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Symposium 2012

Proposal - Rules to Control Government Spending

The Challenge

Large and growing ratios of public debt to GDP in many countries are demanding vigorous efforts to achieve fiscal consolidation. Many observers believe that a fiscal rule should be the central element ...

Large and growing ratios of public debt to GDP in many countries are demanding vigorous efforts to achieve fiscal consolidation. Many observers believe that a fiscal rule should be the central element of a successful strategy: they argue that a rule would restrict discretionary actions by governments, thereby strengthening the credibility of consolidation. But there are substantial differences of opinion on the precise specification of the rule.

True - rules can be broken, but breaking them imposes costs and having them historically has provided some discipline. As a consequence, a combination of a spending rule with immediate spending cuts to make more credible the action of the government can be effective ways to enhance the economic security of a country.

There are a number of potential rules that can be used. My expertise is the United States so I will focus on the US. The closest we came at the Federal level to a spending rule was the Gramm-Rudman-Hollings Balanced Budget Act of 1985. Current plans by Vice Presidential candidate Paul Ryan and others in Congress are superior. I proposed a plan myself about two years ago that is sketched below.

An “inflation-minus-one rule,” would place a limit on spending growth. As long as the ratio of government expenditures-to-GDP exceeds 18% (the thirty year average of tax revenues), each year’s growth in government spending would be limited to the last three years’ inflation rate, according to the GDP deflator (annualized), minus one percentage point. Because GDP growth would almost always exceed budget growth, the ratio of spending-to-GDP would come down. Legislators would be constrained on the total growth in spending. Nothing- not defense, not entitlements, not favorite projects - would be exempted. Total spending means that everything is included. Just as now, there can and will be wrangling over what gets funded, but the amount of budget growth would be constrained.

Based on current figures, the inflation-minus-one rule would confine the growth in nominal spending from this year to next to one percent. (One percent equals the three year annualized inflation rate of 2%, minus one percent.) If this were done, we would return to the Bush levels by 2020, when the spend-to-GDP ratio averaged under 20%. It would take about two more years to get to a balanced budget.

The rule would not prevent an aggressive Congress from cutting faster than the limit imposed by the inflation-minus-one rule. Were Congress to do so, the cuts would have the additional bonus of being baked into future budgets because each year’s budge would be based on the previous year.

During emergencies, Congress could suspend the rule for a year with a 60% vote, after which the base would return to the pre-suspension year budget levels. This could be important. The history of rigid rules is checkered. Gramm-Rudman was repealed when compliance became too tough to get around with the usual approaches. The inflation-minus-one rule would be different in two respects. First, the 60% override safety valve would allow temporary suspension of the rule, albeit it with difficulty, so that the more draconian measure of repeal would be less likely. Second, because growth is tied to an historic number, the rule is much more difficult, if not impossible to circumvent.

The rule provides discipline for the long run and prevents us from falling into the political trap of using excuses like recessions to escalate permanently the size of the government. To prevent slipping back into the same mess, we should limit budget growth in any year, even those in which the ratio of spending-to-GDP was under the target of 18%, to no more than twice 1 the prior years increase. And once the spend-to-GDP ratio exceeded 18%, the inflation-minusone rule would prevent us from ever approaching our current situation.

The inflation-minus-one rule provides a mechanism by which we can grow our way out of the problem, without raising the proportion of GDP that is taxed. As GDP grows more rapidly than spending, the ratio of the spending-to-GDP declines. Eventually, the deficit vanishes, and with taxes remaining at historic levels, there is no additional impediment to economic growth.

A variant would be to tie the growth in government spending to growth in GDP. This has the advantage that it is more directly tied to the problem, namely that the size of the government grows faster than the size of the economy. It has the disadvantage that during a prolonged recession and slow recovery, like the current one, the constraints on spending growth might be too severe. Of course, the safety valve would allow legislators to circumvent the constraint, but it is better to build this in directly rather than relying on extraordinary measures.

Spending – and not the deficit - is the most important measure of fiscal restraint because the deficit combines two factors, namely spending and taxes. It is for that reason that fiscal consolidation is the wrong term. Consolidation can mean higher taxes as well as lower spending and they are not the same. A fiscally irresponsible government that increased spending, say, from 20% to 30% of GDP (in the US and significantly higher in Europe) might still run a low deficit if taxes were raised sufficiently. We should not be looking to raise taxes to eliminate the deficit problem. This is especially true for most of Europe, which is not under-taxed at this point. The evidence suggests that the large size of government in Europe has had adverse consequences for economic growth. As a consequence, I much prefer spending growth limitations to polices that call for balancing the budget.

Finally, it is important to couple the enactment of a rule with current action that makes credible the commitment to reduce spending growth. Without that, economic agents might rightly fear that the rule will be too easily suspended or even repealed when it starts to bite.

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