Balanced Budget Requirements Research Articles

Fiscal Rules and the Scope for Stabilisation Policy – The Case of Sweden

Yngve Lindh and Gosta Ljungman focus on the scope for stabilisation policies in the context of the strict Swedish fiscal framework, characterized by three mutually supportive elements: a surplus target for general government, a multi annual nominal expenditure ceiling for the central government and a balanced budget requirement for local governments. The surplus target is set as an average over the business cycle, allowing for countercyclical fiscal policy through both automatic stabilizers and discretionary measures, albeit with the constraint that expansionary policies should be offset during a later phase of the same cycle. The authors propose to use an average of net lending based on both past- and forward looking data to assess whether the annual target is in line with the surplus target for the cycle. In order to absorb any unexpected increase in expenditure, the government has to set the relevant figures at a level lower than the ceiling. Nevertheless, the margin thus created to mitigate temporary increases could actually be used to expand expenditure permanently. So the authors suggest setting expenditure at a level close to the ceiling. Accordingly, the government has to plan expenditure cuts for future years to make sure that uncertainty can be managed within the ceiling.

Budgetary policies in a DSGE model with finite horizons

This paper presents a dynamic stochastic general equilibrium model with nominal rigidities, capital accumulation and finite horizons. Our New Keynesian framework exhibits intergenerational wealth effects and is intended to investigate the macroeconomic implications of fiscal policy, which is specified by either a debt-based tax rule or a balanced-budget rule allowing for temporary deficits. The model predicts that fiscal expansions generate a trade-off in output dynamics between short-term gains and medium-term losses. It is shown that the effects of fiscal shocks crucially depend upon the conduct of monetary policy. Simulation analysis suggests that balanced-budget requirements enhance the determinacy properties of feedback interest rate rules by guaranteeing inflation stabilization.

A Balanced Budget Amendment: What Can We Learn From State Experience?

On its current course, United States fiscal policy threatens to hobble the nation's prospects for economic growth. Economic theory suggests that an important source of the problem is the government's ability to purchase services for current voters with taxes levied on future generations. A balanced budget requirement, by internalizing both the costs and benefits of government services, would therefore seem to be a natural solution. In this testimony, I summarize the scope of the fiscal problem and then review state-level evidence to consider the ways that a federal balanced budget amendment might impact the nation's fiscal and economic future.

Fiscal stringency and fiscal sustainability: Panel evidence from the American state and local governments

Most state (and local) governments in the U.S. operate under formal fiscal rules which limit their ability to run budget deficits and resort to debt financing. A priori, one would expect to find evidence in favor of an intertemporally balanced budget, or fiscal sustainability, for these states, especially those characterized by a relatively high degree of fiscal stringency. We test this hypothesis for a panel of 47 state–local government units (1961–2006) using four budget balance definitions and several subsamples defined based on regional classifications, or presence of certain balanced budget requirements (BBRs). Our results, obtained from panel estimation techniques that allow for general forms of serial and cross-sectional dependence, suggest that a sufficient condition for “strong” sustainability is consistently satisfied for the full sample and all subsamples in relation to balances that include special funds and/or federal grants. However, we find evidence consistent with the “weak” version of sustainability for the full sample and some regional subsamples (particularly Far West dominated by California) in at least one of the two balances that exclude these items. Finally, the BBRs seem to matter only in relation to the sustainability of the more narrowly defined balances. We discuss the implications of these findings for the role of fiscal rules and federal grant policies.

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

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.

State Balanced Budget Requirements and Macroeconomic Volatility

State Balanced Budget Requirements and Macroeconomic Volatility

Best in class: Public finances in Sweden during the financial crisis

This paper studies why public finances in Sweden have remained very strong during the current financial crisis. Unlike almost all other European countries, Sweden has had budget surpluses and a government debt ratio around 40 percent of GDP during the recent crisis. We attribute this to two important factors. First, Sweden entered the crisis with strong public finances and second that unemployment did not rise as much as normally during recessions. The Swedish fiscal framework that was introduced after the banking crisis in the early 1990s with expenditure ceilings, a top-down budget process, balanced budget requirement for local governments has played an important role. We show that the behavior of budget deficits has changed significantly recently, from a deficit bias to a surplus bias. Aggregate demand remained strong during the crisis even though exports fell sharply. As unemployment in the manufacturing sector increased, it was to a large extent offset by increased employment in the service sector.

Budgetary Policies in a DSGE Model with Finite Horizons

This paper presents a dynamic stochastic general equilibrium model with nominal rigidities, capital accumulation and finite horizons. Our New Keynesian framework exhibits intergenerational wealth effects and is intended to investigate the macroeconomic implications of fiscal policy, which is specified by either a debt-based tax rule or a balanced-budget rule allowing for temporary deficits. The model predicts that fiscal expansions generate a tradeoff in output dynamics between short-term gains and medium-term losses. It is shown that the effects of fiscal shocks crucially depend upon the conduct of monetary policy. Simulation analysis suggests that balanced-budget requirements enhance the determinacy properties of feedback interest rate rules by guaranteeing inflation stabilization.

State Dependent Unemployment Benefits

Optimal design of unemployment insurance is considered in a search setting where the state of nature (business cycle) affects the unemployment risk and thus the return to search. The incentive effects or distortions of individual job search arising due to the unemployment insurance scheme are crucial for optimal policies, so is the scope for risk diversification that depends critically on whether the balanced budget requirement applies to each state of nature or across states of nature. In the former case a basic budget effect tends to cause optimal benefits to be procyclical. If risk diversification across states of nature is possible, the fact that incentives are more distorted in good than bad states of nature tends to make both benefits and contribution rates countercyclical. It is shown that countercyclical benefits exacerbate employment fluctuations but increase average employment by aligning benefits more with states of nature where the incentive costs are small.

Do state balanced budget requirements matter? Testing two explanatory frameworks

Balanced budget requirements (BBRs) affect all aspects of financial operations. Previous studies relied on characterizations that highlight a constitutional-statutory distinction. Hou and Smith (Public Budgeting & Finance 26(3):22–45, 2006) instead propose a political-technical construct. This article uses probit estimation, six measures of balance, and long panels to test which framework offers more explanatory power. The findings suggest that BBRs matter to varying degrees. Technical requirements exert bigger effects than political ones, the effects are more obvious on narrower than broader measures of balance and in the later phases of the budget cycle, and the political-technical construct offers more explanatory power than the constitutional-statutory distinction.

Informal Norms as a Bridge between Formal Rules and Outcomes of Government Financial Operations: Evidence from State Balanced Budget Requirements

Both formal rules and informal norms guide government operations; formal rules often function through informal norms. Balanced budget requirements (BBRs) are formal rules, but they are implemented via the intermediary of informal norms—interpretation of BBRs by state officials. This article examines the fiscal implications of informal norms that govern budgetary balance. We propose that informal norms have substantive implications in policy making and implementation. To test the proposition, we obtain state self-reported, time-varying data on balanced budget provisions as observations of informal norms, compare them against formal, codified balanced budget requirements from recent research to identify gaps between rules and norms, and decompose the gaps using two categories—“interpretations” and “reverse interpretations” of formal balanced budget requirements. We then conduct probit estimation to obtain the effects of informal norms as well as the interpretations and reverse interpretations on two measures of budgetary balance. Results show that informal norms do affect outcomes of government financial operations; the two-step decomposition of the gaps between formal rules and informal norms provides further information on the locus of these effects. The article identifies the interpretation of formal rules as a new research area, thus contributing to the budgetary institutions and policy implementation literatures.

A better budget rule

AbstractDebt limits, interest coverage ratios, one‐off balanced budget requirements, pay‐as‐you‐go rules, and tax and expenditure limits are among the most important fiscal rules for constraining intertemporal transfers. There is considerable evidence that the least costly and most effective of such rules are those that focus directly on the rate of spending growth, even with their seemingly ad hoc nature and possibilities for circumvention. In this paper, we use optimal control theory and martingale methods to justify a transparent, nonarbitrary rule governing maximum sustainable rate of spending growth, treating the revenue structure of a jurisdiction as a given continuous‐time stochastic process. Our results can be used to determine whether a proposed rate of spending growth is sustainable or not. © 2009 by the Association for Public Policy Analysis and Management

State Saving Behavior: Effects of Two Fiscal and Budgetary Institutions

This paper explores how state saving behavior is affected by two fiscal/budgetary institutions—budget stabilization funds (BSF) and balanced budget requirements (BBR). While adopted for different reasons, BSF and BBR could have significant effects on state savings behavior depending on their design features. We empirically examine the effects of BSF and BBR using a panel data set that covers three business cycles, controlling for budgetary institutions, state economy, social services, politics, and business cycles. The paper finds that adopting BSF and BBR can raise savings by 2 and 3 percentage points, respectively; however, the effects depend crucially on the devices' design.

An Examination of the Effects of Budgetary Control on Performance: Evidence from the Cities

According to government statistics, at the end of June 2006, there was over $7 trillion of corporate, state, and local government, asset-backed structured finance bonds outstanding with much of it rated by only a (literal) handful of bond rating companies that establish creditworthiness of corporate entities and of governmental units. Linking bond ratings to performance is important particularly in a governmental setting where credit ratings remain a key feature of municipal debt management, and debt is the key source of capital. Yet we know little about the direct linkage between budgetary control and ultimate bond ratings in this setting. In this study, we examine whether budgetary control is associated with performance, using a sample of large U.S. cities over the 2003-04 timeframe. Subject to the same general legal and regulatory constraints, these cities exhibit tight budgetary control at the organizational level, in large part due to the balanced budget requirements. Within this unique context, we examine whether tightness of budgetary controls or effective level of budgetary control within the cities, as measured by budget variances, contribute to performance, as measured by bond rating. We find that the effective level of budgetary control is significantly and positively related to bond rating, refuting a common, but unfounded, assumption that tight budgetary control is the most effective level of budgetary control. This suggests that city mangers interested in maintaining or improving their municipal bond ratings to manage debt costs may consider paying closer attention to the effective level of budgetary control within the cities, as measured by budget variances.

State Budgetary Processes and Reforms: The California Story

This paper analyzes state budgetary processes and reforms to inform California budgetary policy. We consider key institutional provisions, including budget periodicity, tax and expenditure limitations, balanced budget and reserve requirements, and supermajority vote requirements, and analyze the extent to which changes are likely to advance procedural norms. Our analysis suggests that empirically unproven assumptions and poorly articulated linkages between budgetary processes and outcomes have undermined the state's ability to understand the budgetary problem and identify effective reforms. We recommend a focus on procedural norms and related reforms that promote effective budgeting processes as a less partisan framework for reform.

State Saving Behavior: Effects of Two Fiscal and Budgetary Institutions

This paper explores how state saving behavior is affected by two fiscal/budgetary institutionsbudget stabilization funds (BSF) and balanced budget requirements (BBR). While adopted for different reasons, BSF and BBR could have significant effects on state savings behavior depending on their design features. We empirically examine the effects of BSF and BBR using a panel data set that covers three business cycles, controlling for budgetary institutions, state economy, social services, politics, and business cycles. The paper finds that adopting BSF and BBR can raise savings by 2 and 3 percentage points, respectively; however, the effects depend crucially on the devices' design.

A Framework for Understanding State Balanced Budget Requirement Systems: Reexamining Distinctive Features and an Operational Definition

Studies of state fiscal and budgetary policies often use balanced budget requirements (BBRs) as explanatory variables. While current measures laid the crucial groundwork for a basic understanding of state BBRs, their lack of comprehensiveness threatens the validity of empirical work. Based on comprehensive legal research, this article offers a framework for analyzing state requirements: each state's BBRs form a coherent system for achieving budget balance through budget cycles; a fully developed BBR system offers a three‐line construct against imbalance; and the more complete, developed, and explicit a BBR system is, the more stringent it will be in achieving budgetary balance.

The Jamaican Parliament and Public Spending

This paper presents a Jamaican dynamic political economy theory of public spending, taxation and debt. Policy choices are made by a Jamaican legislature consisting of representatives elected by geographically-defined areas. The legislature can raise revenues via a distortionary income tax and by borrowing. These revenues can be used to finance a Jamaican national public good and area-specific transfers (interpreted as Jamaican pork-barrel spending-scarce benefits and spoils). The value of the Jamaican public good is stochastic (non-deterministic), reflecting shocks such as civil disturbances or natural disasters such as hurricanes or earthquakes or floods. In equilibrium, Jamaican policy-making cycles between two distinct regimes: 1. BAU business-as-usual in which legislators bargain over the allocation of scarce benefits and spoils and 2. RPM responsible-policy-making in which policies maximize the collective good of the Nation. Transitions between the two regimes in Jamaica are brought about by shocks in the value of the public good. In the long run, equilibrium tax rates are too high and too volatile, public good provision is too low and debt levels are too high. In Jamaica, a balanced budget requirement could improve citizen welfare.

Starving the beast? Intra-generational conflict and balanced budget rules

A balanced budget requirement does not only prevent fiscal policy makers from smoothing tax distortions but also affects their preferred choice of government spending. The paper analyzes the conditions under which groups opposed to government spending might want to implement a balanced budget requirement in order to induce the government to spend less. It shows that relaxing a balanced budget requirement need not be associated with higher government spending.

Fiscal Rules: Useful Policy Framework or Unnecessary Ornament?

With the primary objective of conferring credibility on macroeconomic policies, an increasing number of advanced and emerging market economies have adopted various forms of fiscal rules (mainly balanced-budget requirements and debt limits). In contrast to previous fiscal rules, many of which lacked transparency, recently introduced rules have the potential of serving as a useful depoliticized policy framework, and over time, can contribute to stability and growth. To this end, they need to be well designed and supported by an appropriate institutional infrastructure.