State Fiscal Policies for Budget Stabilization and Economic Growth: A Dynamic Scoring Analysis

By Merrifield, John; Poulson, Barry W. | The Cato Journal, Winter 2014 | Go to article overview

State Fiscal Policies for Budget Stabilization and Economic Growth: A Dynamic Scoring Analysis


Merrifield, John, Poulson, Barry W., The Cato Journal


Economic downturns expose unsustainable fiscal practices. Widespread fiscal crises create opportunities to compare policy options that address especially adverse circumstances, especially pro-growth fiscal constraints that can stabilize state budgets over the business cycle. Our policy option assessments depart from the normal practice of assessing rules and policies independently. Our premise is that the fiscal policy mix determines its outcomes. We include dynamic scoring to provide a richer view of the policy interactions.

In this article, we assess reforms that address fiscal stress issues. We were driven, in part, by our conviction that stable spending growth over the business cycle curbs fiscal stress-induced pressures to raise taxes and weaken caps on spending growth. To generalize our findings as much as possible, we apply our dynamic scoring model to California, Montana, and Utah--states familiar to us that span the blue state-red state gamut, with Montana in the middle. Utah is "'famously conservative" (Woo 2010), with one of the top business tax climates (Tax Foundation 2011). California's response to fiscal stress included large tax hikes, which helped create one of the worst business climates. With fiscal data and dynamic scoring, we simulate the economic growth and fiscal effects of income tax rate reductions and fiscal rules designed to constrain the growth in state spending and stabilize the budget over the business cycle.

The Fiscal Rollercoaster

In the five years that preceded the still lingering 2007-09 Great Recession, spending growth topped personal income growth in 37 states, including those with fiscal caps more extensive than the balanced budget rule, absent only in Vermont (Poterba 1994, Merrifield 2000). The expansion in those 37 states was enough to achieve a 50-state average spending growth rate 5 percent faster than personal income growth. Large budget deficits and fiscal crises arose when the Great Recession sharply cut revenues (Chapman 2009, Eaton 2009, Kalita 2009, Vock et al. 2009). Legislators could not sustain the good times' rapid spending growth achieved, in part, by overriding their statutory tax and expenditure limits (Stansel and Mitchell 2008).

A key reason for rapid state spending growth has been widespread use of personal income growth to define fiscal discipline (Shadbegian 1996, Waisanen 2010). An income growth-based cap is a convenient, politically comfortable limit when economic growth is normal, but uncomfortable when persona/income growth is modest, and a crisis when growth is negative, as it has been recently (Schunk and Woodward 2005, Wagner and Elder 2005). Fiscal instability and uncertainty seem to accelerate spending growth (Holcombe and Sobel 1997). Fiscal crises can be primary agents of tax hikes that typically survive into future high-growth periods; a process that ratchets spending upward over successive iterations of the business cycle. Fiscal stress also spills over into off-budget spending (Bennett and DiLorenzo 1982, Merrifield 1994), and into on-budget funding substitutes such as regulation and more responsibility for local governments.

Tax and Expenditure Limits

Early studies of tax and expenditure limits (TELs) found evidence that they had only a small effect on state budgets. (1) But more recent studies provide evidence that TELs can effectively constrain the growth in state spending (2) TELs that link spending growth to personal income are often nonbinding, and for binding TELs, the instability of personal income growth erodes support for TELs by creating periods of costly fiscal instability and uncertainty. (3) Eeonomic conditions and the phase of the business cycle are key determinants of the effectiveness of TELs. For example, they seemed to be more binding in low-income states. Florida introduced a tax and expenditure limit in the recession phase of the business cycle that was never binding. The cap rose more rapidly than actual growth in state revenue. …

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