State Fiscal Adjustment During Times of Stress: Possible Causes of the Severity and Composition of Budget Cuts

Abstract

Efforts to maintain balanced budgets lead to substantial pro-cyclicality in states' capital investments, transfers to local governments, and spending in areas like education and transportation. Reliance on volatile revenue sources predicts relatively severe volatility in these expenditures. States with strict balanced budget requirements must restore fiscal balance faster than those without, leading to rescissions during years in which they face unexpected shocks. I find that these rescissions occur disproportionately in areas with readily deferred projects. Evidence points to the relative strength of public sector union groups as a driver of variation in the composition of mid-year rescissions across states. * Address: University of California at San Diego, Jeffrey Clemens, Economics Department, 9500 Gilman Drive #0508, La Jolla, CA 92093-0508, USA. Telephone: 1-509-570-2690. E-mail: clemens.jeffrey@gmail.com. Harvard University. I am grateful to Raj Chetty, Martin Feldstein, Edward Glaeser, Joshua Gottlieb, Byron Lutz, David Merriman, James Poterba, Kim Reuben, Stan Veuger, the Lincoln Institute of Land Policy, participants at the Harvard labor/public economics lunch, and participants in a session on state and local governments at the NTA's 2009 meetings in Denver, CO, and especially to David Cutler and Lawrence Katz. All errors are my own. State Fiscal Adjustment During Times of Stress: Possible Causes of the Severity and Composition of Budget Cuts AbstractEfforts to maintain balanced budgets lead to substantial pro-cyclicality in states' capital investments, transfers to local governments, and spending in areas like education and transportation. Reliance on volatile revenue sources predicts relatively severe volatility in these expenditures. States with strict balanced budget requirements must restore fiscal balance faster than those without, leading to rescissions during years in which they face unexpected shocks. I find that these rescissions occur disproportionately in areas with readily deferred projects. Evidence points to the relative strength of public sector union groups as a driver of variation in the composition of mid-year rescissions across states.

Do Fiscal Rules Matter?

“…Studies on the United States also include VonHagen (1991),Alt and Lowry (1994),Bayoumi and Eichengreen (1995),Bohn and Inman (1996),Alesina and Bayoumi (1996),Knight (2000),Auerbach (2006),Clemens (2012), andClemens and Miran (2012).10 On the endogenous determination of laws, seeAghion, Alesina, and Trebbi (2004) andGivati and Troiano (2012). From a theoretical perspective, other authors analyze the welfare effect of fiscal restraints:Besley and Smart (2007) study limits on the size of government in a two-period agency model;Bassetto and Sargent (2006) study the welfare case for allowing the government to issue debt only to finance certain expenditures.11 This literature has been reviewed byAlesina and Perotti (1999).…”

Implications of the Covid-19 Pandemic for State Government Tax Revenues

“…There are two key (2016) and Kodrzycki (2014) document that the cyclical sensitivity of states' revenues has increased over time. Clemens (2012) shows that states' expenditures exhibit greater sensitivity to changes in aggregate income when their revenues rely to a greater degree on relatively volatile tax bases, as would be expected in light of their balanced budget requirements.…”

Implications of Medicaid Financing Reform for State Government Budgets

“…(Oates, 1972(Oates, , 1999Gramlich, 1987 16 For a recent discussion, see Bagley (2017). Research on the implications of states' balanced budget requirements for their responsiveness to short-run shocks includes Poterba (1994); Clemens and Miran (2012); and Clemens (2013). Additional research on the relevance of fiscal institutions for state budgeting practices includes Bohn and Inman (1996); Levinson (1998); Smith (2006, 2010); Smith and Hou (2013); Poterba (1995); and Costello, Petacchi, and Weber (2012).…”