Public Financing Under Balanced Budget Rules

Abstract

This paper analyzes the impact of a balanced budget rule (BBR) on government financing
cost and its implications for the government balance sheet. Exploiting the variation in BBR
implementation across different states, we find that states with more stringent BBRs exhibit
significantly lower debt spreads and credit default swap spreads, demonstrating the crucial
role of default risk. A sovereign default model incorporating BBRs aligns with the empirical
results. Our quantitative analysis suggests that implementing a BBR in Illinois could decrease
the state bond spread by approximately 50% and lower the debt by a third within a decade.
Additionally, we compare the effects of BBRs with those of alternative fiscal rules.

Keywords: Public financing, balanced budget rule, sovereign default risk, state government, fiscal rule

JEL Classification: E62, F34