Marking a milestone in the economy's recovery, states are now collectively boosting their cash reserves to the highest levels since 2008, giving lawmakers the rare luxury of arguing over how to use the cash.

During the recession and subsequent years of sluggish growth, state governments raided their so-called rainy-day funds and slashed spending deeply to plug budget gaps caused by falling tax receipts.

Kaya Henderson, left, and her mother Tammy Dillon, right, in their Grand Rapids, Mich., home with Kaya's stepfather, Brandon Dillon, a state representative who wants rainy-day funds to plug education-funding gaps. Adam Bird for The Wall Street Journal

Now, with revenue rebounding along with housing values and employment, most states are breaking even or running small surpluses. Several state governors are moving to replenish or even boost their cash reserves, stirring debate about whether the money should be used instead to cut taxes or spent to save jobs and spur the economy.

States are projected to increase cash reserves collectively by $3.4 billion to $41.4 billion in the fiscal year that for most states ends June 30, according to the National Conference of State Legislatures. At that point, the accounts would be equivalent to roughly 9% of state revenue, the highest level since 2008, and near a level economists consider healthy, according to the National Association of State Budget Officers. At their lowest point, in 2010, the funds were 5.2% of revenue.

Some governors are proposing to raise reserves further as they prepare budgets for the next fiscal year. Michigan Gov. Rick Snyder is calling for adding $75 million to the $505 million that is projected to be in the state rainy day fund at the end of this fiscal year. In Tennessee, Gov. Bill Haslam is proposing a $100 million deposit, on top of the $356 million slated to be in the account by this summer.

They say having substantial cash reserves enables them to borrow at lower interest rates, saving money in the long run. And they argue states need to prepare for rising health-care costs and cuts in federal aid.

"The hardest thing to do in government is to hold in the reins when times are good," said Mr. Haslam, a first-term Republican. "Let's be prepared for the fact that there is going to be a lot of federal money going away. It's all the more reason to be responsible."

But some state lawmakers say now isn't the time to save, with unemployment still historically high and schools and other programs strained from years of budget cuts.

In Tennessee, Senate Democratic Leader Jim Kyle said across-the-board federal spending cuts, known as sequestration, are expected to cost his state nearly $15 million in funding for primary and secondary education this year. A program that provides meals for senior citizens would lose $1 million in funding.

"It's rainy," Mr. Kyle said. "I don't know what rainy is if sequestration is not rainy. We should hold Tennesseans harmless because we can afford to. It's their money."

The debate is particularly intense in Michigan, where unemployment is hovering near 9%, well above the 7.7% national average. Mr. Snyder, a first-term Republican, has made it a priority to boost the state's rainy-day fund. When he entered office in January 2011, the fund was at $2.2 million, barely enough to fund the government for a half hour, said his budget chief, John Nixon.

After big injections each of the past two years, the fund is set to reach $505 million by the end of this fiscal year. Mr. Nixon said the fund is critical not just for the state to gain a triple-A bond rating, but to also be prepared for higher health-care costs in coming years and to maintain consistent program funding levels.

"As revenues decline and go up and down you've got to have those reserves or you're in crisis management," Mr. Nixon said. "The state of Michigan has been in crisis management for the previous decade."

Mr. Snyder is proposing to add another $75 million to the fund under his latest budget proposal. He believes the fund should be equal to at least 6% of state government revenue, or roughly $1 billon, Mr. Nixon said.

But some state lawmakers are resisting the plan.

Michigan state Rep. Brandon Dillon, a Grand Rapids Democrat, said the money should instead be used to restore school funding, which was cut early in the governor's term, despite severe crowding in schools. His 10th-grade stepdaughter's English class has 46 students, he said. Nearly a fifth of the schools in his district are set to be closed this year to cut expenses, he said.

"We are not funding education at any level at an adequate level," Mr. Dillon said. "Before we start putting hundreds of millions of dollars in a rainy-day fund, we should first be meeting the basic commitments."

Still others say the funds should be used to cut taxes, arguing that would lift the economy. Michigan state Rep. Tom McMillin, a Rochester Hills Republican, said he isn't opposed to a rainy-day fund but believes it has become too big. "I think the citizens know what's best to do with extra money than government," Mr. McMillin said.

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