Balanced Budget Rules Work Only if Strictly Interpreted and Enforced

...permanent deficit reductions occurred only when there were permanent cuts in spending rather than increases in taxation.

The "Excessive Deficit Procedure" of the Maastricht Treaty on Economic and Monetary Union (EMU) requires that a country's overall budget deficit for each fiscal year be less than or equal to 3 percent of its GDP, and that its gross public debt be less than or equal to 60 percent of its GDP. In Do Balanced Budget Rules Work? The U.S. Experience and Possible Lessons for the EMU (NBER Working Paper No. 5838), NBER Research Associate Robert Inman concludes that the effectiveness of these EMU constraints is in doubt. He bases his conclusion on evidence from balanced budget rules (BBRs) that restrict the fiscal policy of U.S. states. States with tough, well-enforced rules have substantially lower deficits or higher surpluses than states with looser rules, he finds.

In particular, Inman finds that four things matter for BBRs to be effective. First, effective deficit constraints must require a balanced budget at the end of the fiscal year, not just in prospect at the beginning. Such a constraint is imposed with a "no-carryover" provision: states are not allowed to carry over a deficit from one fiscal year to another, but must raise taxes or reduce spending within the fiscal year to prevent a deficit from emerging. (Enforcement of the no-carryover rule will allow small, "good faith" deficits in years of extreme, but temporary, fiscal stress.) Inman reports that the presence of a no-carryover BBR during the years 1970 to 1991 reduced state deficits or increased surpluses by an average of $100 per resident, or approximately 6 percent of the average state's budget of $1,700 per resident. The additional $100 per resident was allocated to the state's rainy day fund (about $80/resident), to paying back previously accumulated rolled-over short-term debt (about $15/resident), and to new capital investment (about $5/resident). Furthermore, all else equal, a no-carryover BBR reduced the probability that a state would have a deficit at the end of a fiscal year from one in four to one in ten. Almost all of the estimated effect on the deficit was caused by restraint on current account spending rather than by increases in taxes. Inman notes that this is consistent with the experience of countries that belong to the Organization for Economic Cooperation and Development: permanent deficit reductions occurred only when there were permanent cuts in spending rather than increases in taxation. Finally, the no-carryover constraint was not met by various budget tricks, such as postponing other financial obligations or reducing asset accumulation, for example in employee pensions or insurance trust funds. Inman suggests that this is because these other accounts typically are protected by their own balanced-budget rules.

The second requirement for effective constraints on deficits is that the BBRs be grounded constitutionally rather than merely based on statutes. This makes sense: legislatures easily can change statutes, while constitutions are much more difficult to amend. Though the estimate is more tentative, Inman reports that states with constitutionally grounded no-carryover rules had surpluses that were $55/resident higher on average than states with statutorily based rules. The third factor that matters is how the BBR is enforced. In 36 states with no-carryover rules, the supreme court is the enforcer. In the 15 of those states whose supreme courts are appointed by the state's legislature or governor, surpluses were smaller, or deficits were larger, by an average of $96/resident than in the 21 states whose supreme court is elected directly by voters. In other words, the more independent from current budgetary politics is the enforcer, the more effective is the balanced budget rule. Fourth, the BBR must be difficult to amend.

Current EMU balanced budget requirements do not meet all four requirements for a strong BBR. Because the EMU's BBRs can be changed only with a change in the Maastricht Treaty, they certainly are difficult to amend. But enforcement is weak. The European Commission enforces the rules and is allowed wide latitude in deciding if a country's deficit violates the 3 percent rule; the European Court of Justice is prohibited explicitly from reviewing violations of debt and deficit rules. Also, penalties on countries that violate the guidelines are weak. Although the European Investment Bank may withhold funds, only a few EU countries receive significant funding from the Bank. Right now, the EMU's excessive deficit procedures appear to lack the institutional foundations necessary to serve as a truly effective balanced budget rule.