One marker of prudent fiscal practices is maintaining balance between spending and revenues. Policymakers at the federal level have had more flexibility with deficit-spending than their counterparts at the state level.
Historically, the federal government has often run annual deficits, meaning that the revenues in a given year fell short of the year’s spending. Since 2008, deficits have grown far above historic averages resulting in a large and growing federal debt, which is the total of all past annual deficits and surpluses.
Occasionally deficits may be necessary, even prudent, to counteract economic downturns or spur growth. Over the long term, however, large deficits and substantial debt can require large interest payments, undermine investors’ confidence in government bonds, force government to cut non-interest spending, and limit policymakers’ ability to react to economic crises.
Federal policymakers face the challenge of adopting fiscal policies that cut the deficit without risking economic growth or essential programs serving vulnerable populations. Periods of solid economic growth are the most opportune moments to keep the national debt under control.
State budget dynamics and options are different, in part because of their balanced budget requirements. Although almost every state has such a requirement, the definition of budget balance varies significantly and generally applies only to a state’s operating budget. States can still issue debt to pay for needed public investments. Many states build up rainy-day funds during good economic times and use them to sustain spending on needed programs during recessions.
State revenue invariably decreases during recessions due to reduced economic activity – businesses have lower profits and fewer people are working and thus paying taxes. States that have balanced budget requirements but no rainy-day funds must contract spending considerably during recessions to match reduced revenue streams, removing even more money from the economy and compounding the effects of the recession.
During economic downturns some states need to find new revenue sources to keep the budget balanced. Sometimes those revenue sources are temporary, inherently unstable, or declining (such as taxes on tobacco and alcohol). If these types of funding mechanisms are tied to vital programs, those programs are jeopardized.
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, actually decline. The process of restoring the balance of rainy-day funds should be made more automatic, perhaps by earmarking a specified fraction of current revenue for this purpose.
The federal government must strive for long-term fiscal balance to forestall hardships that result from higher inflation, a falling dollar, higher interest rates, and the inability of government to fulfill its commitments, particularly to the most vulnerable or needy. The need to reduce long-term fiscal imbalances, however, should be tempered by the occasional need for short-term fiscal stimuli, emergency spending, and long-term investment.