Menzie Chinn's post on the pro-cyclical nature of state and local government spending, "Make that Four Reasons Why Recession May be Averted," reminded me of this editorial written by a colleague exactly six years ago. Menzie is analyzing and disputing a claim that robust state and local government spending will help to avert a recession. As he notes, due to reasons such as balanced budget requirements at the state and local levels and borrowing constraints, in recessions revenues fall as income falls, and since the budget must be balanced, spending falls as well (and the fall in property taxes in the current case could make things worse than usual). This is about Oregon, but the principles apply to all state and local government spending where budgets are required to be in balance year by year. [For a bit of background, in Oregon (where there is no sales tax) if state revenues are more than 2% above the forecasted amount, the entire amount of the surplus must be refunded to taxpayers - I received a check a couple of weeks ago since revenues have been higher than anticipated this year even though future finances are in question if the economy falls into a recession. It works the other way too - if revenues are too low there are automatic cuts in state spending. This editorial was written when state and local government services were being cut by quite a bit due to revenue problems from the 2001 recession.]:
Commentary: State badly needs a rainy day fund, by George Evans, Commentary, The Register-Guard, December 20, 2001: Oregon's budget crisis is the direct result of the lack of a rainy day fund and indirectly due to past tax kickers. The principle of the rainy day fund is simple: income tax revenue automatically rises in boom times and falls in recessions, so common sense and a sound economic policy dictate that part of the revenue during periods of strong growth be set aside in a special fund to finance expenditures in recessions.
This is common sense, because it is a principle that would be followed by a prudent household facing systematic fluctuations in income. It is sound economics because it helps to smooth government expenditures and stabilize the state economy. Economists agree that government budgets should also be balanced over the business cycle, running surpluses in booms and using them to finance deficits in recessions. Such a policy acts as an automatic stabilizer, restraining the economy during booms and stimulating the economy during recessions.
The way to implement this policy at the state level is through a rainy day fund. The advantage of such a fund is painfully obvious now that we have entered a recession, but it should have been anticipated by setting up a rainy day fund in Oregon in the early 1990s.
What political forces prevented setting up a rainy day fund that would have avoided the current budget crisis? The principal obstacle has been the "tax kicker," which returns to households the "excess" tax revenues that are generated during booms.
I understand the argument made in favor of the kicker, that it prevents state spending from increasing if politicians are tempted to spend the excess tax revenues. But this argument fails to apply if the excess tax funds are instead set aside in a rainy day fund that can only be tapped during recessions. In contrast, the kicker operates with a perverse and devastating cyclical timing. Because the kicker deprives us of the rainy day fund, it in practice leads to downward pressure on state government spending during recessions, and therefore acts to intensify the recession. ...
The current State budget crisis would have been much less acute, and possibly entirely avoided, if a rainy day fund had been in place, and tapping the rainy day fund would have also helped reduce the extent of the recession in Oregon.
The current regime of balancing the budget year by year is bad economics. At the national level this "Hoover economics" approach to fiscal policy is widely understood to be discredited. The same principle applies at the state level. Current budgetary choices remain critical, but we are operating under artificial constraints. Not having a rainy day fund in place is subjecting us to unnecessary economic distress. Surely we can at least now agree to change our flawed budget policy design so that we are never again compelled to face a recession so unprepared.
I wonder how much additional stabilization could be achieved at the national level if all states had such a fund to stabilize their economies over the business cycle.