Preventing State Budget Crises: Managing the Fiscal Volatility Problem

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Forty-nine of the U.S. states have balanced budget requirements, and every state acts as though bound by such constraints. These constraints create fiscal volatility - the states must either cut spending or raise taxes during economic downturns, while doing the opposite during upturns. This paper discusses how states should cope with fiscal volatility on both the levels of ordinary politics and of institutional-design policy. On the level of ordinary politics, the paper applies principles of risk allocation theory to conclude that states should primarily adjust the rates of broad-based taxes as their economies cycle, rather than fluctuating public spending. States should raise their tax rates during economic downturns and lower them during periods of growth. On the level of institutional-design policy, the key question is how we define terms like “tax cuts” and “tax hikes.” By adopting a new baseline for defining these terms, states can increase the likelihood of using tax rate adjustments to cope with fiscal volatility rather than (more harmful) spending fluctuations.