State Budget Gaps and State Budget Growth: Between a Rock and a Hard Place

Abstract

For the past two fiscal cycles, states have grappled with unprecedentedly large budget gaps. By the simple arithmetic of fiscal policy, these gaps can be closed with budget cuts or revenue increases. An important question for the policy maker is: Which of these two courses of action is likely to spur further budget gaps in future years? In this paper, I examine this question by looking at state policies and institutions in the decades preceding the budget gaps. I find that state governments that spent a larger fraction of state income – and had done so for many decades – experienced smaller percentage budget gaps in FY2010. On the other hand, states whose per capita spending levels increased the most over the last two decades had larger percentage budget gaps in FY2010. Furthermore, states whose policies permit economic freedom and states with strict balanced budget requirements experienced smaller budget gaps. Taken together, these results suggest that spending restraint, economic freedom, and institutional rules that ensure a strict balanced budget requirement seem to be a more reliable path to fiscal balance than tax increases.