A Better Budget Rule

Abstract:     
During recessions, the newspapers are filled with stories of the pain caused by state and local budget cuts: slashed mental health funding, reductions in school meals, further delays in long-overdue infrastructure maintenance and replacement, and new taxes. During booms, they are filled stories of state and local spending initiatives, tax cuts, and rebates. This manic-depressive pattern of binge and purge is usually attributed to revenue volatility. But putting first things first, the problem is spending volatility. Governments ought to be capable of growing spending at a sustainable rate, using savings and/or borrowing to smooth out spending over time. The solution to the real problem lies in defining budgetary balance in terms of sustainable growth.

This article shows how to identify an optimal spending level for a particular jurisdiction, one in which the present value of its exhaustive expenditures is equal to its net-financial assets (or liabilities) plus the present value of future tax revenues minus transfers. At this level of expenditure, the sustainable rate of spending growth is approximately equal to the geometric mean rate of revenue growth (tax revenues minus transfers). At higher levels of current expenditure, the sustainable rate of spending growth is less and, at lower levels, slightly more than the geometric mean rate of revenue growth. If actual revenues in the budget period exceed the forecast, the difference should be saved or used to reduce outstanding debt and vice versa.

These are fairly simple rules (although their calculation is not). They are relevant to any jurisdiction that can neither force central banks to buy their bonds nor expect some other entity to rescue them from fiscal distress. Moreover, their application would reduce the tendency of public officials to let concerns about revenue volatility override equity, efficiency, and adequacy considerations in the design of tax codes and transfer mechanisms.

Number of Pages in PDF File: 37

Keywords: State government expenditure, State government investment, Reserve funds

JEL Classification: H71, H72

Accepted Paper Series