Is a Good Normative Model of Public Spending Run Backward a Good Positive Model?

Abstract

We test a positive model of government spending and savings, where jurisdictions seek to stabilize spending growth and where revenue growth and savings are assumed to be continuous‐time stochastic processes, the Dothan–Thompson optimal budget model. Our empirical tests address two reduced‐form specifications derived from this model, each applied to two different subsets of municipalities. For each of the two specifications, we first estimated models using data for all available municipalities (more than 20,000) covered by the U.S. Census government finance data, and then tested them again on a much smaller balanced subset of the full panel. We find that municipalities do not, on average, optimally stabilize spending in the face of revenue volatility, nor do they consistently use savings to do so. There is, however, at least modest statistical evidence that savings reflect revenue volatility at typical levels of volatility. For all model specifications tested, the single greatest determinant of savings at the municipal level is the state in which the municipality is located. The next challenge is to identify and measure the impact of the underlying factors that explain the dramatic state‐to‐state differences observed in municipal savings patterns.

Toward a Theory of Fiscal Slack

“…By juxtaposing city and state fixed‐effect models we further refine the understanding of determinants of city reserves. Similar to Thompson et al (), we find that state fixed‐effect models explain close to 40 percent of the total variation in city fund balances and close to 50 percent of variation in unrestricted net asset models, but we also show that the explanatory power of city fixed‐effect models is almost twice as high.…”

“…Though the authors interpreted Florida cities' high reserves as evidence of effective adaptation to economic fluctuations, the puzzle as to why governments store reserves, if not for handling revenues and expenditure variance in a recession, remains unresolved. Thompson et al (2017) observe that local reliance on intergovernmental aid has a negative impact on local fiscal reserves whereas larger revenues and more volatile and diversified revenue structures stimulate local savings. Interestingly, Thompson et al (2017) identify statelevel fixed effects as the most powerful predictor of municipal-level reserves.…”

“…Thompson et al () observe that local reliance on intergovernmental aid has a negative impact on local fiscal reserves whereas larger revenues and more volatile and diversified revenue structures stimulate local savings. Interestingly, Thompson et al () identify state‐level fixed effects as the most powerful predictor of municipal‐level reserves.…”

“…Thompson et al () observe that local reliance on intergovernmental aid has a negative impact on local fiscal reserves whereas larger revenues and more volatile and diversified revenue structures stimulate local savings. Interestingly, Thompson et al () identify state‐level fixed effects as the most powerful predictor of municipal‐level reserves. This finding means that while local‐level fiscal risk matters, state policies (e.g., limits on local revenue generation, spending, and debt) as well as local willingness to hold similar reserves as their neighbors should not be overlooked as determinants of municipal reserves.…”

“…Evidence on the role of revenue volatility, debt finance, politics, and socio‐economics has not been fully consistent either. The explanatory power of these predictors has been relatively weak, and scholars continue to be puzzled by high levels of local reserves in their samples (Arapis and Reitano ; Arapis, Reitano, and Bruck ; Duncombe and Hou ; Marlowe , , ; Stewart, Hamman, and Pink‐Harper ; Thompson et al ). Studies that focus on determining optimal fiscal reserves through simulations, however, tend to justify high reserves because they tend to produce wide confidence intervals for future budget imbalances (Dothan and Thompson ; Kriz , ).…”