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Balanced Budget Rules and Fiscal Policy: Evidence from the States James M BALANCED BUDGET RULES AND FISCAL POLICY: EVIDENCE FROM THE STATES JAMES M. POTERBA* Against this backdrop, the variation in The persistence of fiscal deficits in many budget practices across states within the industrial democracies has spawned a United States provides a valuable source vast theoretical literature in political econ- of information on the potential effects of omy on why nations run budget deficits, fiscal institutions. One must recognize at along with a sharp policy debate concern- the outset that it is difficult to interpret ing fiscal institutions that might reduce correlations between fiscal institutions these deficits. The debate on fiscal institu- and budget outcomes; budget institutions tions, such as proposed balanced budget may be endogenous. Changes in institu- amendments for the federal government, tions that affect the prospect of deficit fi- involves relatively little empirical evidence nance may reflect changing political sup- on the potential effects of such institu- port for budget deficits, and as such tions. The lack of such evidence can be cannot be viewed as “natural experi- traced to several factors. First, some of ments” in fiscal institutions. Riker (1980) the proposed institutions under discussion argues that essentially all political institu- are budgetary innovations that have not tions reflect the “congealed preferences” been tried on a national or subnational of the electorate. Institutions that no scale before. Second, there is relatively lit- longer suit a majority of the electorate tle intranational variation over time in the will be overturned. This harsh view is nature of budget processes. Therefore, it probably too extreme, because at least is difficult to compare fiscal policy before some of the variation in state fiscal insti- and after significant institutional reforms. tutions is due to historical accidents Third, while there are differences across rather than current fiscal policy tastes. countries in fiscal institutions, many ana- lysts are hesitant to draw strong conclu- This paper consrders the nature of bal- sions from cross-national comparisons be- anced budget requirements in the U.S. cause it is difficult to hold constant other states and explores what lessons, if any, factors that may affect fiscal policy. the state-level experience holds for dis- cussions of a federal balanced budget *Massachusetts Institute of Technology and Natlonal Bureau of amendment. It emphasizes that most Economic Research, Cambndge, MA 02139-4307 such requirements are substantially differ- 329 ent from those currently being discussed state borrowing, and thelperception of at the federal level. In particular, virtually capital market participants with respect to all states allow some types of borrowing state fiscal health. This dibcussion also to be used in budget balancing, most considers the interaction between bal- states apply the balanced budget rule to anced budget rules and tax and expendi- only part of their budget, and there are ture limits (TELs), because some proposals virtually no formal provisions for enforc- for balancing the federal budget combine ing state balanced budget rules. anti-deficit rules with prolisions that re- semble state TELs. The thlird section is a These limitations notwithstanding, evi- bnef conclusion. dence on the effects of state balanced budget institutions is relevant for the STATE BALANCED BUDFET RULES broader question of whether fiscal institu- tions can affect fiscal policy outcomes. Most state constitutions prevent state The view of fiscal institutions that is im- governments from running deficits in plicit in most empirical public finance re- their general operating budgets, but the search on the demand for state and local nature and scope of these limits varies government services holds that these in- widely across states. Only one state, Ver- stitutions are simply “veils” that do not mont, has no balanced budget require- affect spending outc:omes. Studies in this ment. This section drawsupon recent tradition model the demand for spending summaries of state budgeting rules by as a function of median income, the af- the National Association of State Budget ter-tax price of raisinig revenue, derno- Officers (NASBO) (1992) and the U.S. graphic variables, and similar factors, but General Accounting Office (GAO) (1993) exclude variables describing the budget- to highlight several key features of bal- ing or legislative environment. Yet the anced budget requirements in the U.S. preponderance of evidence from empiri- states. cal studies of fiscal institutions and budget outcomes suggests that tightly What Does Budget Ba/@nce Mean? drawn anti-deficit rules, especially when The balanced budget requirements in the cloupled with limits on government bor- 49 states with such requ’rements can be rowing, induce smaller deficits and more I broadly categorized into three groups, rapid adjustment of taxes and spending depending on the stage in the budget to unexpected fiscal shortfalls. This evi- process at which balance is required. This dence suggests that modifying the federal categorization draws on the survey of budget process has the potential to affect budget practices by the NASBO (1992). federal fiscal policy. First, in 44 states, the governor must sub- This paper is divided into three parts. The mit a balanced budget. This is the weak- first describes the nature of current state est of the various balanced budget re- balanced budget rules. It devotes particu- quirernents. Second, 37 states impose a lar attention to mechanisms that states stricter standard, requiring that the legis- use to satisfy their balanced budget re- lature enact a balanced budget. Balanced quirements, such as borrowing, transfer budget rules of this type nevertheless al- elf funds across accounts, and retiming low for actual revenues and expenditures various income and expenditure flows. to diverge from balance if realizations dif- The second section summarizes previous fer from expectations. In many states that empirical evidence oIn how balanced require passage of a balanced budget, bludget institutions affect state deficits, the actual budget for the year may be in 330 I BALANCED BUDGET RULES AND FISCAL POLICY deficit and the state can borrow to carry of their spending was affected by these this deficit forward to future years. The rules, nine states reported that 50 to 75 third and strictest type of balanced percent of spending was affected, and budget rule combines a requirement that the remaining states with balanced the legislature enact a balanced budget budget rules indicated that these rules with a prohibition on deficit carry-for- applied to at least 75 percent of their ward. This is the situation in 24 of the 37 state spending. states that require the legislature to enact a balanced budget. Such stringent anti- New Taxes and Spending Cuts, or deficit rules are more common in small Budget Gimmicks? than in large states; seven of the ten larg- States that face budget deficits at some est states allow deficits to be carried for- stage of their budget process have three ward to subsequent years. options for closing such deficits. They can How Much of the Budget Must Be raise taxes, reduce spending, or change Balanced? “budget execution” to close the apparent deficit. Proponents of balanced budget An important difference between existing rules typically assume that these rules will state balanced budget rules and recent lead to tax increases or spending cuts, proposals at the federal level is that state while skeptics argue that balanced rules frequently apply to only part of the budget targets will be met through ac- budget. The general fund, or state oper- counting changes or various budgeting ating budget, is almost always subject to gimmicks. The state experience suggests a balanced budget rule. In 48 of the 49 that while some cosmetic changes are states classified by NASBO (1992) as hav- used to meet balanced budget require- ing balanced budget rules, these rules ap- ments, these changes are quantitatively ply to the general fund. Such rules are less important than tax increases and less likely to apply to special funds (34 spending cuts. states), such as those with earmarked tax receipts or those used to fund particular States can use a wide range of account- programs such as intergovernmental aid, ing changes and related techniques to capital spending funds (33 states), and satisfy balanced budget rules. The GAO’s trust funds (30 states) such as those for (1985) study provides several examples of highways or some social insurance pro- the changes that were used to satisfy grams. In some cases, particularly with re- budgetary targets in the early 1980s. Cal- spect to the capital account, funds raised ifornia transferred revenues from an oil by issuing long-term debt can be included extraction royalty tax from a trust fund to in the revenue flow that balances the the general fund; New York State adop- budget. ted a new payroll system to shift its last payroll payment from fiscal year 1983 These statistics on the applicability of into the next fiscal year; Minnesota accel- state balanced budget rules suggest two erated tax collections to move receipts conclusions. First, balanced budget rules across fiscal years. typically apply to more than just the state operating budget. Second, there is sub- The GAO’s (1993) survey of state budget- stantial variation across states in the frac- ing collected information on the dollar tion of state spending that is likely to be value of various accounting changes that affected by balanced budget rules. In the states used to meet balanced budget tar- NASBO (1992) survey, three states re- gets. Twenty-five states reported that ported that between 25 and 50 percent they had faced prospective deficits during 331 a recent budget enactment period and BALANCED BUDGET R~ULESAND had taken actions to close these deficits. FISCAL POLICY OUTCOMES Nearly half (49 percent) of the deficit re- duction was achieved through spending Existing research has fo used on the ef- cuts, another 32 percent through revenue fects of balanced budg ,’ t rules on the size Increases, and the remaining 19 percent and persistence of state’ budget deficits.
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