THE ELUSIVE COSTS AND THE IMMATERIAL GAINS OF FISCAL CONSTRAINTS

Abstract

We study whether and how fiscal restrictions alter the business cycle features macrovariables for a sample of 48 US states. We also examine the 'typical' transmission properties of fiscal disturbances and the implied fiscal rules of states with different fiscal restrictions. Fiscal constraints are characterized with a number of indicators. There are similarities in second moments of macrovariables and in the transmission properties of fiscal shocks across states with different fiscal constraints. The cyclical response of expenditure differs in size and sometimes in sign, but heterogeneity within groups makes point estimates statistically insignificant. Creative budget accounting is responsible for the pattern. Implications for the design of fiscal rules and the reform of the Stability and Growth Pact are discussed.

Why is it that fiscal constraints appear to make so little macroeconomic difference? We show that the main reason is ability of state governments to work around the rules and transfer expenditure items to either less restricted accounts or to less constrained portions of the government. In addition, the presence of rainy days funds, which are available to all state governments by the end of the sample, effectively allow to limit current expenditure cuts at times when the constraints become binding. Given that constraints apply only to a portion of the total budget, that no formal provision for the enforcement of the constraints exist and that rainy days funds play a buffer-stock role, it is not surprising to find that tight fiscal constraints do not statistically alter the magnitude and the nature of macroeconomic fluctuations.

Our results have important implications for the design of fiscal restrictions. If constraints are imposed to keep government behavior under control, tight restrictions may be the wrong way to go, since they simply imply more creative accounting practices, unless they come together with clearly stated and easily verifiable enforcement requirements. That is to say, tight fiscal constraints are neither a necessary nor a sufficient condition for good government performance. On the other hand, if constraints are imposed to reduce default probabilities or to limit the effects that local spending has on average area wide inflation, and given that their negative macroeconomic effects appear to be marginal, tight constraints with some carefully selected escape route could be preferable.

Is there a lesson to be learned from the results for the reform of the SGP? While Canova and Pappa (2003) have shown that the response of macroeconomic variables to fiscal shocks in the two monetary unions share a number of important similarities, care should be exercised to use our evidence for that purpose. There are at least three reasons which make most of our conclusions dubious in an European environment. First, US state labor markets are sufficiently flexible, people move across states and other margins (such as relative prices) quickly adjust to absorb macroeconomic shocks. Europe is different in this respect and the imposition of tighter fiscal restrictions in the EMU may have completely different effects. Second, since fiscal constraints in the US almost always exclude capital account expenditures, the conclusions we reach are not necessarily applicable to situations where non-golden rule type of constraints are in place. Third, social security, medical and welfare expenditures constitute the largest portion of current account expenditure of European countries, while they are a tiny portion of expenditure of US states (less than four percent). Given that such expenditures are inflexible and, to a large extent, acyclical, direct extension of our conclusions to the European arena should be avoided. Nevertheless, we would like to stress that, while the presence of strict fiscal constraints does not make an important difference for cyclical fluctuations, some fiscal restriction is present in all but one US states. Therefore, none of our conclusions implies the abandonment of some kind of legislated fiscal restraint.

The rest of the paper is organized as follows. The next section describes the empirical model, explains our methodology and compares it with those typically used in the literature. Section 3 presents the procedure used to identify fiscal shocks and to construct fiscal rules. Section 4 describes how indicators capturing deficit and debt restrictions are constructed. Section 5 presents the results and section 6 compares our results to the existing literature. Section 7 concludes.

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