Summary of WP/94/82: “Restraining Yourself: Fiscal Rules and Stabilization”

Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street, Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201 This compilation of summaries of Working Papers released during July-December 1994 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period.

Abstract

Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street, Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201 This compilation of summaries of Working Papers released during July-December 1994 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period.

Restraints on the fiscal autonomy of budgetary authorities are very much in the news. In Europe, the Maastricht Treaty on Economic Union specifies ceilings or “reference values” for the debts and deficits of EU members that participate in the monetary union. In the United States, the Gramm-Rudman-Hollings Act and subsequent legislation limit the U.S. Congress’ leeway to legislate increases in the federal budget deficit.

Most previous research on statutory and constitutional fiscal restrictions has focused on their effectiveness in limiting debts and deficits. Many investigators have used data across U.S. states, all of which, aside from Vermont, are subject to statutory or constitutional debt and deficit limits. Since the stringency of these provisions differs, they offer a natural experiment on the effects of fiscal constraints on behavior. Political economy analyses which emphasize the roles of log-rolling and pork-barrel politics in creating excessive debts and deficits imply that fiscal restrictions designed to bring about their reduction are desirable.

This paper suggests, however, that there is another side to this coin. Fiscal restrictions that limit U.S. state debts and deficits are also found to reduce the responsiveness of state budgets to the cycle by up to 40 percent, and hence weaken the fiscal stabilization that could otherwise be provided by U.S. state budgets. These results are then used to estimate the potential effect of fiscal constraints on the level of stabilization provided by national governments. Simulations indicate that a reduction in national fiscal stabilizers of the magnitude estimated here for U.S. state governments could lead to a significant increase in the variance of output, on the order of 20 percent.

These findings have implications for several contexts in which the need for fiscal restraints has been mooted. The paper ends by considering the example of the Maastricht Treaty’s ceilings on budget deficits. The U.S. experience suggests that such restraints, if vigorously enforced, could significantly diminish the stabilization afforded by national budgets. Since the EU budget will probably remain small compared with the national budgets, if the treaty does in fact inhibit national governments from adjusting their budgets to the cycle, post-Maastricht Europe could enjoy significantly less fiscal stabilization than does the United States.

Working Paper Summaries (WP/94/77 - WP/94/147)
Author: International Monetary Fund