A government budget is a formal agreement that stipulates how much revenue will be raised, the sources of this revenue, and how the revenue will be spent. In most polities, "the budget" is actually a collection of policy agreements that stipulate tax laws and spending levels for specific programs, rather than a comprehensive, all-inclusive document. The budgetary process thus refers to the set of rules and procedures that policy makers use to formulate, enact, and enforce these revenue and spending agreements.
The process used by American state governments and the United States federal government to create budgets is relatively easy to describe in a stylized fashion. In general, revenue and spending proposals follow the same path through the legislative and executive branches as all measures that get signed into law. Legislators introduce formal revenue and spending proposals; hearings and debates are held on the proposals; votes are taken in oversight committees and then by the full legislative membership; and finally bills are sent to the chief executive for consideration. At the last stage, as with other types of legislation, budget bills can become law in two ways: the chief executive either "signs" the bill into law or, if he or she refuses, the bill can become law with the approval of a super-majority vote of both houses of the legislature.
The periodic or repetitive nature of budget legislation, combined with the relative imperative that it be approved, means that some specialized rules and procedures will emerge that apply solely to budget making. In this sense there is a "budgetary process," as distinguished from the rules and procedures that generally apply to the "legislative process." Within this stylized overview for how budgetary policies move through the political system in the United States, we find key institutional divergences in the budgetary processes employed. Naturally, such differences invite empirical scrutiny, and numerous scholars have exploited the cross-sectional and time-series variation among American states to analyze how specific budgetary institutions affect fiscal outcomes.
In his 1997 comprehensive survey of the studies of state budgetary institutions James Poterba concludes that while the evidence is not conclusive, the preponderance of studies suggest that institutions are not simply veils pierced by voters but are important constraints on the nature of political bargaining. In essence, the demand for public spending and taxation is mediated through a set of fiscal and budget rules. In Poterba’s succinct assessment: "fiscal institutions matter."
The remainder of this essay summarizes major findings in the literature on how specific rules that define the budgetary process affect fiscal outcomes.
1. Balanced Budget Rules
Every state except Vermont has a balanced budget requirement. However, the details of these 49 state requirements differ in an important respect, namely the stage in the budget process at which balance is required. A survey of past research points to four categories. The weakest standard requires the governor to submit a balanced budget. A stricter standard requires the legislature to pass a balanced budget. Under these two categories actual expenditures may exceed revenues, if end-of-year realizations happen to diverge from the enacted budget. The third standard requires the state to acknowledge its deficit, but allows the deficit to be carried over into the next budget with no consequences. Bohn and Inman (1996) aptly label these three categories "prospective budget constraints." The fourth and strictest form of balanced budget rule combines the practice of enacting a balanced budget with a prohibition on a deficit carry-forward. Bohn and Inman label this strictest form a "retrospective budget constraint." While numerous studies have examined state balanced budget rules, four studies convincingly advance the idea that the "retrospective" standard has a significant impact on budgetary outcomes, whereas the other three do not.
Bohn and Inman find that balanced budget rules that prohibit the carry-over of end-of-year budget deficits have a statistically significant effect, reducing state general fund deficits by $100 per person. In contrast, soft or "prospective" budget constraints on proposed budgets do not affect deficits. Importantly, the deficit reduction in retrospective budget constraint states comes through lower levels of spending and not through higher tax revenues.
Poterba (1994) examines the fiscal responses in states to unexpected deficits or surpluses. He compares the adjustments to fiscal shocks under "weak" versus "strict" anti-deficit rules, categories that closely resemble the Bohn-Inman division. Poterba’s results suggest that states with weak anti-deficit rules adjust less to shocks than states with strict rules. A $100 deficit overrun leads to only a $17 expenditure cut in a state with a weak rule and to a $44 cut in states with strict rules. Poterba also finds no evidence that anti-deficit rules affect the magnitude of tax changes in the aftermath of an unexpected deficit.
Alt and Lowry (1994) focus on the role of political partisanship in fiscal policy. They examine reactions to disparities between revenues and expenditures that can exist even in states with balanced budget requirements. In states that prohibit deficit carryovers, the party in control matters. In Republican-controlled states, they find a one-dollar state deficit triggers a 77-cent response through tax increases or spending reduction. In Democrat-controlled states a one-dollar deficit triggers a 34-cent reaction. In states that do not prohibit carryovers, the adjustments are 31 cents (Republicans) and 40 cents (Democrats). In other words, the Alt-Lowry evidence suggests that state politics plays an important role, and that anti-deficit rules affect fiscal actions.
Crain (2003) examines panel data for the years 1969 through 1998 and finds that states with a strict balanced budget requirement spend on average 3.2 percent less than other states. Crain also re-examines the often-voiced concern over a balanced budget requirement, namely its potential to force tax increases in response to a fiscal imbalance. Consistent with Bohn and Inman (1996) and Poterba (1994), the updated results suggest that strict budget balance rules influence fiscal policy largely through expenditure adjustments and not through increases in taxes or other revenue sources.
2. The Item Reduction Veto
Governors in all but five states have the ability to veto a particular item in an appropriations bill (a rule known as an item veto), in addition to their normal authority to veto an entire bill. Several studies on the fiscal impact of the item veto provide mixed and inconclusive results. Bohn and Inman (1996) find that the item veto generally has no statistically significant relationship to state general fund surpluses or deficits. Similarly, Carter and Schap (1990) find no systematic effect of the item veto on state spending. Holtz-Eakin (1988) finds that when government power is divided between the two parties, one controlling the executive branch, the other controlling the legislative branch, the item veto helps the governor reduce spending and raise taxes. Under political conditions of non-divided government, Holtz-Eakin finds that the item veto yields little, if any effect on budget outcomes.
The Holtz-Eakin study stresses that the item veto powers differ among states, and Crain and Miller (1990) examine these different powers in further detail. Of the 45 states that have an item veto, 10 give their governors the authority to either write in a lower spending level or to veto the entire item, the so-called item reduction veto. Crain and Miller argue that the item reduction veto differs from the standard item veto because it provides the governor with superior agenda setting authority. For example, a governor faced with excessive funding for a remedial reading program is unlikely to veto the measure, but likely would consider a marginal reduction in the amount of funding for that type of program. In contrast to a generic classification of the item veto, Crain and Miller find that the item reduction veto significantly reduces state spending growth. In a subsequent analysis, Crain (2003) again finds that the item reduction veto authority has major budget consequences. An item reduction veto predictably lowers per capita spending by about 13 percent relative to the mean in state spending per capita.
3. Tax and Expenditure Limitations (TELs)
The earliest studies of TELs concluded that they have virtually no affect on state fiscal policy (for example Abrams and Dougan, 1986). Elder (1992) was among the first studies to examine TELs using an empirical model that controlled for other factors (such as income and population) that influence spending. With this improved specification Elder finds evidence that TELs reduce the growth of state government.
Eichengreen (1992) estimates regression models for both the level and growth rate in state spending as a function of the presence of tax and expenditure limits and the interaction between these limits and the state’s personal income growth rate. He finds that the interaction term is particularly important because limits are typically specified as a fraction of personal income. In states with slow income growth rates, limitation laws have had a more restrictive effect on government growth than in states with fast income grow rates. Shadbegian (1996) specifies an almost identical empirical model, again taking into consideration the interaction between income and TELs.
Reuben (1995) develops an empirical specification that controls for the potential endogeneity problem that the passage of tax limits may be related to a state’s fiscal conditions. Reuben finds that when these institutions are treated as endogenous the explanatory power of the institutional variables rises markedly; the estimated effects indicate that TELs significantly reduce state spending.
Crain (2003) updates the analysis using panel data for the 1969-1998 period based on the methodology in Eichengreen (1992) and Shadbegian (1996). Evaluating the effect at the mean of per capita income, Crain’s projections indicate that if a state’s income were one standard deviation below the mean, a TEL would reduce per capita spending by 3 percent in relation to mean spending. Alternatively, if a state’s income were one standard deviation above the mean, a TEL would increase spending by 16 percent. As Shadbegian (1996) points out, one interpretation of these results is that TELs may provide political cover for state policymakers. Legislators can claim that the government is not growing too fast because a TEL law designed specifically to curtail government is in force. In effect, under some conditions (high state income) the TEL guidelines may become a floor for spending increases rather than a ceiling.
4. Super-Majority Voting Requirement for Tax Increases
Knight (2000) points out that in addition to the 12 states that have enacted super-majority requirements, 16 states in the 1990s introduced proposals to enact such requirements. Adding a super-majority voting requirement to the U.S. federal budget process is also a popular reform measure. Three empirical studies have analyzed the effect of super-majority requirements on state fiscal outcomes. Crain and Miller (1990) find that such rules reduce the growth in state spending by about 2 percent based on a relatively short sample period, 1980-1986. The study by Knight (2000) expands the sample period, employs pooled time-series, cross-sectional data, and uses state and year fixed effects variables. He finds that supermajority requirements decrease the level of taxes by about eight percent relative to the mean level of state taxes. Crain (2003) estimates that the super-majority voting requirement for a tax increase lowers per capita spending by about four percent evaluated at the sample mean.
5. Budget Cycles
Since 1977 a number of proposals have been introduced in the U.S. Congress to lengthen the federal budget cycle from an annual to a biennial process. The perception behind these proposals is that a federal biennial budget would help curtail the growth of federal expenditures. Motivated by these federal proposals, the U.S. General Accounting Office (1987) conducted a study of the state experiences. That study reports a positive correlation between state spending and annual budget cycles.
Kearns (1994) lays out the theoretical issues and provides a comprehensive empirical study of state budget cycles. Kearns presents two competing hypotheses. On the one hand, a biennial budget transfers power over fiscal decisions from the legislative branch to the governor. This power transfer reduces spending activities associated with logrolling and pork barrel politics because legislators favor programs that benefit their narrow, geograhically-based constituencies. The main costs of such geographically targeted programs may be exported to non-constituents. By comparison, the governor makes fiscal decisions based on more inclusive benefit-cost calculations because he or she represents a broader, statewide constituency. In other words, at-large representation mitigates the fiscal commons problem. As an alternative hypothesis, Kearns posits that a biennial budget cycle imparts durability to spending decisions and thereby encourages political pressure groups to seek government programs. Empirically Kearns finds that states with biennial budgets have higher spending per capita than states with annual budgets. Crain (2003) finds evidence that coincides with Kearns, in at least some model specifications; spending per capita is three percent higher in biennial budgeting states relative to annual budgeting states, other things equal.
6. Budgetary Baselines
Crain and Crain (1998) analyze alternative budget baseline rules. The two main choices for a budget baseline are the dollar amounts spent the year before or the level of services that those dollars bought, which is labeled a ‘current services’ baseline. For example, the U.S. federal budget procedure for computing the current services level takes what was spent in the year before, adjusts it for inflation and, in the case of programs like Social Security or unemployment compensation, for the number of people projected to be eligible in the year ahead, and that becomes the spending baseline. Any amount in excess of that level is defined as a spending increase, lesser amounts a spending cut. A current services baseline and a last year’s budget baseline create different reference points, and based on prospect theory and experimental evidence, Crain and Crain posit that legislators may exhibit loss averting behavior in voting on budgetary proposals (for example, see Tversky and Kahneman, 1986). This means that future spending levels on programs enacted under a current services baseline are more secure than spending levels on programs enacted under a budgetary rule that uses last year’s spending as a baseline. The present value of programs enacted under a current services regime is thus higher than under the latter budgetary regime. This increase in present value in turn raises the expected return to investments in lobbying by pressure groups to secure wealth transfers and thereby fuels an expansion in public sector spending. Controlling for a host of institutional, economic, and demographic factors, the findings in Crain and Crain show that over the course of the 1980s a current services baseline rule added about five percentage points to the growth in real state government spending.
7. Fiscal Volatility
Crain (2003) develops the argument that fiscal uncertainty impairs efficiency and raises the cost of government programs. Empirically, a 10 percent increase in expenditure volatility increases per capita spending by 3.5 percent relative to the state mean. This link between budget volatility and spending levels can be framed in a constructive manner: a state may reap substantial budgetary savings by reducing fiscal volatility. Importantly, the trade-off between budget volatility and government efficiency means that the role of budgetary institutions is more complex than previous analysis has generally assumed. Some institutions appear to carry a duel role, exerting not only a direct influence on spending, but also an indirect influence on the size of state budgets via their impact on fiscal stability.
The wide array of budgetary processes among American states provides a rich empirical laboratory to analyze the impact of specific institutions on spending and revenue policy. A growing body of work indicates that the design of budgetary processes conveys major fiscal consequences. Models of fiscal policy that treat institutions as relatively transparent and neutral communicators of voter preferences have severely limited explanatory power.
