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 discussions 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 institutions 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 reduction 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. through “other actlons” such as account- This section summarizes this work, focus- ing changes. In addition, 32 states re- ing first on fiscal actionsi, then on state borrowing behavior, an finally on the ef- [ported that they had faced prospective 6 deficits after budget enactment and had feet of fiscal institutions’on the interest taken actions to close these deficits. rates that states face in t he capital mar- Spending cuts accounted for 60 percent ket. of the within-fiscal-year deficit reduction, Balanced Budget Rule! and State revenue increases accounted for 4 per- Fiscal Adjustment cent, and other actions accounted for 36 percent. These other actions included Two recent studies havq examined the drawing down rainy day funds (32 per- link between state balarhced budget recent of the total deficit reduction), inter- quirements and state fi$al policy. Alt and fund transfers (22 percent), short-term Lowry (1994) study ho\hi anti-deficit carry- borrowing (17 percent), deferred pay- over provisions affect th level of state ments (13 percent), and several other taxes and spending, an my own work, changes in budget execution. Accounting Poterba (1994), tests w i ether anti-deficit changes and related actions thus appear rules affect the short-ru tax and spend- to account for a substantial part of fiscal ing adjustments that fol ow from unex- adjustment within the budget cycle, but pected deficits. Each of I hese studies sug- they are not the primary source of longer- gest that anti-deficit rulgs have real term state deficit reduction. effects on state fiscal pc/licy.

Ensuring Compliance Alt and Lowry (1994) a ‘alyze data from the Census of Governm a nts for the pe- Some of the most difficult questions that riod 1968-87. They mo#el state revenue arise in designing a federal balanced and expenditures as a fgnction of current budget rule concern enforcement. On this state income, current feberal grants, point, the state experience is not terribly lagged values of state r venue, state ex- helpful. Gold (1992) notes that most penditures, the lagged ifference be- states have no formal enforcement mech- tween revenues and ex i enditures,, and a anisms for their balanced budget require- set of indicator variablesi for state political ments, and the GAO (1993) reports that circumstances. They conlpare fiscal policy there have never been lawsuits to chal- reactions to disparities ‘etween revenues lenge state budgeting outcomes, even and expenditures, “defi its,” in states though there have been instances when with different political a d institutional budgets failed to balance. The GAO’s configurations. It is imp rtant to recall, as (1985) survey suggested that state policy the foregoing discussio suggests, that makers view tradition, or a history of bal- states can exhibit differ 1 rices between anced budgets, as the pnmary factor en- revenues and expenditu es while still sat- couraging them to maintain budget bal- isfying their balanced b dget require- ance. It is not clear how such experience ments. Alt and Lowry (1:, 94) find that a can be translated to analyze the potential $1 state deficit in the current year trig- effects of federal anti-deficit rules. gers a 77q response, thiough tax increase

332 I BALANCED BUDGET RULES AND FISCAL POLICY or spending reduction, for states that are and tax increases, surpluses are largely Republican-controlled and prohibit deficit used to fund increases in state rainy day carryovers, compared with a 34~ reaction funds. The disparate responses to deficits in states that are Democrat-controlled and surpluses can be viewed as further and have such limits. In states that do not evidence of the impact of state anti-defi- restrict deficit carryovers, the adjustments cit laws, and it also provides some sup- are 31 Q and 404 for Republican and port for previous empirical work suggest- Democratic states, respectively. This em- ing a “flypaper effect” in state and local pirical evidence suggests that state poli- fiscal behavior. tics is an important influence on deficit reduction, and that at least in some politi- My investigation of state reactions to un- cal configurations, variation in anti-deficit expected deficits also considers the effect rules is associated with variation in fiscal of tax limitation laws. These laws vary actions. widely in their provisions. Some limit annual tax increases to a fixed fraction of In Poterba (I 994), I study how state bal- previous taxes or of contemporaneous in- anced budget rules affect the way state come growth, while others require legis- fiscal policies responded to unexpected lative supermajorities or popular refer- deficits or surpluses. My analysis considers enda to enact tax increases. States with both within fiscal year adjustment, tax limitation rules enact smaller tax in- through spending cuts or tax increases, as creases in response to unexpected deficits well as adjustment in the next fiscal year. than do states without such limits. These Unexpected deficits could be the result of results confirm Crain and Miller’s (1990) tax revenues below projections or of finding that taxes grew less between spending in excess of projections. I ana- 1979 and 1986 in states with tax limits lyze how an indicator variable for states than in states without such limits. More with “weak antideficit rules,” as classified generally, the finding that state tax limita- in the Advisory Commission on Intergov- tions matter is consistent with several ernmental Relations (ACIR) (1987) study studies, including those of Dye and Mc- on fiscal stringency, is related to state re- Guire (1995), Elder (1992), lchniowski actions to fiscal shocks. and Preston (I 991>, and Poterba and My results, which are based on the 27 Rueben (1995), which conclude that local continental states with annual budget cy- property tax limits have real effects in re- cles, suggest that states with weak anti- ducing the growth rate of local revenues. deficit rules adjust spending less in re- These studies buttress the central conclu- sponse to unexpected deficits than do sion that fiscal institutions have real ef- their counterparts with strict anti-deficit fects on fiscal policy outcomes. rules. A $100 deficit overrun leads to only a $17 expenditure cut in a state with a Balanced Budget Rules and State weak anti-deficit law, while it leads to a Borrowing $44 cut in other states. I do not find any In addition to the evidence on how bal- evidence that anti-deficit rules affect the anced budget rules affect tax and spend- magnitude of tax changes in the after- ing policies, there is also some evidence math of an unexpected deficit. on how these rules and debt limitation My analysis of state fiscal adjustment also laws affect the level of state indebted- suggests that states adjust asymmetrically ness. Von Hagen (1991) compares the to unexpected deficits and surpluses. level of state general obligation debt, per While deficits are met with spending cuts capita and relative to state income, in

333 states with and without stringent bal- Balanced Budget Rulef and the anced budget requirements. His index of Municipal Bond Market budgetary stringenc:y is the ACIR (1987) index described above. His findings sug- An ingenious line of res$arch developed gest that general obligation indebtedness by Goldstein and Woglo(m (1992), and is substantially lower in states with strin- subsequently extended t/~yBayoumi and gent balanced budget amendments than Woglom [(I 995) and Loqry and Alt (1995) in other states. He also explores the effect tests whether the interegt rates at which of stringent balanced budget rules on the states can borrow funds~ are a function of ratio of non-full faith and credit to full state fiscal institutions. This literature is of faith and credit debt across states. States Interest for two reasons., First, because with more stringent deficit limits, as well capital markets are one of the institutions as states with lower general obligation that may discipline state! when they pur- debt limits, exhibit higher levels of reve- sue lax fiscal policies, studying how fiscal nue debt and other debt that is not Institutions affect borrowing rates can backed by the full faith and credit of the provide evidence on whether this discipli- state. These results are consistent with nary Idevice is operative. Second, borrow- Ejunche’s (1991) demonstration that ing rates provide a unique market-based states with tighter debt limits or balanced measure of prospective ftate fiscal perfor- budget rules are more likely to use public manc:e. There are a range of data prob- authorities and other alternatives to state- lems that make it difficu~lt to evaluate the backed borrowing to finance various pro- results of empirical analyses of how taxes jects. and spending are relate4 to fiscal institutions, precisely because differences in ac- A related analysis of the real effects of counting practices may ffect the re- antideficit rules and related limits on state ported statistics. lnteres s”rates are subject borrowing is Kiewiet and Szakaly’s (1992) to no such measuremen/t problems and study. It analyzes whether state constitu- therefore provide a less Brbitrary measure tional debt limits have any effect on total of fiscal policy outcome$ The drawback state indebtedness or on the composition of studying interest ratef is that they can of this debt. The only institution that the be affected by many facjtors other than authors find to be. highly negatively corre- fiscal Institutions, includilng state fiscal lated with state indebtedness is a require- history and economic prbspects. ment that state debt be approved by popular referendum. This suggests that a Several recent studies hqve explored the combination of a stringent anti-deficit link between fiscal institbtions and bor- rule and a requirement that debt be ap- rowing rates, with partidular attention to proved by the voters is likely to bring the role that balanced bkdget rules play pressure for tax increases or spending in this process. Goldsteiq and Woglom cuts, rather than debt finance, in re- (1992) relate the interesb rate on general sponse to state deficits. This evidence is obligation debt to the A~CIRindex of state also consistent with the findings reported limits on deficits described above. Their above on the effect of tax limitation laws. results, which also contrlol for the level of Constitutional or legislative provisions state indebtedness and the observed t:hat make it more costly to balance the state deficit, suggest th;it a state with the budget in a given fashion, by raising taxes most restrictive set of f&al limits faces an or by issuing long-term debt, appear to interest rate 0.05 perceitage points lower have real effects in discouraging these fis- than a state with an avqrage set of limits. cal actions. Lowry and Alt (1995) show that the bond

334 I BALANCED BUDGET RULES AND FISCAL POLICY market reaction to a state deficit projec- ity view, or to reject it. One argument tion depends on whether the state has a against this view is that several of the balanced budget requirement. States with studies described above have controlled balanced budget rules experience smaller for some measure of state voter prefer- increases in their borrowing costs for a ences, such as the political party of the given deficit. governor or the legislature, so they in- clude at least crude proxies for voter pref- These results are important in the current erences. Other work in a similar vein, context because they suggest that capital such as my study, Poterba (1995>, of how market participants, who have strong in- capital budgeting institutions affect state centives to monitor and evaluate state fis- capital spending, adds controls for the cal performance, consider the presence of fraction of the state voting for each par- anti-deficit rules relevant in evaluating ty’s presidential candidate in recent elec- state fiscal conditions. They also represent tions, again without changing the meas- a first step toward a normative analysis of ured effect of fiscal institutions. whether states benefit from adopting anti-deficit rules, since such rules involve A second defense of the exogeneity of a trade-off between flexibility in respond- budget institutions draws on the history ing to fiscal shocks and a commitment to of these institutions, summarized, for ex- long-term fiscal responsibility. ample, in Kiewiet and Szakaly (1992). Many of the constitutional limits on state CONCLUSIONS AND INTERPRETATION deficits were enacted in the nineteenth century; whether these rules reflect the The range of budgetary institutions across preferences of current state residents is the states in the United States provides a an open issue. The more difficult it is to rich opportunity to study the effects of make changes in state constitutions, the these institutions on fiscal policy. The more valuable the cross-state variation is studies surveyed in this paper suggest in identifying the effect of these institu- that there are correlations between state tions on fiscal policy. balanced budget rules and state fiscal policy. The critical question for policy While these difficulties of interpretation evaluation is how to interpret these corre- prohibit strong conclusions, the available lations. It is possible that they simply re- evidence suggests that changes in budget flect a correlation between fiscal disci- processes and in the rules affecting the pline, fiscal institutions, and an omitted dynamics of taxes and expenditures can third variable, voter tastes for fiscal re- affect fiscal policy outcomes. The view straint. Voters in some jurisdictions may that these fiscal institutions are simply a be less inclined to borrow to support cur- veil, pierced by voters and their elected rent state outlays and to use deficits to representatives, appears to be dominated shift the burden of paying for current by the richer view suggesting that fiscal state programs to the future. If these vot- institutions mediate the link between ers are also more likely to support legisla- voter tastes and policy outcomes. While tive or constitutional limits on deficit fi- this does not imply that all potential re- nance, then the observed link between forms in the federal budgetary process fiscal rules and fiscal policy could be spu- would have real effects, it suggests cau- rious. tion in dismissing them as irrelevant institutional reforms that are likely to change It is difficult to provide definitive evidence accounting practices more than taxes and in support of this institutional endogene- expenditures.

335 ENDNOTES Masson, 228-69. Cambridbe: Cambridge Uni- versity Press, 1992. l I am grateful to the National Science Foun- Ichniowski, Casey and Anne E. Preston. “A dation for research support, and to Steve National Perspective on the Nature and Effects Gold, Sunny Ladd, Matthew McCubbrns, of the Local Property Tax Revolt.” National Tax and Kim Rueben for helpful discussions. Journal44 No. 2 (June, 1991): 123-46. REFERENCES Kiewiet, D. Roderick and Kristin Szakaly. “The Efficacy of Constitutional Restrictions on Advisory Commission on Intergovernmen- Borrowing, Taxing, and Spending: An Analysis tal Relations. Fiscal Disciplrne in the Federal of State Blonded Indebted ess, 1961-90.” Cali- System: National Reform and the Experience of fornia Institute of Technol 1 gy. Manuscript, the States. Washington, D C.: ACIR, 1987. 1992. Alt, James E. and Robert C. Lowry. “Divided Lowry, Robert C. and la es E. Alt. “A Visi- Government and Budget Deficits: Evidence ble Hand? Inter-temporal E? ficiency, Costly In- from the States.” American Political Science formation, and Market-Based Enforcement of Review 88 (December, 1994): 81 l-28. Balanced Budget Laws.” Hbrvard University De- Bayoumi, Tamin and Geoffrey Woglom. partment of Government. Mimeo, 1995. “Do Credit Markets Discipline Sovereign Bor- National Association of State Budget Offi- rowers: Evidence from U.S. States.” burnal of cers. State Balanced Budget Requirements: Money, Credit and Bankin!g, 1995. Provisions and Practice. Washington, D.C.: Bunche, Beverly 5. “The Effect of Constitu- NASBO, 1992. tional Debt Limits on State Governments’ Use Poterba, James M. “State Responses to Fiscal of Public Authorities.” Public Choice 68 (Janu- Crises: The Effects of Bud etary Institutions ary, 1991): 57-69. and Politics.” lournal of Pgo litical Economy 102 Crain, W. Mark and James C. Miller III. (August, 1994): 799-82 1. “Budget Process and Spending Growth.” Wil- Poterba, James M. “Capital Budgets, Borrow- liam and Mary Law Review .3 1 (Spring, 1990): ing Rules, and State Capital Spending.” Journal 1021-46. of Public fconomics 56 (January, 1995): 165- Dye, Richard F. and Therese 1. McGuire. 87. “Impact of Property Tax Ltmitations on Local Poterba, James M. and Kim 5. Rueben. Governments: Evidence from the Chicago Met- “The Effect of Property Tax Limits on Wages ropolitan Area.” University of Illinois Institute and Employment in the Local Public Sector.” of Government and Public Affairs. Mimeo, American Economic Review 85 (May, 1995): 1995. 384-9. Elder, Harold W. “Exploring the Tax Revolt: Riker, William. “Implications for the Disequi- An Analysis of the Effects of Tax and Expendi- librium of Majority Rule for the Study of Insti- ture Limitations.” Public Finance Quarter/y 20 tutions.” American Political Science Review 74 (June, 1992): 47-63. (1980): 432-46. Gold, Steven D. “State Government Experi- U.S. General Accounting1 Office. Budget Is- ence with Balanced Budget Requirements: Rel- sues: State Balanced Budget Practices. GAO/ evance to Federal Proposals.” Testimony before AFMD-86-22BR. Washington, D.C., 1985. U.S. House of Representatrves, Budget Com- U.S. General Accounting1 Office. Balanced mittee. Washington, ID.C., May 13, 1992. Budget Requirements: Stare Experiences and Goldstein, Morris and Geoffrey Woglom. Implications for the Federal Government. GAO/ “Market-Based Fiscal Discipline in Monetary AFMD-93..58BR. Washington, D.C., 1993. Unions: Evidence fronn the U.S. Municipal Bond von Hagen, Jurgen. “A Note on the Empirical Market.” In Establishjng a Central Bank: issues Effectiveness of Formal Fiscal Restraints.” Jour- in Europe and Lessons from the United States, nal of Public Economics 44 (March, 1991): edited by M. B. Canzonen, V. Grilli, and P. R. 199-210.

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