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Balanced Budget Rules and Unintended Consequences

by Matt Mitchell on July 21, 2011

in Institutions

In my view this is one reason of many why a balanced budget amendment is not a workable path toward fiscal conservatism.

That is Tyler Cowen’s take on my paper with Noel Johnson and Steven Yamarik. I can certainly see why he might come to this conclusion.  We find that when Democratically-controlled states face a binding constraint on their ability to carry a deficit over from one year to the next, they may regulate more instead. A friend of mine calls this the “muffin-top” problem: belt-tightening can sometimes lead to unsightly bulging…elsewhere.  In spite of the muffin-top problem, I am actually still an advocate of a balanced budget amendment at the federal level.

Though I often marvel at the fiscal irresponsibility of state governments, I can’t help but feel that if the states and the federal government were in some sort of fiscal beauty contest, the states would easily come in 1st through 50th while the federal government would come in 51st.  Consider:

  • Collectively, state and local governments are in debt to the tune of about 2.6 trillion dollars, while the federal government has racked up nearly 4 times that amount.
  • The states have accumulated $9.9 trillion in unfunded obligations that will come due over the next several decades.  The Feds, meanwhile have accumulated 5 to 10 times this amount (depending on whether you agree with Medicare’s chief actuary that the current political path is highly unlikely).
  • Most states manage to balance their operating expenses (some gimmickry aside) on an annual or biannual basis. In contrast,
    for the last 80 years, the federal government’s norm has been to run an annual operating deficit (with deficits about 85 percent of the time).
  • When states do borrow, it is typically for long-term capital projects (again, some gimmickry aside).  So future generations are on the hook for bridges and buildings that they, too, will use. In contrast, the Feds don’t even pretend to borrow for future projects; much of what my daughter’s generation will pay for is my generation’s consumption.
  • When states encounter budgetary problems, they tend to deal with them by cutting spending rather than raising taxes.

All of this is somewhat surprising given the fact that, constitutionally, the states were given a blank check whereas the feds were not. As Madison put it in Federalist 45:

The powers delegated by the proposed Constitution to the federal government, are few and defined. Those which are to remain in the State governments are numerous and indefinite.

So why, given so much more (constitutional) power than the feds, do the states seem to manage their affairs more-responsibly? Tiebout competition and the lack of a central bank likely play a role. But I believe the fact that every state but Vermont has to balance its books each year must account for a large share of this relative fiscal probity.  As James Buchanan and Richard Wagner argued over 30 years ago, the ability to buy items for today’s generation while putting the tab on tomorrow’s generation creates a systematic bias in favor of irresponsible spending. In contrast, they argue:

The restoration of the balanced-budget rule will serve only to allow for a somewhat more conscious and careful weighting of benefits and costs. The rule will have the effect of bringing the real costs of public outlays to the awareness of decision makers; it will tend to dispel the illusory “something for nothing” aspects of fiscal choice.

I believe the evidence supports this claim.  David Primo (2003) and Mark Crain (2003) find that states with a strict balanced budget requirement tend to spend less than other states.  Shanna Rose (2006) finds that states with strict balanced budget requirements tend not to experience a political business cycle in which government spending rises just prior to an election and falls shortly thereafter. Bohn and Inman (1996) find that states with strict balanced budget requirements tend to have larger General Fund surpluses and larger rainy day funds.

In our paper we find that stricter balanced budget rules tend to constrain partisan fiscal outcomes.  The fact that they may lead to bulges in the regulatory state is, indeed, unfortunate.  But in my view, that suggests that we should also examine biases in the political economy of regulation and consider institutional reform to address those as well.  Perhaps there is need for a more-conscious weighing of the benefits and costs of regulation?  If belt-tightening leads to muffin-tops, maybe we need more than a balanced budget amendment?  Perhaps spanxs?

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