State Budgets and the Business Cycle: Implications for the Federal Balanced Budget Amendment Debate

By McGranahan, Leslie | Economic Perspectives, Fall 1999 | Go to article overview

State Budgets and the Business Cycle: Implications for the Federal Balanced Budget Amendment Debate


McGranahan, Leslie, Economic Perspectives


Introduction and summary

A proposal to amend the U.S. Constitution to require that the federal budget be balanced has been a part of the national debate for over 25 years. Following its inclusion as one of the central planks of the Republican Contract with America in 1994, the balanced budget amendment became a prominent item on the congressional agenda. The amendment easily passed the House by a vote of 300 to 132 in January 1995, but failed to achieve the two-thirds majority required in the Senate to send it back to the states. Since the proposal's most recent failure in the Senate, by one vote on March 4, 1997, it has been a less important agenda item because of the strength of the economy and the surplus in the federal budget. However, the issue is by no means dead. In January 1999, the amendment was again proposed in the House with the cosponsorship of 117 representatives.

Balanced budget amendment supporters frequently cite the experience of the states, most of which have statutory or constitutional balanced budget restrictions.(1) In this article, I question how the state experience with balanced budget restrictions can inform the federal debate on a balanced budget amendment. First, I address how the longstanding state restrictions compare with those contemplated at the federal level. I then investigate how state government revenues, expenditures, debt issuance, and asset holdings have responded to changes in the states' economic conditions, as measured by the unemployment rate, during the last two decades. I use regression analysis to ask how, controlling for a time trend and state fixed effects, state finances have reacted to fiscal year state unemployment rates from 1977 to 1997. I further question whether similar responses on the part of the federal government would be either feasible or prudent.

In my investigation of how state finances respond to business cycle conditions, I discover that states use four main mechanisms to maintain budget balances during downturns: they issue more short- and long-term debt; they rely more heavily on the federal government for funds while giving less to local governments; they increase tax rates; and they lower capital spending. This is not a feasible policy combination for the federal government for a number of reasons. Most importantly, the provisions of the balanced budget amendment would not allow the federal government to issue any new debt without a legislative super-majority. In this way, the federal balanced budget amendment differs significantly from the restrictions in place in the states. While the states use the issuance of debt as an important safety valve, this option would not be available to the federal government.

Of course, the opportunity to receive more from a higher level of government would also not be available to the federal government. However, the federal government could follow the states' lead by transferring less money to the states during difficult times. This would reverse the current relationship between federal government intergovernmental spending and the business cycle and would make it more difficult for the state governments to balance their budgets. Importantly, this suggests that one of the reasons that the states are able to balance their budgets is that the federal government does not.

The federal government could follow the states by increasing tax rates during economic downturns. This would be an unpopular policy for two main reasons. First, tax increases are always unpopular and difficult to pass. Second, unlike the state governments, the federal government is responsible for the condition of the macroeconomy. Tax increases during recessions would further depress disposable incomes and consumption and could prolong downturns.

The other state behavior open to the federal government would be to decrease capital spending during economic downturns. States get a lot of leverage out of their ability to cut capital spending during difficult times; my results show that this is among the most pronounced state responses to a deteriorating economic situation. …

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