Balanced-budget provision hurts state in tough times

The article appeared in the Patriot News, January 27, 2009.

The U.S. economy has been in a recession for just over a year. The contraction began in December 2007, and shows no sign of abating. Unemployment, currently at 7.2%, is rising inexorably, as vast swathes of the economy--automobiles, construction, finance--shed jobs by the tens of thousands, and spending by the private sector falls rapidly.

The recession also exposes a problem with a principle embraced in the name of fiscal rectitude, viz. balanced budgets.

Like most other states, Pennsylvania is required to maintain a balanced budget: its spending in a year is supposed to roughly equal its revenues in that year. When the economy is doing well, this stricture is quite manageable. As tax revenues rise (with growing incomes), so does expenditure on various government programs--and the budget remains in balance (or goes into a surplus, leading to "rainy day" savings).

But when the economy goes into a recession, tax revenues begin to suffer. In this particular instance, the pain is coming from all sides. Higher unemployment means fewer people are paying income taxes. Declining house prices means reduced property taxes. Lower incomes means less spending and therefore declining sales taxes. Falling stock market means lower capital gains taxes.

In July-Nov 2008, revenues for the state were $658 million (or 6.8 percent) below estimates. The budget shortfall for 2008-09 is now expected to be $1.6 billion.

In order to arrest the growing budget deficit, the state has to cut spending. Non-unionized state employees will forgo salary raises (as will Ed Rendell's cabinet members). Budgets of various government agencies are being frozen or cut, leading to savings of $500 million. And, despite loud protestations that they would renounce their automatic salary increase, state legislators appear to have concluded that such abstemiousness is unnecessary and pocketed the 2.8 percent raise.

The sweeping array of spending cuts being contemplated highlights the problem with balanced budgets. For, reducing government expenditures in a recession results in a further decrease in aggregate demand for goods and services. This accentuates the already-diminished demand from the private sector, and makes the recession deeper. Thus the balanced-budget provision forces the government to act in manner precisely contrary to what is needed: an injection of government spending to counter the anemic spending by consumers and firms.

But Pennsylvania is not doomed. Barack Obama and Congress have made clear that the federal government will provide substantial sums, possibly hundreds of billions of dollars, to state governments. (Pennsylvania is counting on at least $450 million.) This infusion of federal funds should keep aggregate demand from falling, and with suitable spending policies in place, states should be able to escape the stranglehold of balanced budgets. 

The problem with limited budget deficits is also evident in the European Union. When countries join the EU, they promise to keep their national budget deficits to under 3 percent of gross domestic product. But now, with tax revenues shrinking, deficits are rising, and unless the budget rules are breached, governments will find themselves with the unpleasant option of cutting spending at exactly the wrong time.

Politicians often seek to project an image of fiscal rectitude by calling for governments to maintain balanced budgets. "If families can balance their budgets," they claim, "why can't the government balance its?" Well, families routinely spend more than they earn, going into debt to buy a house or a car, for instance. Similarly, governments too may accumulate debt when economic conditions demand it. This is one of those times.
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