One indicator of sensible fiscal practices is maintaining balance between spending and revenues. Occasional deficits may be necessary. They may even be sensible to counteract economic downturns or spur growth. Annual deficits are caused when spending exceeds revenue in a given year. They can accumulate into ongoing debt, the grand total of all past annual deficits and surpluses. During periods of low interest rates, government may have the capacity to handle high debt with relative ease. But higher interest rates increase the cost of debt.
The federal government has often run annual budget deficits. Since the turn of the century, deficits have grown far above historic averages, hitting record levels in the wake of the COVID-19 pandemic.
Unsustainable deficits and debt can cause stress to economic systems over time. Eventually, they may undermine investor confidence in government bonds. Interest rates may increase, investments and productivity may decline, and economic growth may be undermined. Deficits and debts may force the government to cut spending and limit policymakers’ ability to react to economic crises.
Federal policymakers face challenges in attempting to balance the budget. They need to adopt fiscal policies that cut the deficit to sustainable levels without risking economic growth or essential programs that serve populations made vulnerable by inadequate policies. Periods of solid economic growth are the most opportune moments to keep the national debt under control.
Balancing budgets has its own set of unique challenges at the state and local level. State budget dynamics are different from those of the federal government due in part to states’ balanced budget requirements. Generally, this requirement applies only to a state’s operating budget, leaving open an option to issue debt to fund public investments. State revenues tend to decrease during economic contractions, while their spending needs remain the same or grow. Yet unlike the federal government, states cannot finance deficits by issuing debt.
Some states use rainy-day funds to help them maintain budget balance. This is a special fund built up during good economic times and used to cushion the blow of unexpected economic adversity. These funds often help sustain spending on needed public programs during recessions. In contrast, states with balanced budget requirements but no rainy-day funds must reduce spending during recessions to cover for reduced revenue streams. This removes even more money from the economy and compounds the effects of the recession.
During economic downturns, some states need new revenue sources to keep the budget balanced. These revenue sources can be temporary, one-time, variable, or declining. Such unstable funding cannot sustain vital long-term programs over the long term.
PURSUING BUDGET BALANCE: Policy
PURSUING BUDGET BALANCE: Policy
When economic conditions permit, states should accumulate budget reserves adequate to maintain services during recessions. The use of rainy-day funds should be restricted to times when revenues adjusted for inflation decline.
The process of restoring the balance of rainy-day funds should be made more automatic. Governments could earmark a specified fraction of current revenue for this purpose.
Deficit-reduction efforts should avoid cuts in programs that serve low- and moderate-income populations.
States should not tie essential spending programs to unstable revenue sources.
The federal government must strive for long-term fiscal balance. However, the need to reduce long-term fiscal imbalances should be tempered by the occasional need for short-term fiscal stimuli, emergency spending, and long-term investment.