Full Article

J. OF PUBLIC BUDGETING, ACCOUNTING & FINANCIAL MANAGEMENT, 14(2), 159-173
WINTER 2002
AN EXAMINATION OF THE EFFECTS OF BALANCED
BUDGET LAWS ON STATE BORROWING COSTS
Cynthia Sneed*
ABSTRACT. This study investigates the relationship between different levels of
state balanced budget laws and state borrowing costs. Using federal guidelines for
state balanced budget law classifications, this author inserted dichotomous variables
in an empirical model of state borrowing costs. Ordinary Least Squares Regression
is utilized to determine which balanced budget laws are recognized in state interest
costs. The results indicate a significant relationship between the most restrictive
levels of balanced budget laws and state borrowing costs. The strongest balanced
budget laws are associated with lower interest costs while the weakest budget laws
are associated with higher costs. It appears that taxpayers in states with weaker
balanced budget amendments may not be as protected against excessive government
growth as those in states with the most stringent balancing requirements.
INTRODUCTION
Washington is very excited over the apparently generous surpluses that
resulted from the bipartisan balanced budget agreement. However, if the
experience of state governments is any indicator, a balanced-budget
amendment requiring the federal government to balance the budget in the
Constitution may reduce future federal budget deficits, but not eliminate
them entirely. Some 49 states have balanced budget provisions, yet many
of them have significant debt. This debt results from state provisions
allowing their individual budgets to be separated and exceptions to be
written into their constitutions or statutes. Thus, whether a balanced-budget
amendment is truly effective in curbing spending depends on the relative
restrictiveness of the agreement.
____________
* Cynthia Sneed, Ph.D. CGFM, is an Associate Professor of Accounting at
Jacksonville State University. Her research interests are public sector retirement
system issues and governmental bond market issues. Her teaching interests are
information systems and e-commerce issues related to accounting.
Copyright 8 2002 by PrAcademics Press
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It can be quite difficult to determine exactly what a state's constitutional
balanced budget agreement requires. Some constitutions only require that
the governors submit a balanced budget plan to the state legislature but
there is no requirement that the legislature actually pass a balanced budget.
Also, some twenty constitutions allow states to carry a deficit over into the
next fiscal year, yet these states are classified as "balanced budget" states.
According to a recent General Accounting Office survey, budget officers in
ten states, most of which are balanced budget states, said they were not
subject to requirements of a year-end balance. Budget officers in another
eleven states said that they were allowed to carry over deficit financing if
necessary. Thus, one can see that simply classifying a state as having a
balanced budget law does not mean that the state has no deficit spending.
This research investigates governmental bond market recognition of the
relative strength of the balanced budget laws when pricing state bonds. The
research hypothesizes that bond markets recognize the most restrictive
balanced budget laws in borrowing costs because these types of balanced
budget laws are harder to circumvent through accounting gimmicks or
(1)
tricks. Evidence that governmental bond markets recognize the most
restrictive form of balanced budget laws (relative to the other more
moderate or weaker laws) would suggest that governmental markets may be
more efficient than prior research suggests.
The research results also would have important implications for fiscal
policy. Taxpayers in states with moderate or weak balanced budget laws
may believe they are protected from excessive government growth when in
fact the states have ample opportunity to increase spending and their
borrowing costs are higher. The increased government growth would have
important intergenerational consequences for the future citizens the laws
were purportedly designed to protect. Finally, if Congress does decide to
pass a constitutional amendment to balance the budget, the policymakers
may want to look at the most restrictive state balanced budget agreements
for guidance in choosing an effective balanced budget law.
This paper will describe the state balanced budget rules, discuss the
prior literature, describe the research methodology, and discuss the
empirical results, followed by a conclusion.
EFFECTS OF BALANCED BUDGET LAWS ON STATE BORROWING COSTS
161
OVERVIEW OF BALANCED BUDGET LAWS
Those who advocate amending the United States Constitution to require
a balanced federal budget enjoy substantial public, if not political, support
for their position. However, until the Keynesian school of microeconomic
theory during the 1930s and 1940s, the norm of our national political
history was to balance the budget. Even without Constitutional
requirements to do so, the accepted attitude about how our government
should finance its affairs was fiscal conservatism. Buchanan (1995) notes
that, prior to World War II, politicians would have considered it to be
immoral to spend more than they were willing to generate in taxes except in
the case of extreme national emergency. Spending borrowed funds on
current expenditures was not acceptable political behavior. There were
basic moral constraints in place and no need for an explicit fiscal rule in the
written constitution.
However, during the Keynesian period, the government budget was
seen as a mechanism to set social and economic policy as well as political
agenda. Keynesian economists believe that the budget provides an
instrument through which economic objectives such as full employment and
economic growth can be attained. In order to sell the theory, the public had
to believe that government debt and deficits were not only socially
acceptable, but also a desirable method to attain socioeconomic objectives.
Thus, it became necessary to convince the public that there were no
negative consequences to debt financing. Needless to say, this turnabout in
public attitudes did not take place overnight. What started as a theoretical
movement during the 1930s and 1940s took almost thirty years for fruition.
However, by the time the Johnson administration's "Great Society"
programs of the 1960s were proposed, the politicians were ready for a way
to spend money for their constituents without having to raise immediate tax
revenues to pay for the increase in services. Thus, a cycle of substantial
deficit financing began that has resulted in a federal debt in excess of five
trillion dollars.
Summaries of state balanced budget requirements and state budgeting
practices can be found in the National Association of State Budget Officers
(NASBO 1992) and the U.S. General Accounting Office (1993). Only
Vermont does not have a balanced budget law; however, the restrictiveness
of the laws varies from state to state. The laws can be classified into three
broad categories depending on where in the budget process the balance is
required. The least restrictive of the laws require simply that the governor
submit a balance budget but says nothing about enforcement of the law.
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Forty-four states have this requirement but many also have other
restrictions. Thirty-seven states require that the state legislature enact a
balance budget but allow for deficits to run in years where actual revenues
and expenditures deviate from budget expectations. How long states are
allowed to carry these deficits varies from state to state. Some states require
a balanced budget by the next fiscal year, others the next biennium. The
third and most stringent type combines the requirement to enact a law with
no deficit carryforwards. Twenty-four of the thirty-seven states that require
a balanced budget have this law.
According to Portera (1994), forty-eight of the forty-nine states
classified by NASBO have balanced budget laws but the laws apply only to
the general fund. In 34 states the rules do not apply to special funds (such
as those earmarked for tax receipts of capital spending or trust funds). In
some states funds raised by issuing long-term debt for capital projects can
be included in the revenues for the budget period. Table 1 provides a
summary of the state balanced budget laws including where in the
budgeting process the budget is required to be balanced.
PRIOR LITERATURE
Prior literature on balanced budget laws and state fiscal policy includes
recent studies by Alt and Lowry (1994) and Poterba (1994). Alt and Lowry
investigate how anti-deficit carrying provisions affect state spending and
taxes. Using Census data, they model state revenues and expenditures as a
function of current state income, current federal grants, lagged difference
between revenues and expenditures and variables for political
circumstances. Comparing state fiscal policy reactions to differences
between revenues and expenditures, they found that a $1 state deficit in the
current year triggers a 77 cent response, through tax increases or spending
reductions in Republican-controlled states that restrict deficit carryovers,
and a 34 cent response in Democratic states with deficit restrictions. In
states that do not restrict carryovers, the adjustments were 31 cents and 40
cents for Republican and Democrat states respectively. Thus, the evidence
suggests that state politics is an important influence in controlling state
spending. Poterba (1994) investigates how state fiscal policies respond to
unexpected deficits or surpluses. His results indicate that states with weak
balanced budget laws adjust spending less in response to unexpected
EFFECTS OF BALANCED BUDGET LAWS ON STATE BORROWING COSTS
TABLE 1
Summary of State Balanced Budget Laws with ACIR Index
Classification
State
(1)
(2)
(3)
(4)
(5)
(6)
Alabama
X
10
Alaska
X
6
Arizona
X
X
10
Arkansas
X
9
California
X
6
Colorado
X
10
Connecticut
X
5
Delaware
X
10
Florida
X
X
10
Georgia
X
X
10
Hawaii
X
10
Idaho
X
10
Illinois
X
4
Indiana
X
X
10
Iowa
X
X
10
Kansas
X
10
Kentucky
X
10
Louisiana
X
4
Maine
X
9
Maryland
X
6
Massachusetts
X
3
Michigan
X
6
Minnesota
X
8
Mississippi
X
9
Missouri
X
X
10
Montana
X
X
10
Nebraska
X
10
Nevada
X
4
New Hampshire
X
2
New Jersey
X
10
New Mexico
X
10
New York
X
3
North Carolina
X
10
163
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TABLE 1 (Continued)
State
(1)
(2)
(3)
(4)
(5)
(6)
North Dakota
X
8
Ohio
X
X
10
Oklahoma
X
10
Oregon
X
X
8
Pennsylvania
X
6
Rhode Island
X
10
South Carolina
X
10
South Dakota
X
10
Tennessee
X
10
Texas
X
10
Utah
X
X
10
Virginia
X
8
Washington
X
8
West Virginia
X
10
Wisconsin
X
6
Wyoming
X
8
Notes:
Column (1) = Governor only has to submit a balanced budget.
Column (2) = Legislature Only has to Pass a Balanced Budget
Column (3) = May Carry Over a Deficit but Must be Corrected in Next
Fiscal year.
Column (4) = State Cannot Carry Over a Deficit Into Next Biennium
Column (5) = State Cannot Carry Over a Deficit Into Next Fiscal Year
Column (6) = Stringency Index.
deficits than do states with more restrictive laws. Poterba found that a $100
deficit overrun leads to only a $17 expenditure reduction in a state with a
weak balanced budget law, while it leads to a $44 reduction in other states.
In addition to how balanced budget laws affect fiscal policy, there also is
research on balanced budget rules and state borrowing. Von Hagen (1991)
compares the level of state general obligation debt, and per capita state
income, in states with and without stringent balanced budget requirements.
Von Hagen used the Advisory Council on Intergovernmental Relations
2
(ACIR index 1987) to classify the balanced budget laws. His results
EFFECTS OF BALANCED BUDGET LAWS ON STATE BORROWING COSTS
165
indicate that general obligation debt is substantially lower in states with
stringent balanced budget amendments than in other states. He also
examines the effect of stringent balanced budget rules on the ratio of nongeneral obligation debt to general obligation debt across states. The results
indicate that states with more restrictive balanced budget laws, as well as
states with lower general obligation debt limits, exhibit higher levels of
revenue debt and other non-general obligation debt.
These results were consistent with Bunche (1991) and Kiewiet and
Szakaly (1992). Bunche found that states with more stringent debt limits or
balanced budget laws are more likely to use alternatives to state-approved
borrowing to finance projects. Kiewiet and Szakaly examined the effects
of antideficit measures and limits on state borrowing and found that a
combination of stringent anti-deficit rules and voter-approval of debt was
more likely to bring about pressure for tax increases or spending cuts, rather
than debt financing. Lowry and Alt (1995) found that the bond market
reaction to a state deficit depended on whether the state had a balanced
budget requirement. States with balanced budget rules experience small
increases in their borrowing costs for a given deficit period.
This study extends prior research by examining the bond market
reaction to the various levels of restrictiveness of the balanced budget laws.
Using ACIR guidelines, the balanced budget rules are classified into three
categories (strong, moderate and weak) and the significance of the
dichotomous variables representing the balanced budget rules is examined
to test the research hypothesis. The following section describes the research
hypothesis and methodology.
RESEARCH METHODOLOGY
This research investigates the following hypotheses:
H1: States with strong balanced budget laws have lower borrowing costs
then states with moderate or weaker balanced budget laws.
H2: States with moderate balanced budget laws have lower borrowing
costs than states with weaker balanced budget laws.
The research hypotheses are investigated by examining the significance
of two dichotomous variables representing three different levels of balanced
budget laws in a standard model of state borrowing costs developed in the
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literature. The research model, control variables and research variables are
discussed below.
Research Model and Variable Selection
The empirical model is summarized in the following equation. The
variable definitions and expected signs of the coefficients are presented
below.
NIC = B0 + B1(HI) + B2(MED) + B3(INT) + B4(MAT)
+ B5(GODEBT) + B6(OWNREV) + eit
where:
NIC =
HI =
yield to maturity on state bonds;
a dichotomous variable representing the balanced budget law.
Variable is 1 if the state had the most restrictive law and 0
otherwise (-);
MED = a dichotomous variable representing the balanced budget law.
Variable is 1 if the state has a moderate BBL and 0 otherwise ();
INT = the general level of interest rates on the date the bond was
issued (+);
MAT = term to maturity, measured in years (+);
GODEBT = general obligation debt per capita (+);
OWNREV = ratio of general revenues from own sources to total
general revenues (-);
i = state;
t = year;
e = random error term.
The research model tests whether states with the strongest laws have
lower borrowing costs than states with moderate or weaker balanced budget
laws. To test the hypothesis the dependent variable, net interest cost (NIC),
is operationalized as average yield-to-maturity on new state bond issues.
The interest variable (INT) is included to control for the general level of
interest rates at the time of the bond issue. The predicted sign of the
coefficient is positive as higher levels of general interest rates are expected
to raise state borrowing costs.
Maturity (MAT) is a control variable included to control for differences
in yields across different maturities. Longer maturities are expected to have
EFFECTS OF BALANCED BUDGET LAWS ON STATE BORROWING COSTS
167
higher yields because of increased risk. Thus, the anticipated sign of the
MAT coefficient is positive. A variable to control for the amount of general
obligation debt the state has incurred is included in the model. GODEBT is
operationalized as general obligation debt per capita. The predicted sign of
the coefficient is positive since states with higher per capita debt are
expected to have higher levels of borrowing costs. The last control variable
(OWNREV) measures the percentage of a state's general revenues that are
provided by the state's own sources. This variable measures a state's selfreliance in generating revenues. The higher the ratio the lower the default
risk, which is expected to result in a negative relationship between
OWNREV and NIC.
The research variables, HI and LOW, are dichotomous variables
included in the model to test the research hypothesis. Using ACIR
classifications, the balanced budget laws were classified according to level
of restrictiveness. The ACIR classified BBL on a scale of 1 to 10, with 10
being the strongest form of BBL. In keeping with ACIR classifications,
states with ranking 1-3 are weak, 4-7 are moderate and 8-10 are strong.
Table 1 describes the state ACIR classifications. The predicted sign of the
HI coefficient is negative. States with strong and moderate balanced budget
laws are hypothesized to have lower borrowing costs relative to other states
with weak balanced budget laws.
Sample Selection and Data Sources
Data for the dependent variable, NIC, for all new states bond issues
from 1990-1992 were collected from Bloomberg's Financial Markets
database. Examining the data indicated that 26 states combined for a total
of 78 new bond issues for the sample period. The new bond issues are
serial bonds, where a portion of the principal is repaid each year.
Data for the balanced budget laws for states over 1991-1992 were
(2)
obtained from the ACIR classification table. The data sources for other
model variable were State Government Finances 1991 and 1992. Ordinary
least squares regression was used to estimate the parameters of the
regression model. The data were first examined for evidence of the
violations of the ordinary least square assumptions that would cause
inefficient estimates of the regression coefficients or biased estimates of
their variances. Plots of the independent variables against the dependent
variable indicate that the data were normally distributed. Additionally, the
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data were examined for evidence of correlation among the variables. The
correlation matrix in Table 2 did not indicate a multicollinearity problem
among the variables. White's adjustment procedure was used to correct
heteroscedasticity (Breusch-Pagan Chi-Square 62.7684 with 6 degrees of
freedom).
TABLE 2
Correlation Matrix
Variables in the Regression Model
HI
MED
INT
MAT
GODEBT OWNREV
-----------------------------------------------------------------------------------------HI
1.000
-.290
.257
-.144
-.359
-.027
MED
-.290
1.000
-.088
-.015
-.037
.196
INT
.257
-.086
1.000
-.037
-.054
.158
MAT
-.144
-.015
-.037
1.000
.110
.142
GODBT
-.359
-.037
-.054
.110
1.000
.305
OWNRV
-.027
.196
.158
.142
.305
1.000
where:
NIC = yield to maturity on state bonds;
HI = a dichotomous variable representing the balanced budget law.
Variable is 1 if the state had the most restrictive law and 0
otherwise (-);
MED = a dichotomous variable representing the balanced budget law.
Variable is 1 if the state has a moderate BBL and 0 otherwise
(-);
INT = the general level of interest rates on the date the bond was
issued (+);
MAT = term to maturity, measured in years (+);
GODEBT = general obligation debt per capita (+);
OWNREV = ratio of general revenues from own sources to total
general revenues (-);
i = state;
t = year;
e = random error term.
EFFECTS OF BALANCED BUDGET LAWS ON STATE BORROWING COSTS
169
EMPIRICAL RESULTS
The descriptive statistics for the continuous variables in the research
model are presented in Table 3 and estimates of the coefficients and pTABLE 3
NIC = B0 + B1(HI) + B2(MED) + B3(INT) + B4(MAT)
+ B5(GODEBT) + B6(OWNREV) + eit
Panel A. Descriptive States for Model Variables
Variable
Mean
Std. Dev.
Minimum
Maximum
---------------------------------------------------------------------------------------NIC
HI
MED
INT
MAT
GODEBT
OWNREV
5.8923 .9125
.6025
.0512
6.7565
8.9840
$419.5500
.7407
2.3000
.4925
.2200
.3603
2.6265
$436.4300
.0298
10.0000
.0000
.0000
5.8800
2.5000
$12.2000
.6784
1.0000
1.0000
7.5300
15.5000
$2001.0000
.8027
---------------------------------------------------------------------------------------Panel B. Estimates of the Model Parameters
Variable
Coefficient
T-ratio
P-value*
---------------------------------------------------------------------------------------One
HI
MED
INT
MAT
GODEBT
OWNREV
R2 = .4558
N = 78
P-values are one tail.
where:
NIC =
HI =
MED =
-2.0592
- .2717
- .2717
1.3596
.0675
.0358
-2.1504
-1.4890
-1.8870
-1.1520
7.3680
2.7300
2.1360
-1.7110
.0704
.0374
.1230
.0000
.0039
.0015
.0456
yield to maturity on state bonds;
a dichotomous variable representing the balanced budget law.
Variable is 1 if the state had the most restrictive law and 0
otherwise (-);
a dichotomous variable representing the balanced budget law.
Variable is 1 if the state has a moderate BBL and 0 otherwise
(-);
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INT =
the general level of interest rates on the date the bond was
issued (+);
MAT =
term to maturity, measured in years (+);
GODEBT = general obligation debt per capita (+);
OWNREV = ratio of general revenues from own sources to total
general revenues (-);
i = state;
t = year;
e = random error term.
values of the variables are presented in Table 4. The overall model is
2
statistically significant (p-value .000) with an adjusted R of .4553. All of
the control variables are significant and have the predicted sign. INT is
highly significant (p-value .0000) and positive, indicating that state
borrowing costs are higher as interest rates rise. As expected, MAT is
significant and positive (p-value .0039) indicating that borrowing costs are
higher for longer maturities. GODEBT is highly significant and positive (pvalue .0015) indicating that higher levels of general obligation debt are
associated with higher borrowing costs. Finally, OWNREV is significant
(p-value .0456) and has the predicted negative sign indicating that
borrowing costs are less for states with a higher ratio of their own revenues
to general revenues.
As was expected, the research variable, HI is highly significant (pvalue .0374) and negative, indicating that states with the strongest form of
balanced budget laws have lower levels of borrowing costs than states with
weaker or more moderate laws. The MED variable is not significant in the
research model (p-value .1230) but did have the predicted sign. These
findings suggest that taxpayers in states with the less restrictive balanced
budget laws pay higher interest costs than do taxpayers in other states. The
results also suggest that the bond market recognize the less restrictive laws
as somewhat less effective than the stronger and acts accordingly.
EFFECTS OF BALANCED BUDGET LAWS ON STATE BORROWING COSTS
171
SUMMARY AND CONCLUSIONS
This research examines the association between state borrowing costs
and different levels of balanced budget laws. States with budget deficits
have only three options for dealing with the problem. They can raise taxes,
reduce spending or close the deficit through some other method such as
deferring payments across the fiscal year or accelerating receipts. The
results provide evidence that governmental bond markets do recognize the
most restrictive form of balanced budget laws (relative to the weaker laws)
and also suggest that governmental markets may be more efficient than
previously recognized.
In a descriptive sense, the findings indicate that taxpayers in states
with strong balanced budget laws pay less in interest costs than other states
with balanced budget laws. Taxpayers in states with moderate or weak
balanced budget laws may believe they are protected from excessive
government growth when in fact the states have ample opportunity to
increase spending and their borrowing costs are higher. The increased
government growth would have important intergenerational consequences
for the future citizens the laws were purportedly designed to protect.
Proponents of the balanced budget law often cite states' success in achieving
fiscal restraint as the catalyst for the balanced budget movement. But
supporters often ignore the fact that the combined debt for all 50 states in
1993 was $387.7 billion, or more than half their combined annual
expenditures of $742.9 billion. Estimates are that local governments carry
even larger amounts of debt (Hosansky, 1995). States can incur this debt
because they are able to split apart their budgets and use loopholes written
into their constitutions or statutes.
Investigating the effects of balanced budget laws on state borrowing
costs is timely given the political debates regarding the disposition of
current federal surpluses. If the Congress does decide to require a balanced
budget, then policymakers may want to look at the most restrictive state
balanced budget agreements for guidance. Foes of a federal balanced budget
amendment oftentimes cite the problems with funding capital projects as a
reason not to enact a constitutional amendment to balance the federal
budget. However, state officials have long argued that relying on debt for
capital project expenditures is necessary and fair because it allows them to
spread the burden of capital projects over many years. Florida's budget
director, Robert Bradley said that asking current-year taxpayers to absorb
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all the costs that the future residents are going to cause is unfair and
impractical (Hosansky, 1995). The results of this research may provide
insight for policymakers into practical methods of writing a balanced
budget law that would insure protection of taxpayers against massive
government growth while also providing for vital government services such
as infrastructure and capital expansion.
ACKNOWLEDGMENTS
The author would like to thank participants at the 1999 American
Accounting Association Midwest Meeting as well as several anonymous
reviewers for their insightful and helpful comments. Any errors and
omissions are entirely my own.
NOTES
1.
Examples of actions taken by states to remedy budget deficits include
California’s transferring revenues from an oil extraction tax in a trust
fund to the general fund and New York’s deferring the 1983 payroll
period over into 1984 to balance the budget (GAO 1985).
2.
The ACIR Index can be found in the publication "Significant Features
of Fiscal Federalism" complied by the Advisory Commission on
Intergovernmental Relations. This publication provides information
about state statutory or constitutional limits on borrowing, including
information about when the balanced budget law was adopted and
what type of balanced budget law was adopted. The ACIR Index
describes degree of stringency of the balanced budget laws.
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