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Balanced-budget rules and public deficits: evidence from the U.S. states A comment
Carnegie-Rochester Conference Series on Public Policy 45 (1996) 77-87 North-Holland
B a l a n c e d - b u d g e t rules and public deficits: evidence from the U.S. states A comment Shaghil Ahmed* Board of Governors of the Federal Reserve System
The paper by Henning Bohn and Bob Inman is a careful, very rigorous, and thought-provoking empirical study and I enjoyed reading it, despite its length. The paper evaluates the effectiveness of various budget rules that states are subject to in curtailing their propensity for deficit financing. Among other i~sues, this clearly has implications for the ongoing debate about some form of a balanced-budget amendment at the national level. It is taken as given in the paper that there are severe allocative and distributive costs associated with deficit financing. Thus, I guess, the authors would ask state governments not to heed the advice of Artemus Ward who, in the 19th century, said: "Let us be happy and live within our means, even if we have to borrow the money to do it with." So, taking as given the non-Ricardian position that borrowing has sub~tantial costs associated with it, the authors ask the following questions: 1. What type of constitutional and statutory limit~tions is most effective in curtailing deficit financing? 2. For the rules that are effective, what specific adjustments take place in a state's spending and taxation decisions? 3. Are there substantial costs associated with these rules in terms of losing the ability to smooth taxes and/or sacrificing the role of budget deficits as "automatic stabilizers"? *The author is Staff Economist in the International Finance Division. The views expressed here are those of the author and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System or any other member of its staff. 0167-2231/96/$15.00/© 1996 - Elsevier Science B.V. All rights reserved. Pll 0167-2231 (96)00018-8
I will organize my discussion of the authors' answers to these questions along the following lines. First, I will briefly summarize the model and the main results. Second, I will comment on the derivation of the overall deficit equation, equation (5) in the paper, which forms the basis of the empirical work. Finally, I will raise some econometric issues which might have a bearing on the interpretation of the main results. T h e empirical m o d e l and the main results The centerpiece of the layout in the paper is the following equation, which is equation (5) in the paper and is reproduced here for convenience:
+ ~ , + OW,, + pP,, + At + u~,
(1)
where S U R G F refers to the general fund surplus, Y is a vector of economic variables, W is a vector of balance-sheet variables, P is a vector of political variables, t is a time trend, C is a time-invariant indicator variable equal to 1, if the state has a particular fiscal rule, 0 otherwise, u is an error term, 7r average probability of enforcement of the fiscal rule, ~ = average adjustment of the budget surplus in those states where the rule exists, z is a vector representing other time-invariant controls (for example, control for southern ~. other states). This equation is estimated in two stages. In stage '1, the authors estimate (1) using panel data, treating a8 as a state-spec':~c effect, where ~, is defined by: a . = a" +
+
(2)
In stage 2, the estimated ¢~,, is regressed on za and Ca to obtain estimated values of 7 and ~r@. The authors then test the proposition that a particular budget rule is effective by testing the hypothesis that the estimated value of 7r~bis grea'~cr than zero. They do this for many different rules. In what follows I will refer to these results (which are reported in Tables 5-7 of the paper) as "evidence on the effectiveness of particular fiscal rules." Once it is established which particular fiscal rules are effective, the au. thors also provide additional results that help us in more fully understanding the impact of fiscal rules for state deficit funding. Along these lines, the authors (i) regress state fixed effects for individual budget ~.tems on the budget rule indicator variable to see which items are most affected by the presence of a fiscal rule (Table 8); (ii) examine the relationship between the average level of different types of assets/liabilities and the fiscal rules to get at "steady-state" long-run differences across states which have a particular budget rule and those that do not (Ta~,!e 9); (iii) examine the impact of 78
previously omitted measures of state fiscal conservatism, the impact of the type of enforcement mechanisms in place for following the fiscal rule, and the role played by biennial budgets which some states use (Tables 10-13); and (iv) provide evidence on the implications of budget rules for tax smoothing and the use of budget deficits as automatic stabilizers (Table 14). For convenience, I will group all this evidence into the general category of "additional results."
2
Results
There are many results in the paper and, therefore, I list them on|y~ briefly. The authors' main results from the evidence on the effectiveness of l~ar~icular fiscal rules can be summarized as follows: - States that cannot carry over a budget deficit from one period to the next (NOCARR¥) run higher general fund surpluses on average. a~ wu~re the governor t..~ v;.,~;~..m ,,.÷,., v,~...,v~,w [T.T~TT~I~/I'~ ~.LA.aalJ..~.m..L ~'~w~.] and ,,,h,~,~ there is a referendum restriction on issuing new debt (DEBTRES) also show fiscal restraint. - The ability to carry over a deficit into the next period (CARRY) and the requirement to pass a balanced budget (PASS) have a negative effect on the general fund surplus. - The requirement to only submit (SUBMIT) a balanced budget has no effect on the general funds surplus. - Once the NOCARRY rule is controlled for, the other fiscal rules do not have any influence on the budget deficit, with the possible exception of PASS and LINEITEM which, in some specifications, appear to have a marginal additional effect in restraining the state government budget deficit. The conclusions that the authors obtain from the additional evidence that looks at the NOCARRY rule in more detail are as follows: The additional surplus generated by the NOCARRY requirement results primarily from cutting current accounts government spending and is used mainly to augment rainy-day reserve balances. The NOCARRY restriction is associated with substantially higher long-run reserve balances as well. - The effect of the NOCARRY requirement is significantly bigger when the ultimate enforcement is external (elected, rather than appointed, Supreme Court). Also, states with biennial budgets with a two-year NOCARRY requirement and biennial, rather than annual, budget sessions run bigger surpluses. On the other hand, wheLher the rule is constitutional or statutory does not make a significant difference. Costs in terms of forgoing smooth taxes are unlikely to be very high (states that do not have the NOCARRY requirement do not smooth taxes either, in the~sense of making taxes follow a random walk). By contrast, -
,l,.II.Clb~
a
an,,it,,i.,,i,~,,..-,i,~,,,,,,a,,n.,,m,
-
-
79
v.
~ .,.,0,,,,. .,,,.o
the cyclical sensitivity of budget surpluses is much lower in states with more stringent fiscal requirements (indicating that balanced-budget rules may be compromising the "automatic-stabilizer" role.) However, this is less clear if the response of the budget to unemployment rates, rather than to the growth rate of state income, is used to measure cyclical sensitivity.
3
C o m m e n t s on the derivation of the overall deficit equation
The derivation of equation (5) in the paper (reported as equation (1) above) is based on the following two crucial assumptions: (,41) The probability of enforcement of the balanced-budget requirement is time-invariant (and the same for all states). (A2) The adjustment of the surplus in response to a balanced budget requirement is entirely smoothed out over time. These assumptions make r~b time-invariant and the same for all states where the rule exists. There are at least two reasons to question these assumptions: first, consider the plot of the average state general-fund surplus given in Figure 1 of the paper. This variable displays a clear downward trend over time. One must at least allow for the possibility that the factors causing this downward trend are making it more difficult over time to enforce the budget rule. That is, perhaps the downward time trend in Figure 1 is not driven entirely by states that have no effective budget rules, but also by a falling probability of enforcement over time in those states where effective rules are present. Second, even keeping fixed the probability of enforcement, it is unlikely that the adjustment ¢ can be independent of the extent to which the constraint binds each period. Let me illustrate this point by starting with a more general set-up in which the indicator variable is time-dependent. Thus, define: Cat = 1, if the balanced-budget constraint binds for state s at time t, 0 otherwise. This is consistent with the authors' statement that "When a balanced budget constraint binds, however, states must adjust the planned surplus upward to meet the balance constraints." To be more specific, suppose for those states where the balanced-budget amendment exists, Cat = 1, if SURGF:t < 0 (where SURGF* is the optimal surplus, if there was no binding balanced-budget constraint), 0 otherwise. Of course, the variable SURGF* is never observed for those states where the rule exists. It is unlikely that the adjustment ¢ would be independent of the magnitude of SURGF* when this variable becomes negative. If there were a big enough negative shock to SURGF*, either the probability of enforcement would have to give, or a bigger adjustment in that period would be needed to satisfy the end-of-period balanced-budget constraint. As the au80
thors state: "They may even have to implement additional adjustments as the year progresses if they receive signals indicating unexpectedly low revenues or unexpectedly high outlays." Given the two points above, a more general specification of ~rff along the following lines may be more appropriate:
r,¢,
=
-
6,t
SURGF;
-
(3)
With the time-dependent C variable, this specification then leads to the following empirical model:
SURGFst = ~* + 9zs + ~r¢Cst + ~Y~t + OWst + pPst + At + u~t
+ (6x +
+
+
+
+ 6, z, +
(4)
This differs from the authors' equation (5). First, the authors have the indicator variable C, (rather than the time-dependent G~t above), implying that some adjustment continues to be made even in periods when the constraint is not binding. I do not have much quarrel with this, since it is dL-qicu!t to proceed otherwise. However, even if we drop the time subscript on C, equation (4) above is different from the authors' equation (5), unless 6,,6~ are zero. If 61 and 62 are nonzero, the estimates of equation (5) in the paper will be subject to omitted variables bias. We are not necessarily getting the average effect with the authors' procedure, since we have a misspecified equation, having thrown the terms inside the curly brackets into the error component. To correct the situation, one needs to have interaction-with-C terms for all the variables, which amounts tc estimating equation (5) in the paper separately for states with and without stringent bManced-budget requirements and testing if the coefficients across the two groups on all the variables are different. The basic point is that there is no reason why the response of the surplus to all of the right-hand-side variables would not be different in those states where the effective budget rule ezists from thos~ in which it does not, rather than just the intercept term being different. To suppose otherwise a priori seems to be a rather strong assumption. To give more credenc~ to the authors' results, something like equation (4,) above should be estimated and the hypotheses that 61 and 62 are insignificantly different front zero should be formally tested. To be fair, some of this % indirectly done by the authors in a later section, in which it is examined whether' those states which have no stringent balanced-budget requirements are ones in which the surplus responds more to cyclical factors. But the equation estimated there is totally different from the authors' equation (5) and is not closely tied together with the rest of the paper. 81
Moreover, if we believe (4) is the more valid specification, then having a balanced-budget rule necessarily implies a higher "cost" in terms of not reacting optimally (from the viewpoint of tax smoothing and automatic stabilization) to changes in the economy. The two (how much adjustment takes place in light of the constraint and how much "cost" there is to having the constraint) are one and the same thing.
4
4.1
Econometric issues and interpretation of results
The role of the political variables
Given the previous literature in this area, it is surprising that the political variables in the authors' equation (5) are not significant. Several previous studies have found political variable~ to be important determinants of government size with differing effects on revenue size and expenditure size. So, the question arises as to why the political variables not significant in Table 5. Two possibilities suggest themselves. First, the political variables used in these other studies are not quite the same as those used by the authors here. For example, Rogers and Rogers (1995) find that the size of government (defined alternatively as the ratio of total government spending to income and total government revenue to income) is affected strongly positively by the share of Democrats in the legislature and negatively by political competition (1-% of popular vote won by the current governor), and the effects are not equal for rew~ue and speading. Another example is Besley and Case (1993) who find tha~ gubernatorial term limits have an important influence on state taxes and spending. The second possibility is that all the political variables used in this paper are dummy variables. Given this, it is possible, since a lot of the, variation in the political variables is likely to be cross-sectional, that it is mostly the statespecific effects that are related to the political variables. This is acknowledged by the authors (see their footnote 21) when they note that, once the state fixed effects are omitted, the political variables do become significant. But, in this same footnote, they also raise the pessibility that the connection between the political structure and deficit outcomes is spurious. Given the carefully done empirical work on this issue (including the papers the authors cite and the two papers I have cited al:ove), I would argue that it is fairly well-established that such a connection is not spurious.
4.2
Steady-state effects
The authors are able to say something about the steady-state effects of a balanced-budget rule versus the short-run effects by examining (in Table 9)
82
cross-sectional regressions of various balance-sheet items on the no-carryover rule. The motivation for this is to examine how the time-averaged balancesheet positions of states with and without the carry-over rule differ. This set of empirical results is only very loosely tied to equation (5), the empirical model used by the authors earlier. I wonder, if a more efficient econometric procedure for getting at balance-sheet differences-and one that would also be me consistent with the empirical model-would be to get rid of the two stages, estimate equation (5) in the paper directly, but with interaction-with-C terms for the balance-sheet variables also included.
4.3
Balanced-budget rules or expenditure limits
In macroeconomics, a controversial issue with respect to fiscal policy has been whether it is government spending only that has real effects or whether, in addition, the method of financing government expenditure also matters. Given this controversy, a natural possibility that suggests itself is that it is not the balanced-budget rules per se but other fiscal rules such as expenditure limits that are more relevant. In a previous version of this paper, Bohn and Inman had mentioned that they had examined other fiscal rules such as tax-expenditure limits and such rules were found to be ineffective, once other variables were controlled for. Given this, I will not belabor this point. Nevertheless, it would be interesting to know how nr:~ch correlation there is between the type of balanced-budget rules that the authors have found to be effective and expenditure limit rules. To be able to separate the effects of these two types of rules, it needs to be demonstrated that states that have a no-carryover rule do not also tend to be states with stringent expenditure limits.
4.4
Simultaneity problem
It is difficult, to say the least, to do empirical work under the assumption that everything is endogenous. Nevertheless, I believe the simultaneity issue is an important one in the present context and one that, at least, needs to be raised even if not much can be done about it. It is worth pointing out that the simultaneity issue is different from the problem of omitted variables. The authors have admirably controlled for the possibility of an omitted variables that might be influencing both the presence of the budget rule and the size of the budget surplus. The simultaneity problem, however, refer,~ to the budget rule and the surplus being inherently simultaneously determined variables, even after all the relevant exogenous variabl'es have been included in the system. In the present context, the basic question is whether it is states with tighter budget rules that run higher surpluses, or is it that states that can 83
,
afford to have the balanced-budget rules that have them (for political reasons). Or perhaps, it is the states that need the balanced-budget rules that have them. In this case, there would still be a simultaneity problem, although the simultaneity bias would go in the opposite direction from the first case. The authors have pointed out that these budget rules were put into place a long time ago. Nevertheless, this does not rule out the possibility that it was the states that could afford to have these rules or the states that needed these rules that put them into place and that these same states today still can afford or need these rules. I do not really have a solution to offer to the simultaneity problem, but I could not resist running a probit equation with the authors' NOCARRY indicator variable on the left-hand-side. The data on the right-hand-side variable are from Rogers and Rogers (1995). More specifically, first I regressed the NOCARRY variable on grants-in-aid from the federal government as a share of general state revenues (GRANTSHR), state's income per capita (INCPCAP), and the share of democrats in the legislature (DEMSHARE). The results are reported in Table 1. Notice the positive coefficients on GRANTSHR, indicating perhaps that those states that get more aid from the federal government find it easier to have a strict balanced-budget rule. Income per capita and the share of Democrats in the legislature both have a negative influence on the propensity to have a balanced-budget rule, although DEMSHARE is insignificant.
Table 1: Probit Regression of the No-Carry-Over Rule Dependent Variable = NOC~,RRY Panel Data (Annual observations from 1970-1990 on 47 states) Variable Coefficient T-statistic Marginal significance level CONSTANT 0.23 0.63 0.53 GRANTSHR 2.61 2.55 0.01 INCPCAP x 10-4 -0.26 -2.54 0.01 DEMSHARE .-0.13 -0.52 0.60
I also estimated the same equation but added on per capita state total general expenditures (GOVPCAP) on the right-hand-side to capture the effects of the size of government. Of course, this equation will have an endogeneity problem too, but notice that the expenditures are total general 84
expenditures, which are much broader than the general-fund expenditures used to construct the general-funds surph, s. The results are reported in Table 2. The coefficient on GOVPCAP is positive, which seems to indicate that states whose governments are "big"-and, therefore, might "need" the balanced-budget ruler more--are the eihes ~hat have it.
Table 2: Probit Regression of the No-Carry-Over Rule with Government Size included Dependent Variable = NOCARRY Panel Data (Annual observations from 1970-1990 on 47 states) Variable Coefficient T-statistic Marginal significance level 0.96 0.34 CONSTANT 0.36 2.19 2.10 0.04 GRANTSHR INCPCAP xl0 -4 -3.56 0.00 -0.83 0.46 -0.17 -0.73 DEMSHARE GOVPCAP xl0 -4 0.01 2.72 5.23 The regression in Table 2, together with the Bohn/Inman results, lends itself to the following interpretation: states that have bigger overall expenditures are the c,nes that have put into place balanced-budget rules which, in turn, over tiirle have induced them to run bigger general-fund surpluses. I do not quite knc~w what to make of this, except that we should not necessarily conclude that states that have strict budget rules are tile ones that are fiscally more responsible, although one could still argue that they are more prudent. Many readers might agree with the observation that, given how long ago the state budget rules were put into place, it is obvious which way the direction of causation has gone. Therefore, I should emphasize that the above regressions are only illustrative in nature. The simultaneity problem is more general in that, even if the presence of the budget rule is exogenously given, the probability of enforcement (Tr) and the size of the adjustment, or cushion (¢), can still be endogenously determined. For example, the same simultaneity issues would arise if, within those states that had an (exogenously given) no-carryover rule, the probability of enforcement of the rule nevertheless depended on what the authors call the desired state surplus (SURGF*). It would be a very interesting line of inquiry and the logical next step to the authors' present paper to try to endogenize ~r and/or ¢. 85
5
Conclusion
To conclude, I would like to reiterate that this is an interesting and very carefully done empirical piece. Its main contribution over the previous literature is to look at the different types of fiscal rules individually and demonstrate which type of rule holds out the most promise for promoting fiscal restraint. A particular strength of the paper is the lengths the authors have gone to in trying to control for possible third factors that might influence both the presence of a budget rule and the size of the budget surplus. The results of this paper will certainly prove helpful to those who are interested ~in examining whether a workable balanced-budget amendment can be designed at the national level. There are, of course, unanswered and controversial questions about the wisdom, of such a national-level rule. There are also possible caveats of applying the results of this study to rules at the federal level, which the authors have done a good job of mentioning in their conclusions.
86
References
Besley, T. and Case, A., (1993). Does Electoral Accountability Affect Eccynomic Policy Choices? Evidence from Gubernatorial Term Limits. Quartert~,~ Journal of Economics, 110:(3), August, 769-98. Rogers, D.L. and Rogers, J.H., (1995). Political Competition, Fj:~-:o.1Illusion, and U.S. State Government Size: Do Tighter Elections Produce 'Tighter or Looser Budgets? Manuscript, Federal Reserve Board, December.
!
87
B a l a n c e d - b u d g e t rules and public deficits: evidence from the U.S. states A comment Shaghil Ahmed* Board of Governors of the Federal Reserve System
The paper by Henning Bohn and Bob Inman is a careful, very rigorous, and thought-provoking empirical study and I enjoyed reading it, despite its length. The paper evaluates the effectiveness of various budget rules that states are subject to in curtailing their propensity for deficit financing. Among other i~sues, this clearly has implications for the ongoing debate about some form of a balanced-budget amendment at the national level. It is taken as given in the paper that there are severe allocative and distributive costs associated with deficit financing. Thus, I guess, the authors would ask state governments not to heed the advice of Artemus Ward who, in the 19th century, said: "Let us be happy and live within our means, even if we have to borrow the money to do it with." So, taking as given the non-Ricardian position that borrowing has sub~tantial costs associated with it, the authors ask the following questions: 1. What type of constitutional and statutory limit~tions is most effective in curtailing deficit financing? 2. For the rules that are effective, what specific adjustments take place in a state's spending and taxation decisions? 3. Are there substantial costs associated with these rules in terms of losing the ability to smooth taxes and/or sacrificing the role of budget deficits as "automatic stabilizers"? *The author is Staff Economist in the International Finance Division. The views expressed here are those of the author and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System or any other member of its staff. 0167-2231/96/$15.00/© 1996 - Elsevier Science B.V. All rights reserved. Pll 0167-2231 (96)00018-8
I will organize my discussion of the authors' answers to these questions along the following lines. First, I will briefly summarize the model and the main results. Second, I will comment on the derivation of the overall deficit equation, equation (5) in the paper, which forms the basis of the empirical work. Finally, I will raise some econometric issues which might have a bearing on the interpretation of the main results. T h e empirical m o d e l and the main results The centerpiece of the layout in the paper is the following equation, which is equation (5) in the paper and is reproduced here for convenience:
+ ~ , + OW,, + pP,, + At + u~,
(1)
where S U R G F refers to the general fund surplus, Y is a vector of economic variables, W is a vector of balance-sheet variables, P is a vector of political variables, t is a time trend, C is a time-invariant indicator variable equal to 1, if the state has a particular fiscal rule, 0 otherwise, u is an error term, 7r average probability of enforcement of the fiscal rule, ~ = average adjustment of the budget surplus in those states where the rule exists, z is a vector representing other time-invariant controls (for example, control for southern ~. other states). This equation is estimated in two stages. In stage '1, the authors estimate (1) using panel data, treating a8 as a state-spec':~c effect, where ~, is defined by: a . = a" +
+
(2)
In stage 2, the estimated ¢~,, is regressed on za and Ca to obtain estimated values of 7 and ~r@. The authors then test the proposition that a particular budget rule is effective by testing the hypothesis that the estimated value of 7r~bis grea'~cr than zero. They do this for many different rules. In what follows I will refer to these results (which are reported in Tables 5-7 of the paper) as "evidence on the effectiveness of particular fiscal rules." Once it is established which particular fiscal rules are effective, the au. thors also provide additional results that help us in more fully understanding the impact of fiscal rules for state deficit funding. Along these lines, the authors (i) regress state fixed effects for individual budget ~.tems on the budget rule indicator variable to see which items are most affected by the presence of a fiscal rule (Table 8); (ii) examine the relationship between the average level of different types of assets/liabilities and the fiscal rules to get at "steady-state" long-run differences across states which have a particular budget rule and those that do not (Ta~,!e 9); (iii) examine the impact of 78
previously omitted measures of state fiscal conservatism, the impact of the type of enforcement mechanisms in place for following the fiscal rule, and the role played by biennial budgets which some states use (Tables 10-13); and (iv) provide evidence on the implications of budget rules for tax smoothing and the use of budget deficits as automatic stabilizers (Table 14). For convenience, I will group all this evidence into the general category of "additional results."
2
Results
There are many results in the paper and, therefore, I list them on|y~ briefly. The authors' main results from the evidence on the effectiveness of l~ar~icular fiscal rules can be summarized as follows: - States that cannot carry over a budget deficit from one period to the next (NOCARR¥) run higher general fund surpluses on average. a~ wu~re the governor t..~ v;.,~;~..m ,,.÷,., v,~...,v~,w [T.T~TT~I~/I'~ ~.LA.aalJ..~.m..L ~'~w~.] and ,,,h,~,~ there is a referendum restriction on issuing new debt (DEBTRES) also show fiscal restraint. - The ability to carry over a deficit into the next period (CARRY) and the requirement to pass a balanced budget (PASS) have a negative effect on the general fund surplus. - The requirement to only submit (SUBMIT) a balanced budget has no effect on the general funds surplus. - Once the NOCARRY rule is controlled for, the other fiscal rules do not have any influence on the budget deficit, with the possible exception of PASS and LINEITEM which, in some specifications, appear to have a marginal additional effect in restraining the state government budget deficit. The conclusions that the authors obtain from the additional evidence that looks at the NOCARRY rule in more detail are as follows: The additional surplus generated by the NOCARRY requirement results primarily from cutting current accounts government spending and is used mainly to augment rainy-day reserve balances. The NOCARRY restriction is associated with substantially higher long-run reserve balances as well. - The effect of the NOCARRY requirement is significantly bigger when the ultimate enforcement is external (elected, rather than appointed, Supreme Court). Also, states with biennial budgets with a two-year NOCARRY requirement and biennial, rather than annual, budget sessions run bigger surpluses. On the other hand, wheLher the rule is constitutional or statutory does not make a significant difference. Costs in terms of forgoing smooth taxes are unlikely to be very high (states that do not have the NOCARRY requirement do not smooth taxes either, in the~sense of making taxes follow a random walk). By contrast, -
,l,.II.Clb~
a
an,,it,,i.,,i,~,,..-,i,~,,,,,,a,,n.,,m,
-
-
79
v.
~ .,.,0,,,,. .,,,.o
the cyclical sensitivity of budget surpluses is much lower in states with more stringent fiscal requirements (indicating that balanced-budget rules may be compromising the "automatic-stabilizer" role.) However, this is less clear if the response of the budget to unemployment rates, rather than to the growth rate of state income, is used to measure cyclical sensitivity.
3
C o m m e n t s on the derivation of the overall deficit equation
The derivation of equation (5) in the paper (reported as equation (1) above) is based on the following two crucial assumptions: (,41) The probability of enforcement of the balanced-budget requirement is time-invariant (and the same for all states). (A2) The adjustment of the surplus in response to a balanced budget requirement is entirely smoothed out over time. These assumptions make r~b time-invariant and the same for all states where the rule exists. There are at least two reasons to question these assumptions: first, consider the plot of the average state general-fund surplus given in Figure 1 of the paper. This variable displays a clear downward trend over time. One must at least allow for the possibility that the factors causing this downward trend are making it more difficult over time to enforce the budget rule. That is, perhaps the downward time trend in Figure 1 is not driven entirely by states that have no effective budget rules, but also by a falling probability of enforcement over time in those states where effective rules are present. Second, even keeping fixed the probability of enforcement, it is unlikely that the adjustment ¢ can be independent of the extent to which the constraint binds each period. Let me illustrate this point by starting with a more general set-up in which the indicator variable is time-dependent. Thus, define: Cat = 1, if the balanced-budget constraint binds for state s at time t, 0 otherwise. This is consistent with the authors' statement that "When a balanced budget constraint binds, however, states must adjust the planned surplus upward to meet the balance constraints." To be more specific, suppose for those states where the balanced-budget amendment exists, Cat = 1, if SURGF:t < 0 (where SURGF* is the optimal surplus, if there was no binding balanced-budget constraint), 0 otherwise. Of course, the variable SURGF* is never observed for those states where the rule exists. It is unlikely that the adjustment ¢ would be independent of the magnitude of SURGF* when this variable becomes negative. If there were a big enough negative shock to SURGF*, either the probability of enforcement would have to give, or a bigger adjustment in that period would be needed to satisfy the end-of-period balanced-budget constraint. As the au80
thors state: "They may even have to implement additional adjustments as the year progresses if they receive signals indicating unexpectedly low revenues or unexpectedly high outlays." Given the two points above, a more general specification of ~rff along the following lines may be more appropriate:
r,¢,
=
-
6,t
SURGF;
-
(3)
With the time-dependent C variable, this specification then leads to the following empirical model:
SURGFst = ~* + 9zs + ~r¢Cst + ~Y~t + OWst + pPst + At + u~t
+ (6x +
+
+
+
+ 6, z, +
(4)
This differs from the authors' equation (5). First, the authors have the indicator variable C, (rather than the time-dependent G~t above), implying that some adjustment continues to be made even in periods when the constraint is not binding. I do not have much quarrel with this, since it is dL-qicu!t to proceed otherwise. However, even if we drop the time subscript on C, equation (4) above is different from the authors' equation (5), unless 6,,6~ are zero. If 61 and 62 are nonzero, the estimates of equation (5) in the paper will be subject to omitted variables bias. We are not necessarily getting the average effect with the authors' procedure, since we have a misspecified equation, having thrown the terms inside the curly brackets into the error component. To correct the situation, one needs to have interaction-with-C terms for all the variables, which amounts tc estimating equation (5) in the paper separately for states with and without stringent bManced-budget requirements and testing if the coefficients across the two groups on all the variables are different. The basic point is that there is no reason why the response of the surplus to all of the right-hand-side variables would not be different in those states where the effective budget rule ezists from thos~ in which it does not, rather than just the intercept term being different. To suppose otherwise a priori seems to be a rather strong assumption. To give more credenc~ to the authors' results, something like equation (4,) above should be estimated and the hypotheses that 61 and 62 are insignificantly different front zero should be formally tested. To be fair, some of this % indirectly done by the authors in a later section, in which it is examined whether' those states which have no stringent balanced-budget requirements are ones in which the surplus responds more to cyclical factors. But the equation estimated there is totally different from the authors' equation (5) and is not closely tied together with the rest of the paper. 81
Moreover, if we believe (4) is the more valid specification, then having a balanced-budget rule necessarily implies a higher "cost" in terms of not reacting optimally (from the viewpoint of tax smoothing and automatic stabilization) to changes in the economy. The two (how much adjustment takes place in light of the constraint and how much "cost" there is to having the constraint) are one and the same thing.
4
4.1
Econometric issues and interpretation of results
The role of the political variables
Given the previous literature in this area, it is surprising that the political variables in the authors' equation (5) are not significant. Several previous studies have found political variable~ to be important determinants of government size with differing effects on revenue size and expenditure size. So, the question arises as to why the political variables not significant in Table 5. Two possibilities suggest themselves. First, the political variables used in these other studies are not quite the same as those used by the authors here. For example, Rogers and Rogers (1995) find that the size of government (defined alternatively as the ratio of total government spending to income and total government revenue to income) is affected strongly positively by the share of Democrats in the legislature and negatively by political competition (1-% of popular vote won by the current governor), and the effects are not equal for rew~ue and speading. Another example is Besley and Case (1993) who find tha~ gubernatorial term limits have an important influence on state taxes and spending. The second possibility is that all the political variables used in this paper are dummy variables. Given this, it is possible, since a lot of the, variation in the political variables is likely to be cross-sectional, that it is mostly the statespecific effects that are related to the political variables. This is acknowledged by the authors (see their footnote 21) when they note that, once the state fixed effects are omitted, the political variables do become significant. But, in this same footnote, they also raise the pessibility that the connection between the political structure and deficit outcomes is spurious. Given the carefully done empirical work on this issue (including the papers the authors cite and the two papers I have cited al:ove), I would argue that it is fairly well-established that such a connection is not spurious.
4.2
Steady-state effects
The authors are able to say something about the steady-state effects of a balanced-budget rule versus the short-run effects by examining (in Table 9)
82
cross-sectional regressions of various balance-sheet items on the no-carryover rule. The motivation for this is to examine how the time-averaged balancesheet positions of states with and without the carry-over rule differ. This set of empirical results is only very loosely tied to equation (5), the empirical model used by the authors earlier. I wonder, if a more efficient econometric procedure for getting at balance-sheet differences-and one that would also be me consistent with the empirical model-would be to get rid of the two stages, estimate equation (5) in the paper directly, but with interaction-with-C terms for the balance-sheet variables also included.
4.3
Balanced-budget rules or expenditure limits
In macroeconomics, a controversial issue with respect to fiscal policy has been whether it is government spending only that has real effects or whether, in addition, the method of financing government expenditure also matters. Given this controversy, a natural possibility that suggests itself is that it is not the balanced-budget rules per se but other fiscal rules such as expenditure limits that are more relevant. In a previous version of this paper, Bohn and Inman had mentioned that they had examined other fiscal rules such as tax-expenditure limits and such rules were found to be ineffective, once other variables were controlled for. Given this, I will not belabor this point. Nevertheless, it would be interesting to know how nr:~ch correlation there is between the type of balanced-budget rules that the authors have found to be effective and expenditure limit rules. To be able to separate the effects of these two types of rules, it needs to be demonstrated that states that have a no-carryover rule do not also tend to be states with stringent expenditure limits.
4.4
Simultaneity problem
It is difficult, to say the least, to do empirical work under the assumption that everything is endogenous. Nevertheless, I believe the simultaneity issue is an important one in the present context and one that, at least, needs to be raised even if not much can be done about it. It is worth pointing out that the simultaneity issue is different from the problem of omitted variables. The authors have admirably controlled for the possibility of an omitted variables that might be influencing both the presence of the budget rule and the size of the budget surplus. The simultaneity problem, however, refer,~ to the budget rule and the surplus being inherently simultaneously determined variables, even after all the relevant exogenous variabl'es have been included in the system. In the present context, the basic question is whether it is states with tighter budget rules that run higher surpluses, or is it that states that can 83
,
afford to have the balanced-budget rules that have them (for political reasons). Or perhaps, it is the states that need the balanced-budget rules that have them. In this case, there would still be a simultaneity problem, although the simultaneity bias would go in the opposite direction from the first case. The authors have pointed out that these budget rules were put into place a long time ago. Nevertheless, this does not rule out the possibility that it was the states that could afford to have these rules or the states that needed these rules that put them into place and that these same states today still can afford or need these rules. I do not really have a solution to offer to the simultaneity problem, but I could not resist running a probit equation with the authors' NOCARRY indicator variable on the left-hand-side. The data on the right-hand-side variable are from Rogers and Rogers (1995). More specifically, first I regressed the NOCARRY variable on grants-in-aid from the federal government as a share of general state revenues (GRANTSHR), state's income per capita (INCPCAP), and the share of democrats in the legislature (DEMSHARE). The results are reported in Table 1. Notice the positive coefficients on GRANTSHR, indicating perhaps that those states that get more aid from the federal government find it easier to have a strict balanced-budget rule. Income per capita and the share of Democrats in the legislature both have a negative influence on the propensity to have a balanced-budget rule, although DEMSHARE is insignificant.
Table 1: Probit Regression of the No-Carry-Over Rule Dependent Variable = NOC~,RRY Panel Data (Annual observations from 1970-1990 on 47 states) Variable Coefficient T-statistic Marginal significance level CONSTANT 0.23 0.63 0.53 GRANTSHR 2.61 2.55 0.01 INCPCAP x 10-4 -0.26 -2.54 0.01 DEMSHARE .-0.13 -0.52 0.60
I also estimated the same equation but added on per capita state total general expenditures (GOVPCAP) on the right-hand-side to capture the effects of the size of government. Of course, this equation will have an endogeneity problem too, but notice that the expenditures are total general 84
expenditures, which are much broader than the general-fund expenditures used to construct the general-funds surph, s. The results are reported in Table 2. The coefficient on GOVPCAP is positive, which seems to indicate that states whose governments are "big"-and, therefore, might "need" the balanced-budget ruler more--are the eihes ~hat have it.
Table 2: Probit Regression of the No-Carry-Over Rule with Government Size included Dependent Variable = NOCARRY Panel Data (Annual observations from 1970-1990 on 47 states) Variable Coefficient T-statistic Marginal significance level 0.96 0.34 CONSTANT 0.36 2.19 2.10 0.04 GRANTSHR INCPCAP xl0 -4 -3.56 0.00 -0.83 0.46 -0.17 -0.73 DEMSHARE GOVPCAP xl0 -4 0.01 2.72 5.23 The regression in Table 2, together with the Bohn/Inman results, lends itself to the following interpretation: states that have bigger overall expenditures are the c,nes that have put into place balanced-budget rules which, in turn, over tiirle have induced them to run bigger general-fund surpluses. I do not quite knc~w what to make of this, except that we should not necessarily conclude that states that have strict budget rules are tile ones that are fiscally more responsible, although one could still argue that they are more prudent. Many readers might agree with the observation that, given how long ago the state budget rules were put into place, it is obvious which way the direction of causation has gone. Therefore, I should emphasize that the above regressions are only illustrative in nature. The simultaneity problem is more general in that, even if the presence of the budget rule is exogenously given, the probability of enforcement (Tr) and the size of the adjustment, or cushion (¢), can still be endogenously determined. For example, the same simultaneity issues would arise if, within those states that had an (exogenously given) no-carryover rule, the probability of enforcement of the rule nevertheless depended on what the authors call the desired state surplus (SURGF*). It would be a very interesting line of inquiry and the logical next step to the authors' present paper to try to endogenize ~r and/or ¢. 85
5
Conclusion
To conclude, I would like to reiterate that this is an interesting and very carefully done empirical piece. Its main contribution over the previous literature is to look at the different types of fiscal rules individually and demonstrate which type of rule holds out the most promise for promoting fiscal restraint. A particular strength of the paper is the lengths the authors have gone to in trying to control for possible third factors that might influence both the presence of a budget rule and the size of the budget surplus. The results of this paper will certainly prove helpful to those who are interested ~in examining whether a workable balanced-budget amendment can be designed at the national level. There are, of course, unanswered and controversial questions about the wisdom, of such a national-level rule. There are also possible caveats of applying the results of this study to rules at the federal level, which the authors have done a good job of mentioning in their conclusions.
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References
Besley, T. and Case, A., (1993). Does Electoral Accountability Affect Eccynomic Policy Choices? Evidence from Gubernatorial Term Limits. Quartert~,~ Journal of Economics, 110:(3), August, 769-98. Rogers, D.L. and Rogers, J.H., (1995). Political Competition, Fj:~-:o.1Illusion, and U.S. State Government Size: Do Tighter Elections Produce 'Tighter or Looser Budgets? Manuscript, Federal Reserve Board, December.
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