BALANCED BUDGETS: ECONOMIC NIRVANA OR FISCAL CHAOS?

I. INTRODUCTION Economic rhetoric often contributes little to an understanding of economic process and has even less to do with the facts. Nowhere is this disparity more evident than in contemporary discussions of budget balancing and its effects on the economy. Political commentators as well as some economists often speak as if the government budget directly determines the deficit. People often say that cutting the deficit requires cutting the government budget without recognizing the role of government spending in generating income and tax revenues. The fact is that the government controls its expenditure and tax rates; it does not directly control its revenue. That depends on aggregate income. This situation is perfectly analogous to business firms that determine how much they spend on inputs and what prices they charge for goods. They must await their sales, however, before the profit or loss is known. Because there is a business cycle and because it is highly irregular, the revenue of governments--just like that of businesses--is highly variable and irregular, and, as a corollary, so are deficits. Day (1994) reexamines fiscal policy using the dynamic, nonlinear, real/monetary macroeconomic model developed in Day and Shafer (1986) and Day and Lin (1991), which takes these facts into account. When the interaction between money and goods markets is strong enough, this model provides an intrinsic explanation of irregular business fluctuations somewhat like the ones experienced in the 1970s and 1980s. Using this framework, one can show that conventional fiscal policy has complicated ramifications within this framework that do not seem to have been recognized previously. In particular, the following conclusions hold for any fixed level of government spending: (i) A deficit reduction policy based on tax increases could trigger a very deep recession, drastically reducing tax revenue and yielding monstrously high deficits. (ii) The range of tax rates capable of producing a budget surplus may be very narrow and can occur within the range for which quite wide economic fluctuations persist so that small surpluses happen occasionally but deficits of greater or lesser magnitude occur most of the time. (iii) Unstable business cycles may be better on average--and absolutely--than a stable economy both in terms of aggregate income and in terms of the average deficit. This paper summarizes the results obtained with this model when policymakers adopt a balanced budget, pay-as-you-go fiscal policy (patterned after the Arkansas example) that limits government expenditure in any given period to the tax revenue received in the preceding period. Assuming that governments spend all their receipts, tax rate changes have an effect opposite to those when government expenditures are autonomous. Indeed, here is what occurs: (i) Tax rate increases stimulate the economy because of the multiplier effect of increased aggregate demand induced by the increased government spending that higher tax revenues permit. (ii) Sufficiently low tax rates can induce deep recessions. (iii) Sufficiently high tax rates induce aggregate income and employment fluctuations, but income and employment averaged over the cycle may be higher than when tax rates and government spending are lower. (iv) Achieving aggregate income and employment (using a balanced budget policy) that is comparable to the levels experienced with deficit spending in the past one or two decades may require substantially higher than present average tax rates in order to produce adequate aggregate demand. The present model is a "bare bones" representation of the macro economy, but it does contain the core of many large scale econometric models (see Green et al. in Klein, 1991). Relaxing its various simplifying assumptions might change some or even all of these inferences. For one example, distinguishing between personal and corporate income tax rates and incorporating the latter in the investment function--as in Sinai and Eckstein (1983)--surely would moderate if not reverse some of the results presented here. …