. They analyze the rainy-day funds of U.S. states. The authors find that rainy-day funds are ineffective in reducing the volatility of nonsocial sector expenditures but are effective in reducing the volatility of social sector expenditures. The authors also find that states that have stringent deposit and withdrawal rules have higher rainy-day fund balances, and thus are more effective in reducing the volatility of social sector expenditures. Finally, for longterm effectiveness, stabilization funds depend obviously on sustained economic growth.

This paper-a joint product of the Economic Policy Sector Unit and the Social Protection Sector Unit, Latin America and the Caribbean Region-is part of a larger effort in the region to draw lessons from U.S. states on the effects of budget stabilization funds on the volatility of expenditures. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Patricia Holt, room 18-805, telephone 202-473-7707, fax 202-5222119, email address pholt@worldbank.org. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The authors may be contacted at cgonzalez@worldbank.org or vpaqueo@worldbank.org. September 2003. (19 pages) _The Policy Research Working Paper Senes disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent._

## Produced by the Research Support Team
# **Social Sector Expenditures and Rainy-Day Funds**

Christian Y. Gonzalez and Vicente B. Paqueo

> _World Bank, 1818 H Street NW Washington DC 20433, USA_

cgonza1ez(a,worldbank.org vpagueogworldbank.org
# **Social Sector Expenditures and Rainy-Day Funds**

_By Christian Y. Gonzalez and Vicente B. Paqueo_

# **I. INTRODUCTION**

Reflecting increasing concern about economic insecurity and its social welfare consequences, an analysis of Latin American countries reveals the need for better social risk management systems to deal with economic shocks and uncertainty (De Ferranti, Perry, et al., 2000). Such a system involves a combination of policy instruments ranging from market insurance and self-insurance to social protection. One of these instruments highlighted in the above-mentioned study is the budget stabilization fund, often called "rainy-day fund." 'Noting that many countries suffer from pro-cyclical social spending, they argued for governments to save in good times to finance social spending in bad times. To quote: _"The poor do not, for example, frequently pull their children out of school during bad times-although they do when the recession is severe. But the fact that some educational and health outcomes are hurt during especially bad times may be as much the result of the government's inability to maintain the quality of social services as the household's decision to invest less during crises... Governments should save in good times to finance social spending in bad times... "_ (De Ferranti, Perry, et al., 2002, pp. 9-10) During the last two decades, virtually all of the U.S. states have adopted rainy-day funds, that allow them to smooth public spending over time by saving during booms and using the balances to cover revenue shortfalls during recessions. Prior to 1981, few states had such funds (Gold (1981), and Knight and Levinson (1999a)). By 1984, 18 states had enacted rainy day funds, and by 1994, 45 states had them (Knight and Levinson (1999a)). In 2000, almost all of the U.S. states have adopted budget stabilization funds, and their balances averaged $158 per capita, or 3.22 percent of total state expenditures.

This paper examines the effect of rainy-day funds on the volatility of social spending and, for contrast, on non-social sector expenditures. Further, it analyzes empirically the determinants of the size of the rainy funds. The characteristics of state rainy-day funds differ across states, in particular in terms of the stringency of their 3
deposit and withdrawal rules as well as the fund's size. This paper examines those aforementioned rules and other factors in determining the size of the rainy-day funds. Analysis of the U.S. experience could reveal useful lessons for Latin American and other developing countries.

# **II.** LITERATURE REVIEW

The literature on "rainy-day funds" is summarized in table 1. Navin and Navin (1994) examine the state budget stabilization funds of Indiana, Iowa, Missouri, Michigan, Minnesota, Ohio and Wisconsin. In particular, they examined the movement of fund balances over time (1983-1991) to see how the fund balances move in relation to some indicators of fiscal health. The authors find that the use of these funds varies significantly among states as does the level of funding and therefore the ability of these tools to serve as effective instruments of counter-cyclical state fiscal policy.

Sobel and Holcombe (1996) examined the degree to which rainy-day funds eased the fiscal stress experienced by states during the 1990-1991 recession. The authors constructed a measure of state fiscal stress as the amount of discretionary tax increases plus the amount by which expenditure growth fell below average. Then, they constructed an empirical model to see whether the presence of an explicit rainy-day fund had an effect on the degree of fiscal stress experience by a state. Sobel and Holcombe found that rainy-day funds were effective in reducing fiscal stress if they had mandatory requirements for making deposits. Also, they show that for a given amount of fiscal stress, states that have rainy-day funds are more likely to cope with that fiscal stress through spending reductions than through increases in taxes.

Levinson (1998) shows that stringent balanced budget requirements enforced in some U.S. states have exacerbated business cycles in those states. He also shows that states with rainy-day funds have smoother business cycle fluctuations. Knight and Levinson (1999a) examined the effect of rainy-day funds on state savings behavior. They found that states with rainy-day funds have higher total balances than states without such funds and also have higher balances after adoption than before adoption. Furthermore, 4
rainy-day fund deposits increase total balances dollar-for-dollar. In sum, according to these authors rainy-day funds appear to belong to the growing set of fiscal institutions with real fiscal and economic consequences. Wagner (1999) shows that the increase in state budget stabilization funds is attributed to the 1980-1982 recession.

In a descriptive analysis of commodity-based stabilization and savings funds currently in place in Norway, Chile, Alaska, Venezuela, Kuwait, and Oman, Fasano (2000) finds that the outcome of their experience has so far been mixed, with differences among countries reflecting differences in objectives, institutional arrangements, adherence to operational rules, and the soundness of the overall fiscal policy. Nevertheless, he observed that in most cases the stabilization funds he reviewed have contributed to the enhancement of the effectiveness of fiscal policy by making the budget expenditure less driven by revenue availability.

With respect to the determinants of adoption of rainy-day funds, Wagner and Sobel (2001) shows that states with tax and expenditure limit laws in place were significantly more likely to establish these funds. They were significantly less likely, however, to adopt funds with stringent deposit and withdrawal rules. This suggests that some states adopted budget stabilization funds to circumvent existing fiscal constraints.

Finally, in the most recent study of the issue, Gonzalez (2002) has found these rainy-day funds to be ineffective, consistent with the findings of Sobel and Holcombe (1996) and Wagner and Sobel (2001). Noting that most of the states are not well prepared for the most recent recession, he finds that only 4 out of 50 states have enough rainy-day funds to ease a recession similar to that of the early 1990s. In this regard, he points out that the reason why some states don't have enough savings is because they have reached their cap on the fund size.

The above review of the literature reveals that current analyses have not examined the impact of stabilization funds on social expenditures. They have been limited mainly 5
to the analysis of their effectiveness stress.

in smoothing total spending and reducing fiscal It may be argued that rainy-day funds, even if they are not earmarked for specific expenditures such as those of the U.S. states, could reduce the volatility of social sector expenditures - and could do so without simultaneously stabilizing non-social sector expenditures. This differential effect can happen because politicians may prefer certain type of expenditures more than others. For example, during a lean year a politician facing the decision whether to use the rainy-day funds to finance the construction of a new road or to maintain the outlays for a certain school and health services could be more incline to choose the latter. That is, it maybe the case that politicians care more about maintaining a certain level of social sector expenditures, even at the expense of non-social sector expenditures.1

# **III. THE IMPACT OF RAINY-DAY FUNDS** ON **THE VOLATILITY OF** EXPENDITURES

In the United States, state governments are responsible in the allocation on what it is known as the general fund. The general fund can be divided between social and nonsocial sector expenditures. The categories used for social sector expenditures in the General Fund are: elementary education, higher education, Medicaid, and cash assistance programs. In the non-social expenditures we could find the following categories: transportation, correction, and others. We will use these two type of expenditures to measure the effect of rainy-day funds on the volatility of expenditures.

To construct a measure of the volatility of expenditures (income), we ran a regression between expenditures (income) in real terms and a trend line. Then, we predicted the residuals and obtained their absolute value. Thus, the absolute value of the predicted residuals are used as a proxy for the volatility of expenditures (income).

> ' Such political preference would be stronger in cases where the influence of labor unions is relatively strong in the sector.

6
The basic specification that we used to test the'effect of rainy-day funds on the volatility of expenditures is the following: where Volexp is the volatility of expenditures in state s at time t; _Volinc_ is the volatility of gross state product (GSP) in state s at time t; _Rainy_ is the rainy-day fund balance in state s at the end of year t-1; and co are state fixed effects. The above variables are in million 1988 dollars.

**Data:** The data are drawn from a number of different sources. State rainy-day fund balances, and expenditures were obtained from several issues of the _Fiscal Survey of States_ and _State Expenditure Report_ published by the National Association of State Budget Officers (NASBO). Data on the characteristics of rainy-day funds<sup>2</sup> were obtained from NASBO (1999), Wagner (1999), and Knight and Levinson (1999a) and from the departments of finance of some states.

**Results.** Table 3 shows the regression results-for (1), using data from the 1985 to 2000 period. We find that a dollar in the rainy-day fund balance decreases the volatility of social sector expenditures by about 34 cents. By contrast, column (3) of Table 3 shows that rainy-day fund balances do not have any effect on non-social sector expenditures. This implies that rainy-day funds are effective in reducing the volatility of the social sector expenditures but are ineffective as an overall budget stabilization fund. This result is consistent with Sobel and Holcombe (1996), Wagner and Sobel (2001), and Gonzalez (2002), which as mentioned found that rainy-day fimds do not reduce the volatility of aggregate spending. Also, column (1) of Table 3 shows that states with higher volatility of income have a higher volatility in social sector expenditures.

Most of the regression results depicted in columns (1 and 3) of Table 3 are statistically significant at a 90 percent level of confidence. We tried a variation on

> **2** See Table 2.

7
specification (1), using volatility in per capita gross state product instead of _Volinc. As_ shown in column (2) in Table 3, the result is greater precision in the estimated coefficient of the rainy-day variable. A Hausman's specification test was also performed, indicating that the regression results from a random effects specification are biased. However, its coefficients are statistically significant and have the same sign as the fixed effects results. Finally, all of the regression results depicted in column (4) are not statistically significant, which implies that there is no correlation between the volatility of non-social expenditures and the rainy-day fund balances and the volatility of gross state product per capita. We tried different specifications and found the same results.

# IV. **RAINY-DAY FUND BALANCES AND CHARACTERISTICS**

The characteristics of state rainy-day funds differ across states. They differ in particular in their deposit and withdrawal rules as well as the fund's size. Some states' laws mandate deposits to rainy-day funds in certain years. In others, they are determined by a formula based on the projected revenues. The majority of the states require only regular legislative approval for withdrawal of these funds. This allows coverage of revenue shortfalls, but has the drawback of not providing very stringent controls to ensure that funds are left untouched until they are needed. "Some states have maximum limits, or caps, on fund sizes. These limits range from 2 percent to 25 percent of expenditures. The most common limit is 5 percent, the generally accepted minimum level of total balances by credit rating agencies (Eckl (1997)), and the amount suggested by the National Conference of State Legislatures (Sobel and Holcombe (1996))."3 To examine the determinants of the size of the rainy-day fund, we constructed three dummy variables. The first is a dummy that indicates if the state has an stringent deposit rule for its rainy-day fund. This variable takes the value of 1 if the state requires that some money should be deposited into the rainy-day fund account, and the value of zero otherwise. The second dummy indicates whether the state has an stringent withdrawal rule for its budget stabilization fund. Specifically, this variable takes the value

> 3 Knight and Levinson (1 999a).

8
of 1 if the state requires a super majority approval in Congress, and zero otherwise. The third dummy indicates whether the rainy-day fund has a cap or not.

The following specification was estimated to explain the observed differences in the states' rainy-day fund balances.

_Rainy,, = A/Rainy5 ,,., + l 2Withdrawi, +,f 3Cap5,, +f34Deposi(, +f lincomen, 5 +, 6 GrowtA, +_ eV, + _e,,_ (2) where _Rainy_ is the rainy-day fund balance in state s at the end of year t; _Withdraw_<sup>isa</sup> dummy variable indicating if the rainy-day fund has an stringent withdrawal rule; _Cap is_ a dummy variable indicating if the rainy-day fund has a cap; _Deposit_ is a dummy variable indicating if the rainy-day fund has an stringent deposit rule, _Income_ is gross state product (GSP) per capita in state s at time t, _Growth_ is the growth rate of gross state product, and co are state fixed effects.

Results. Table 4 shows the regression results for (2) by using data from the<sup>1985</sup> to 2000 period. We found that, relative to the mean, states with stringent deposit rules have 124 percent more money on their rainy-day fund accounts than states without those strict rules. Also, we found that states with stringent withdrawal rules, on average, 137 percent more dollars on their rainy-day fund accounts than states without those tough withdrawal rules. Contrary to expectation, the coefficient for the rainy-day fund's cap is not statistically significant, although it has the expected sign. Further, high-income states have higher rainy-day fund balances than low-income states. Finally, states with high economic growth rate have higher rainy-day fund balances than those states with lower rates. These results are consistent with those from Sobel and Holcombe (1996).

All of the results depicted in Table 4 are statistically significant. Also, using Hausman's specification test, we find that the regression results from a random effects specification are biased. However, its coefficients are statistically significant and have the same sign as the fixed effects results.

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# V. CONCLUSION

In this paper we examine the effect of rainy-day funds on the volatility of expenditures. We found that rainy-day funds have a negative effect on the volatility of social sector expenditures and has no effect on the volatility of non-social sector expenditures. Therefore, rainy-day funds appear effective in reducing the volatility of social sector expenditures but are ineffective as an overall budget stabilization fund. The finding of a differential effect of rainy-day funds on the volatility of social and non-social spending qualifies earlier results regarding their effectiveness.

With respect to the determinants of the size of rainy-day funds across states, the conclusion is that states with stringent deposit and withdrawal rules have higher balances. Therefore, these states are the most effective in reducing the volatility of social sector expenditures. Moreover, unsurprisingly, the effectiveness of the rainy-day funds depends on economic growth. Higher rates of growth means greater potential for accumulation and less pressure to spend the rainy-day fund. These findings hold important lessons for the establishment and maintenance of an effective stabilization fund to reduce volatility of public social spending, although their application might not be straightforward in developing countries where political maturity is lacking and effective governance is weak.

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