Statement of Principles on Balancing Budgets Over the Business Cycle

Summary

The states and the federal government are dual sovereigns under the U.S. Constitution, each with different responsibilities. Federal encroachment on state authorities often leaps forward during recessions. That’s when states’ annual balanced budget rules force legislators to choose between sudden, major program changes and federal funding with permanent strings to fill temporary budget gaps. Replacing annual balance with structural balance in the states can reduce recession-driven policy instability, reduce excessive spending growth during booms, and strengthen state sovereignty and the ability to resist Congress’ intrusion into state responsibilities.

Statement of Principles on Balancing Budgets Over the Business Cycle

Statement of Principles

Annual Balance is Disruptive and Creates Uncertainty

Households and businesses benefit from stable and predictable state government services. Yet state spending tends to boom along with the economy, and recessions bring sudden and often substantial spending cuts and revenue increases. Budget adjustments that can be made quickly are not necessarily those that legislators would make with long-term priorities in mind, and they add to the uncertainty facing state residents during recessions. This risk premium can reduce private sector investment and work opportunities during both booms and busts, reducing prosperity for state residents.

Annual Balance Erodes State Sovereignty

Proponents of centralization use recessions to expand federal authority over the states. They claim that only the federal government can stabilize the economy because states can’t borrow. New and expanded spending programs often include strings that exceed the federal government’s proper roles and impinge on state powers. Many state officials refrain from challenging Congress, especially in a crisis atmosphere. These state officials cannot properly check and balance federal encroachment.

Structural Balance Promotes Policy Stability and Strengthens State Independence

Structural balance (details below) can reduce excess spending during booms and minimize sudden changes during recessions. It stabilizes state policies over the business cycle—across booms and busts. It gives bond markets the assurance that state budgets are in long-term health. In the most prudent states, structural balance could mean drawing down and replenishing rainy day funds according to predictable rules.

Liberating states from fiscal dependence on DC helps them to shrug off congressional overreach even during emergencies and to challenge existing strings at any time. It also helps members of Congress hold out for emergency response that respects state authorities.

Structural Balance Helps Bring Shadow Budgets into the Light

Even states with a unified budget often exclude funds and programs from the regular budget process and existing budget controls. This undermines legislators’ ability to manage a state’s public finances coherently and holistically. Off-budget accounts reduce transparency about the states’ fiscal footprint. This special treatment is often meant to insulate programs from the boom-and-bust budgeting that annual balance promotes. Structural balance reduces uncertainty and policy instability, so the risks and costs of integrating all parts of the budget into a state’s formal budget process are substantially lower. Structural balance can help state budgets include all spending and all revenue.

Structural Balance Rules are Straightforward to Design and Implement

Structural balance rules produce a single top-line cap on a year’s spending to start the budget cycle. The cap will be less than revenue during booms and higher during recessions. This smooths out economic volatility while holding spending and revenue together over the business cycle.

  1. Cap spending with a trend in gross state product, total personal disposable income, or a similar metric. The trend is a multi-year period prior to the current year or the budget year. This makes spending and revenue policies stable and predictable despite economic fluctuations.
  2. The spending growth rate slows after each year of deficits and rebounds toward the multi-year average following surpluses. This ensures balance over the business cycle.
  3. Optional: Automatically adjust the spending cap for so-called automatic stabilizers and/or changes in the revenue baseline.

Structural balance should complement—not supplant—rainy day funds.