Fiscal Rules Can Help Fix the Budget Process

Some years ago, Rudolph Penner offered an oft-repeated response to politicians who had used proposed changes in the budget process to bolster their credentials as deficit hawks. “The problem,” he said, “is not the process, the problem is the problem.”

What Penner, Director of the Congressional Budget Office from 1983 to 1987, meant is that politicians have it within their power to cut deficits and limit public debt without rewriting the process first. All they have to do is vote to cut spending or raise taxes. Politicians sometimes use discussion of the process to avoid responsibility for directly addressing the problem.                                                                            

While Penner certainly had a point, the persistence of rising government debt over many decades, and in many different political settings around the world, suggests that the problem isn’t solely a function of inadequate political leadership.

Pierre Yared, a macroeconomist at Columbia University, provides a useful summary of what recent academic literature and empirical evidence has to say on this question, primarily from a political economy perspective. He finds that the U.S. debt problem is part of a larger pattern across many advanced economies and is rooted in factors related to democratic governance.

He cites three reasons elected leaders are becoming more excessively focused than they used to be on short-term political and economic outcomes at the expense of long-term considerations.

First, the electorate is aging. All voters have concerns both about their present circumstances as well as what will happen in the future, but not all voters weigh the present and future equally. Older citizens, quite naturally, focus less on what might happen many years from now than on what might happen to their social support system in the very near future. Younger workers tend to place more emphasis on the long term because they see themselves taking an active role in their societies well into the future. Western democracies are in the midst of a profound demographic transformation, with rapid aging and low birth rates. Thus, the electorate is becoming progressively older with each election. Politicians are responding to the shifting age profiles of their voters by emphasizing protection of current benefits at the expense of higher deficits and debt.

Second, the “tragedy of the commons” means no political party is willing to take full responsibility for its deficit-increasing actions, or for fixing problems created by politicians elected in previous years, because they know their political opponents have no incentive or intention of acting responsibly either (this problem was long ago identified by the pioneers of public choice economics). Instead, political parties see short-term benefit from taking quick action when they can to promote their spending and taxation priorities, knowing that some of the responsibility for their actions will fall on their political opponents. As democracies become more polarized and factionalized, political parties become even less willing to assume responsibility for problems they see as being created by others and inconsistent with their agendas and political ambitions.

Third, as democracies become more competitive, political parties are less certain how long they will remain in power, and thus also less willing to take a longer-term perspective. This dynamic is especially relevant in countries that, in earlier times, had longer periods of one-party dominance but which now are characterized by more rapid swings in party control. As political parties increasingly fear their time in power will be short, they have an incentive to put their priorities in place while they can.

As these structural causes of deficits and debt have become more widely understood, many countries have adopted fiscal rules to correct for the biases in their political processes that push toward higher annual deficits and ever-growing debt. In 1990, only 7 countries had such rules in place constraining their budgetary decisions; by 2015, the number had grown to 92.

Fiscal rules impose budgetary constraints on all politicians and political parties in a country, now and into the future. Once a fiscal rule is in place, it must of course be enforced to be taken seriously. The rules work best when voters come to see their value, and punish political parties and politicians who would overturn them.

The evidence shows that fiscal rules do work to an extent, but they don’t make deficits vanish. In a comprehensive overview covering many years, the International Monetary Fund (IMF) estimated that countries with such rules have annual budget deficits that are smaller by an average of 0.5 percent of GDP compared to countries without such rules. 

Switzerland is an interesting case study. In 2001, Swiss citizens voted to limit the growth rate of central government spending to the growth rate of tax revenue. The limit, called the Swiss Debt Brake (SDB), is designed to allow some smoothing over time to accommodate periods of slow economic growth or recessions. After adoption of the SDB, the Swiss government made other adjustments in its internal budget procedures to ensure compliance with the new restraint on spending growth.

Since the SDB was imposed, debt has been stabilized and is now declining. In 2002, Swiss government debt was equal to nearly 60 percent of GDP. As of 2015, the debt had fallen to about 43 percent of GDP. U.S. federal debt, by contrast, rose from 33 percent of GDP in 2002 to 73 percent of GDP in 2015.

There are major differences between the political cultures in Switzerland and the U.S. The Swiss regularly settle important questions of public policy through direct voting on constitutional amendments. In the U.S., constitutional change is very rare, and the expectation is that once amendments are adopted, it won’t be easy to change them again or reverse course (Prohibition being an obvious exception to the rule). Moreover, fiscal rules have technical and definitional aspects to them that are not easily addressed in permanent constitutional language. Statutory fiscal rules would be more easily amended with experience.

There’s no simple solution to the problem of rising U.S. debt, however. New fiscal rules would require many adjustments both within Congress and the executive branch. The starting point might be to agree on a fiscal goal, such as keeping debt to no more than 60 percent of GDP (it is 78 percent this year). The law requiring a presidential budget and the congressional budget process would then need to be amended, to require both branches of government to adopt budgets that move toward the agreed upon goal over time.

Policies and budgets that would not comply with the debt target, or which move in the wrong direction, would face very high political hurdles. Budgets that do not make sufficient progress toward the goal also would be very hard to adopt. The objective should be a gradual change in political expectations for voters and politicians alike, so that massive deficit spending when the economy is strong is no longer tolerated as business as usual. 

Democratic governance has an Achilles’ heel, one which the architects of American government fully understood. Tomorrow’s citizens don’t have a vote today, and so elected leaders do not pay sufficient attention to their interests. One way to correct for this bias is by constraining the decisions that today’s leaders can make, to prevent the imposition of excessive financial burdens on future generations of voters. Many other advanced economies have taken steps in this direction. The U.S. should too.

James C. Capretta is a RealClearPolicy Contributor and a resident fellow at the American Enterprise Institute.