It may be good that many states are required to balance their budgets, but such provisions pose an economically perverse incentive when the economy is at either extreme of the business cycle.
Balanced budget requirements are ubiquitous, with Vermont the exception. For some states, the rule is embedded in the state constitution while in others it is only statutory. But in general terms, when tax receipts drop, nearly all states must cut spending.
These “balanced budget” requirements are asymmetric, in that they ban deficits but not surpluses. But aside from filling relatively small “rainy day funds,” many states cut taxes when tax revenues are high. Some do this via one-time rebates, as Minnesota did in the late 1990s. And surpluses usually prompt increased state spending.
For most states, sales taxes are an important revenue source, often the primary one. Many also have state income taxes. Both sales and income taxes fluctuate greatly with economic conditions. When the economy is booming, incomes are high and households spend freely. Revenues burgeon. When the economy slows, they shrink. Such shrinkage is especially sharp in states like Minnesota that exclude necessities like food and clothing from the sales tax, as household spending on these items falls much less than spending on less vital taxable items.
British economist John Maynard Keynes advocated counter-cyclical fiscal policies to lessen the magnitude of both downturns and upturns. These include increased government spending and lower taxes when the economy slows and higher taxes and reduced spending when it speeds up.
This is precisely the opposite of what most states do. Most state budgets are pro-cyclical. They amplify swings in economic activity rather than reduce them.
Economists typically downplay any state role in offsetting recessions. Any one state’s stimulus can do little to affect the nation as a whole. Much of the benefits of a stimulus inevitably flow to other states. And, just as happened at the national level, adopting Keynesian policies can lead to greater deficit spending. Stepping on the fiscal gas pedal is always more attractive to politicians than stepping on the brake.
All that said, it would be better for the nation right now if states did not collectively cut their spending or raise taxes. Yet most of them must resort to at least one of these options.
One alternative would be for the federal government to give the states large chunks of money with few strings attached. This assumes one accepts the wisdom of the large “fiscal stimulus” package advocated by many prominent economists and favored by the incoming Obama administration. If you want federal dollars to circulate in the economy, giving a significant amount to states to offset their declining tax revenues is a good way to do it.
Some state programs are especially important in downturns. The higher the level of unemployment, the more important it is to fund community and technical colleges, the most immediate retraining option for most laid-off workers. If there are not jobs for people, their time can at least be spent upgrading their skills.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.