Consequences of State Balanced Budget Restrictions: Fiscal Constraints or Accounting Manipulations?

Although balanced budgets are widely used throughout the world, there is considerable debate on whether they are effective. Poterba (1997) provides two theories on the effectiveness of balanced budget restrictions. The institutional irrelevance view suggests that balanced budget rules are ineffective, as governments can circumvent budget rules through accounting manipulations. Alternatively, the public choice view argues that balanced budgets represent important constraints on political actors. In this paper we provide evidence on these contrasting theories by investigating the extent to which states cut expenditures and/or raise taxes to meet the budget or whether they use accounting gimmicks to comply with budget requirements. Our evidence is consistent with both theories; we find that when facing fiscal problems, states use a combination of expenditure cuts and accounting gimmicks like inter-fund transfers and selling assets to meet the budget. A $100 per capita deficit induces states with strong anti-deficit rules to transfer $20 into the governmental funds, to sell $6.10 public assets, and to reduce expenditures by $48.40. We find that the fiscal response to deficits varies based on the size of the deficit; states react to small deficits by increasing taxes and cutting expenditures, and states respond to large deficits using a combination of tax increases, expenditure cuts, and asset sales. Jointly, our results suggest that balanced budget restrictions do provide constraints on political actors, but they also result in the use of accounting gimmicks like fund sweeps and asset sales.