In the last couple of years, the U.S. federal government and the state governments have faced very similar budget shortfalls, but they have reacted to them in radically different ways. While the federal government enacted tax cuts and significantly increased its spending, most states have done exactly the opposite. The stark difference is in large part due to a constitutional provision, adopted by most states but absent from the U.S. Constitution, that severely restricts borrowing, except to finance lasting improvements. This provision, commonly known as the golden rule, has been seen as a way of aligning the identities of the taxpayers and the recipients of government services. For ordinary expenses, beneficiaries are mainly current generations, hence the requirement of budget balance, which mandates funding with contemporaneous tax receipts; for capital improvements, benefits spill over to future generations, that can be made to pay by issuing debt. But what justifies the golden rule at the state level and not at the federal level? Is this rule a needless straitjacket for the states, that causes severe and painful fluctuations in the size of their government? Or is its lack at the federal level an incentive to run large deficits, shifting the burden of taxes onto future generations? Or is there a rationale for adopting the rule in one context, but not in the other? This project develops a dynamic, politico-economic model to study quantitatively the performance of different budget rules. In the model, individuals of different ages vote over the size and composition of the government sector, subject to the financing rules laid out in the constitution. In making their private choices as well as in casting their votes, individuals take into account the repercussions of current policy choices on the future path of the economy. A key role in an individual's preferences over public investment is played by mobility across tax jurisdictions. As an example, the probability that a U.S. resident will move out of the country in any given year is much lower than his/her probability of death in the same year. By contrast, young and middle-age people face a yearly probability of moving across state lines that is about 10 times as high as their probability of death. This stark difference implies that the conflict between current and future generations has a very different meaning in the two cases, and it implies that different fiscal institutions at the state and federal level may be warranted.
The recent resurgence of the federal deficit is likely to rekindle the debate on the restrictions that should be imposed on the yearly budgeting process to insure fiscal discipline, and on the appropriateness of a balanced-budget amendment to the U.S. Constitution. A similar debate is already very lively in the European Union, where the European Stability Pact imposes (in principle, at least) tight bounds to deficit spending, without distinguishing between its different categories. The analysis proposed in this project will be very valuable in making informed decisions on the design of such fiscal institutions.
