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GUIDELINES FOR THE DESIGN OF NEW FISCAL RULES FOR THE U.S.

In our book ‘Restoring America’s Fiscal Constitution’ (Merrifield and Poulson 2017) we make the case for a new set of fiscal rules to guide fiscal policy in the U.S. In recent years an extensive literature on the design of fiscal rules has been written. In a comprehensive survey of this literature, Fall et al. (2015) suggest guidelines for the design of fiscal rules (which they refer to as a ‘fiscal framework’). In this paper we will explore the relevance of these guidelines for the design of new fiscal rules for the U.S. A working group of scholars will be invited to participate in the discussion and analysis of these guidelines. Based on this discussion and analysis, the authors will draft a ‘Handbook’ to guide elected officials and policy makers in drafting new fiscal rules for the U.S. The study is part of the ‘Friedman Project’, the aim of which is to restore America’s Fiscal Constitution’.

(1). What is the Rationale for New Fiscal Rules?

Synopsis (1)

“In all countries, there is a set of rules and institutions that shape fiscal policy making. They comprise the institutions, arrangements and procedures that govern the planning and implementation of budgetary policies.

In most advanced countries, debt ratios have been trending up since the late 1970s, illustrating the lack of fiscal discipline and the inability of governments to commit to sustainable public finances. Indeed, debt breaks the link between taxation and spending, tempting governments to shift the fiscal burden to future generations. A large literature identifies reasons, why such a deficit bias exists (see Persson and Tabellini, 2000; Wyplosz, 2013; Calmfors and Wren-Lewis, 2011).”—

“The major objectives of the fiscal framework are twofold: it should underpin fiscal discipline in reaching the prudent debt target and allow for short-run flexibility of fiscal policy to react to cyclical developments and shocks. A rule serves as a commitment tool to increase the cost of deviations and to anchor expectations about future fiscal developments. Some discretion remains, however, essential to guarantee that fiscal policy can react to sizeable shocks.

The fiscal framework should make it more likely that countries with high debt will follow a path towards a more prudent level and that countries close to the prudent debt target will seek to stay there. Five components of the fiscal framework are considered: a debt target, a fiscal rule, fiscal councils, budgetary processes and medium-term budgeting (Fall et al. 2015 p.30).”

Readings (1)

  • Alesina and F. Giavazzi (eds.), Fiscal Policy after the Financial Crisis, NBER, The University of Chicago Press, Chicago.
  • Fall, F. and J-M. Fournier (2015), “Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules”,OECD Economics Department Working Papers, No. 1230, OECD Publishing,Paris.
  • Merrifield, J., and B Poulson. 2017. Restoring America’s Fiscal Constitution, (forthcoming), Lanham, Lexington Press.
  • Persson, T.and G. Tabellini, (2000), “Political Economics: Explaining Economic Policy”, Cambridge, MA: MIT Press.
  • Wyplosz, C. (2013), “Fiscal Rules, Theoretical Issues and Historical Experiences”, in A. Alesina, and F. Giovassi (eds), Fiscal Policy After the Financial Crisis, NBER, the University of Chicago Press.

Discussion Folder (1)


(2) How Should a Debt Target be Set?

Synopsis (2)

“In designing a fiscal framework, the starting point is to define the targets and instruments. A debt target can be effective in anchoring expectations about future fiscal policy. The prudent debt target serves as the reference point to define numerical fiscal rules, in particular, for countries with high debt that have to converge to a lower prudent debt ratio. A debt target is better than a debt limit. The experience of the EU framework is that, in the absence of a debt target, debt drifted up towards the 60% of GDP limit or even beyond, leaving no room to absorb the sizeable fiscal shock of the recent crisis without breaching the limit (Fall et al. 2015, pp.30-31).”

Readings (2)

  • Fall, F. and J-M. Fournier (2015), “Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules”,OECD Economics Department Working Papers, No. 1230, OECD Publishing,Paris.
  • Rawdanowicz, Ł. (2012), “Choosing the Pace of Fiscal Consolidation”, OECD Economics Department Working Papers, No. 992, OECD Publishing, Paris.
  • Lo, S., and K. Rogoff. 2015. “Secular Stagnation, Debt Overhang and Other Rationales for Sluggish Growth, Six Years on”, Bank for International Settlements, Working Paper 482, January.

Discussion Folder (2)


(3) How Should the Debt Target be achieved using Fiscal Rules?

Synopsis (3)

“The debt trajectory is the core concern of the fiscal framework. Given the uncertainties surrounding the macroeconomic determinants of debt developments and also that these macroeconomic variables are beyond the control of the government, though they are endogenously affected by government policies, fiscal rules will target the main determinants of debt directly under government control.

Fiscal rules should have two objectives: (1) anchor fiscal policy expectations by targeting a prudent debt level and (2) allow for macroeconomic stabilization that enhances economic growth. Fiscal stimulus to mitigate recession increases uncertainties surrounding the debt path: there is a trade-off between these two objectives. Real time stimulus may stabilize the cycle, but also affects debt dynamics (Fall et al. 2015 p.35).”

“A good fiscal rule should have two main properties. The fiscal rules should define a confidence interval or a band for its main variables to accommodate macroeconomic fluctuations. If the economy has a budget or structural deficit close to a fixed limit, the limit constitutes an important restriction for the stabilization effects of both the automatic stabilizers and counter-cyclical discretionary fiscal policy in a downturn.

A combination of rules should ensure compliance with the chosen debt trajectory. A budgetary constraint cannot only refer to the budget balance, if it is to avoid potential adverse effects on the underlying components of the budget balance (e.g. undesirable tax increases to compensate for structural problems on the expenditure side) (Fall et al. 2015 p.36).”

The rules differ in their ability to fulfil objectives of reaching a prudent debt target and of stabilization. The structural budget balance rule combines, in principle, the capacity of satisfying the two objectives, but it has important drawbacks in terms of observability and real time assessment. Structural balance measures, despite some progress on measurement, are highly dependent on volatile and often biased estimates of the output gap and subject to frequent revisions (Hers and Suyker, 2014). For instance, for Slovakia, Klein et al. (2013) report that the structural deficit in 2010 using pre-crisis estimates of potential growth would have been nearer to 4% than 8% of GDP.

Also, structural deficits can be revised sharply in the case of a crisis as potential growth is not well measured in real time. In particular, the downward revision of the structural primary balance was about 7% of GDP for Greece and about 3% of GDP in Ireland. These revisions follow growth surprises: on average across countries, a 1% real output shock is associated with a 0.2% revision of the potential output level (Fall and Fournier, 2015 p.36).

Therefore, the adoption of a budget balance rule complemented by an expenditure rule could suit most countries well, the combination of the two rules responds to the two objectives. A budget balance rule encourages hitting the debt target. And, well-designed expenditure rules appear decisive in ensuring the effectiveness of a budget balance rule (Guichard et al., 2007). Carnot (2014) shows also that a binding spending rule can promote fiscal discipline while allowing for stabilization policies. The marginal benefit of adding a revenue rule is likely outweighed by its costs in terms of complexity and reduction in fiscal flexibility (Fall et al. 2015 p.37).”

Readings (3)

  • Botev, J. J. Fournier, and A. Mourougane. 2016. “A Reassessment of Fiscal Space in OECD Countries’, OECD Working Paper no. 1352, Nov 23.
  • Fall, F. and J-M. Fournier (2015), “Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules”, OECD Economics Department Working Papers, No. 1230, OECD Publishing, Paris.
  • Gosh, A., J. Kim, E. Mendoza, J. Ostry, M. Qureshi, “Fiscal Fatigue, Fiscal Space, and Debt Sustainability in Advanced Economies”, NBER Working Paper Series 16782. February.
  • Guichard, S. et al. (2007), “What Promotes Fiscal Consolidation: OECD Country Experiences”, OECD Economics Department Working Papers, No. 553, OECD Publishing, Paris.
  • Hers, J. and W. Suyker (2014), “Structural Budget Balance: A Love at First Sight Turned Sour”, CPB Policy Brief, 2014/07
  • Klein, C., R. W. Price and A. Wörgötter (2013), “Improving the Fiscal Framework to Enhance Growth in an Era of Fiscal Consolidation in Slovakia”, OECD Economics Department Working Papers, No. 1018, OECD Publishing, Paris.
  • Ostry, J. A Gosh. J. Kim, and S. Qureshi. 2010. ‘Fiscal Space’, IMF Staff Position Note, September 1.

Discussion Folder (3)


(4) What is the Optimum Consolidation Path for High Debtor Countries to achieve the debt Target?

Synopsis (4)

“For countries in transition towards a prudent debt level, a path either in terms of budget balance or debt needs to be defined. The consolidation path links the current debt level to the prudent debt target.

There are many OECD studies on consolidation strategies that provide useful lessons. Rawdanowicz (2012) shows that it is possible to choose an optimal consolidation path to bring the deficit down and stabilise debt at a long-run target in a finite horizon. A previous OECD project on fiscal consolidation (Sutherland et al. (2012), Barrell et al. (2012) and Merola and Sutherland (2012) stressed the need to structure a consolidation strategy such that instruments with low multipliers are used initially and to enhance the institutional framework for fiscal policy in order to minimise the trade-offs with growth in the short run. Hageman (2012) shows that in most countries there is scope to target spending programmes more effectively and eliminate distortions in taxation. Moreover, Cournède et al. (2013) find that there is room in half of the OECD countries to reduce debt mainly through adjustments in instruments (such as subsidies, pensions or property taxes) that have at most limited side-effects on other policy objectives, such as growth or equity (Fall et al. 2015 p.38).”

“Therefore, choosing the consolidation path is the cornerstone of the calibration of fiscal rules (budget balance rule complemented by an expenditure rule). Once the consolidation path is defined in terms of the debt trajectory toward the prudent debt level, the corresponding budget balance and spending rules can be deducted. The stringency of the consolidation path and of the fiscal rules depends on the time horizon to reach the prudent debt level, which may depend on the distance to the prudent debt target. Also, the stringency of the fiscal rules can be kept constant or increased to minimise the risk of missing the timing and the target. When fiscal consolidation is initiated under pressure, then it may be important to build credibility by imposing more stringency from the beginning.

The fiscal rule should include a mechanism to correct for past slippages in upcoming budgets. This could be achieved by means of rules similar to the German “debt brake”, where fiscal slippages are recorded in a special account that has to be balanced over time (Baumann and Kastrop, 2007 and Kastrop et al., 2010) (Fall et al. 2015 p.38).”

Readings (4)

  • Fall, F. and J-M. Fournier (2015), “Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules”,OECD Economics Department Working Papers, No. 1230, OECD Publishing, Paris.
  • Barrell, R., D. Holland and I. Hurst (2012), “Fiscal Consolidation: Part 2. Fiscal Multipliers and Fiscal Consolidations”, OECD Economics Department Working Papers, No. 933, OECD Publishing, Paris.
  • Merola, R. and D. Sutherland (2012), “Fiscal Consolidation: Part 3. Long-Run Projections and Fiscal Gap Calculations”, OECD Economics Department Working Papers, No. 934, OECD Publishing, Paris.
  • Rawdanowicz, Ł. (2012), “Choosing the Pace of Fiscal Consolidation”, OECD Economics Department Working Papers, No. 992, OECD Publishing, Paris.
  • Sutherland, D., P. Hoeller and R. Merola (2012), “Fiscal Consolidation: Part 1. How Much is Needed and How to Reduce Debt to a Prudent Level?”, OECD Economics Department Working Papers, No. 932, OECD Publishing, Paris.

Discussion Folder (4)


(5) How should a Medium Term Budget Framework (MTBF) be used to Anchor the Spending Path?

Synopsis (5)

“For countries that are already close to the debt target, the objectives of the rules are to guarantee debt stability while allowing for stabilisation policies. If the objective is only to stabilise the debt level, then the primary balance needs to be equal to the real cost (difference between real interest rate and real growth times the debt level) of debt. But, as the objective is also to include room for macroeconomic stabilisation, the rules need to allow enough flexibility to dampen fluctuations in economic activity.

There are three dimensions that need to be taken into account when designing the rule:
First, annual budgeting for year t is realised in year t-1 based on the projections of macroeconomic variables. The rules should allow for contemporaneous involuntary (unexpected shocks, automatic stabilisers) or voluntary (fiscal stabilisation) deviations.

Second, because of these contemporaneous deviations, the rules should also include a backward dimension requiring that past deviations get offset over a limited amount of time. That is, the stringency of the budget balance and the spending rules is increased over time up to full correction, taking the form of a binding constraint of ex-post corrections of deviations.

Third, there is a need to anchor the spending path. A medium-term budget framework, (MTBF) in which the government sets a spending trajectory over the medium term complements the budget rule and enhances its effectiveness (Fall et al. 2015 p.39)”.

“The role of the MTBF is to guarantee time-consistency between policies and targets. The MTBF is crucial to convert fiscal targets into detailed revenue and expenditure plans. Successful medium-term budget frameworks provide binding restrictions on multi-year expenditure and a clear and consistent statement of the government’s medium-term priorities within an overall expenditure ceiling (Gupta and Yläoutinen, 2014).

The MTBF needs to be anchored in medium-term numerical objectives (Blondal, 2005). These objectives are intermediary objectives in line with the long-term fiscal targets. Fixed medium- term objectives imply that fiscal rules (budget and spending targets) are not adjusted over time unless unexpected exceptional events arise during the period covered by the framework. For instance, in the Netherlands, Sweden, Finland and the new framework in the United Kingdom, the MTBFs are based on a multi-annual spending rule providing binding expenditure limits. In the case of the Netherlands, each newly elected government announces its medium-term budgetary objectives in accordance with the long- run fiscal target. Then, over the legislature, policies are assessed with regard to their impact on the target.

The key factor in the effectiveness of a medium-term budgetary framework is its influence on annual budgeting. The medium-term path derived from the MTBF should be binding for the budget balance and spending rules. The ex-ante setting of numerical targets for the budget balance and spending rules from the MTBF implies an adjustment of spending and revenue plans to ensure the respect of the different targets. In particular, a prioritisation of spending plans is necessary to make sure that whenever cuts in spending are necessary to respect the fiscal framework, it will not hit policy priorities (Fall et al. 2015 p.38).”

Readings (5)

  • Blondal, J. (2005), “The Reform of Public Expenditure Management Systems in OECD Countries”, in Banca d’Italia (ed.), Fiscal Policy: Public Expenditures, acts of the 7th Public Finance Workshop held in Perugia, 31 March – 2 April.
  • Fall, F. and J-M. Fournier (2015), “Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules”, OECD Economics Department Working Papers, No. 1230, OECD Publishing, Paris.
  • Gupta, S. and S. Yläoutinen (2014), “Budget Institutions in Low-Income Countries: Lessons from G-20”,IMF Working Paper, No. 14/164.

Discussion Folder (5)


(6) Should New Fiscal Rules have Escape Clauses and Rainy Day Funds?

Synopsis (6)

“Tail events happen, but they need not undermine credibility. Clear escape clauses should be set allowing the temporary suspension of fiscal rules. A temporary suspension should be conditional on exceptional events such as natural catastrophes or a sharp output contraction. However, the definition of these escape clauses must be clear to make sure they cannot be used in normal times. Determining the existence of exceptional circumstances can be delegated to a body outside the government or submitted to a validation by qualified majority in the parliament. To cope with tail events, a “rainy day” fund can underpin the respect of the rule over the cycle and would allow greater room for fiscal stabilisation. Unexpected surpluses would be saved and used later to finance unexpected deficits and/or short-term stabilisation policies (Fall et al. 2015 p.37-38).

Readings (6)

  • Fall, F. and J-M. Fournier (2015), “Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules”, OECD Economics Department Working Papers, No. 1230, OECD Publishing, Paris.
  • Merrifield, J., and B Poulson. 2017. Restoring America’s Fiscal Constitution, (forthcoming), Lanham, Lexington Press.

Discussion Folder (6)


(7) Should Public Investment be excluded in Applying New Fiscal Rules?

Synopsis (7)

“It is often argued that public investment that fosters long-run growth should be excluded from fiscal targets. However, drawing the line for public investment that matters for long-run growth is not straightforward, as not only public physical investment, but also spending on education or research and development have a positive effect on growth. Moreover, if public investment is debt financed, it is better to take it into account as debt is created and the positive effects on growth are reaped in the short run (demand effect) and in the long-run (supply effect with spill-overs to the private sector) (Fall et al. 2015 p.31).”..

Readings (7)

  • Fall, F. and J-M. Fournier (2015), “Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules”, OECD Economics Department Working Papers, No. 1230, OECD Publishing, Paris.
  • Merrifield, J., and B Poulson. 2017. Restoring America’s Fiscal Constitution, (forthcoming), Lanham, Lexington Press.

Discussion Folder (7)


(8) How Should Budget Processes be adapted to Implement New Fiscal Rules?

Synopsis (8)

“The budgetary process is also important in ensuring that fiscal rules, in particular spending targets, are met. OECD (2014) sets out the principles of budgetary governance agreed by OECD member countries. Along the ten headline principles emerge the key roles of transparency, sincerity and coordination. Countries deemed successful in the implementation of their fiscal framework (Sweden and the Netherland, for instance) have a centralised budget process (Ministry of finance, Central Budget Administration) ensuring the consistency between ex-ante spending plans and actual spending. Also the centralisation of budgeting procedures is deemed necessary for the effectiveness of top-down budgeting (EC, 2010). In particular, the central budget office should have the possibility to veto any over-spending until a new law is voted to authorise it.

Successful budgetary procedures are likely to be country-specific depending on the size of the country, its central or federal nature and the features of the political system. Von Hagen and Harden (1994) find that budget processes of all governments of large states that successfully limited spending and deficits in the 1970s and 1980s (France, Britain, and Germany) are based on a procedure-oriented approach, that is when there is a process of negotiations between spending ministers and a central minister (budget or finance) which has some power. In contrast, the budget processes of smaller countries (Denmark, the Netherlands and Luxembourg) that successfully limited spending and deficits are target-oriented. This suggests that country size matters for the complexity of administrations, which makes it more difficult to monitor compliance with numerical budget targets.

OECD (2014) and Gupta and Yläoutinen (2014) find that top-down budgeting is one of the key elements that underpin a credible fiscal strategy. In particular, during fiscal consolidation episodes, a top- down budgeting approach imposes limits to spending both at the aggregate and sectoral level, which increases the likelihood that the budget execution is consistent with the ex-ante fiscal plan. The spending limit can be reinforced by requiring that a particular expenditure item cannot be raised without cutting spending within the same area (Fall et al. 2015 p.47-48).”

Readings (8)

  • European Commission (EC), 2010, “Public Finances in EMU – 2010“, European Economy, No. 4/2010 European Commission, Brussels.
  • Fall, F. and J-M. Fournier (2015), “Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules”, OECD Economics Department Working Papers, No. 1230, OECD Publishing, Paris.
  • Gupta, S. and S. Yläoutinen (2014), “Budget Institutions in Low-Income Countries: Lessons from G-20”, IMF Working Paper, No. 14/164.
  • OECD (2014), “Draft Recommendation of the OECD Council on the Principles of Budgetary Governance”, OECD Publishing, Paris.
  • Von Hagen, J. and I. Harden (1994), “National Budget Processes and Fiscal Performance”, European Economy. Reports and Studies, Vol. 3, pp. 315–418.

Discussion Folder (8)


(9) Should a Fiscal Council be used to Implement New Fiscal Rules?

Synopsis (9)

“There is a growing literature on the design of fiscal councils and their effectiveness (see for surveys Debrun et al. 2009, Hagemann, 2011, Kopits, 2011b, and Debrun and Kinda, 2014). Fiscal councils foster fiscal discipline and thereby complement fiscal rules. As the rules are designed to hit fiscal targets and allow for stabilisation policies, deficit bias behaviour should be disentangled from accommodation of short-run shocks to make sure that governments respect their commitments. To that end, an external body can verify whether the government complies with the fiscal rules.

A fiscal council can underpin transparency and thus credibility. The adoption of fiscal rules, in particular of complex rules, increases the need for transparency. Governments may be biased toward overestimating expected revenues, underestimating spending, or unduly exercise escape clauses (Debrun et al. 2013). A fiscal council can help discipline government behaviour.

The role of fiscal councils is to monitor ex ante that fiscal policy is likely to meet the short and long-run targets while allowing fiscal flexibility. Rating agencies have shown clear limitations in terms of monitoring public finances.

There is “no one size fits all” in terms of designing a fiscal council. The design should depend on the country’s political culture, legal traditions and economic characteristics. In some countries, a fiscal council with a monitoring role is not deemed necessary due the high standards of accountability and transparency already in place (New Zealand); while in others, an independent authority is in charge of fiscal surveillance (United Kingdom)

Fiscal councils often have very different roles and remits. In addition to analysis of budget proposals and current fiscal developments, common functions include producing independent projections and forecasts or endorsing or assessing government projections and forecasts; monitoring compliance with fiscal rules and targets; analysis of long-term fiscal sustainability; costing of policy proposals; and analytical studies on selected issues. A minority of fiscal councils also provide normative assessments.

The exact combination of these features in the remit of the fiscal council should be guided by the weaknesses of and risks surrounding fiscal policy. If the government tends to miss its targets due to over-optimistic fiscal projections, then these forecasts should be delegated to a fiscal council, or alternatively a council could audit government forecasts. If the main issue is insufficient assessment of the long-run consequences of decisions, providing fiscal sustainability calculations highlighting these consequences might alleviate the bias.

Another important role for fiscal councils is the assessment of the need for counter-cyclical fiscal policy. Governments often miss the opportunity to build fiscal buffers in good times and a council could call for adjustments in that case. Moreover, when the government calls for the application of escape clauses to deviate from the fiscal rules, then the fiscal council could be in charge of assessing the correctness of this call.

Fiscal councils appear to limit spending when associated with a budget balance rule. These results are in line with the findings by Debrun et al. (2013) who conducted a thorough analysis of the performance of fiscal councils. On average the mere existence of a fiscal council appears only loosely related to stronger fiscal outcomes. But, higher primary balances are associated with fiscal councils featuring certain characteristics. For instance, the task of monitoring compliance with fiscal rules is unlikely to be sufficient to affect fiscal performance if it is not paired with strict independence and a presence in the public debate. They also find that, in the European Union, countries with fiscal councils have stronger fiscal positions, more accurate and less optimistic forecasts and policy is less pro-cyclical (Fall et al. 2015 p.44-47).”

Readings (9)

  • Debrun, X. and T. Kinda (2014), “Strengthening Post-Crisis Fiscal Credibility—Fiscal Councils on the Rise. A New Dataset”, IMF Working Paper, WP/14/58.
  • Debrun X., T. Kinda, T. Curristine, L. Eyraud, J. Harris, and J. Seiwald, (2013), “The Functions and Impact of Fiscal Councils”, IMF Policy Paper, July.
  • Fall, F. and J-M. Fournier (2015), “Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules”,OECD Economics Department Working Papers, No. 1230, OECD Publishing,Paris.
  • Hagemann, R.P. (2011), “How Can Fiscal Councils Strengthen Fiscal Performance?”, OECD Journal: Economic Studies, Vol. 2011/1.
    Kopits, G. (2011b), “Independent Fiscal Institutions: Developing Good Practices”, OECD Journal on Budgeting, Vol. 11/3, https://dx.doi.org/10.1787/budget-11-5kg3pdgcpn42.

Discussion Folder (9)


(10) How Can the U.S. Generate Savings from Entitlement Reform Required to make those programs Sustainable and Meet the Debt Target

Synopsis (10)

Eight years after the financial crisis the federal government continues to incur deficits and accumulate debt at an unsustainable rate.Total federal debt now exceeds GDP, and the Congressional Budget Office projects that the debt/GDP ratio will continue to climb at an unsustainable rate in coming decades. Because entitlement spending accounts for most of the projected growth in spending, it will be virtually impossible to reduce debt to tolerable levels without fundamental reform of entitlement programs (Congressional Budget Office. 2017).

In a forthcoming study that relies on the Congressional Budget Office’s “Long Term Forecast,” we use a dynamic simulation model to estimate the impact of alternative fiscal policies on the economy over the next two decades (Merrifield, J., and B Poulson. 2017). Our simulations show that even with a 3 percent growth rate, the federal government would continue to incur deficits and accumulate debt at an unsustainable rate. This is discouraging news for those who pin their hopes on higher rates of economic growth as a solution to the nation’s debt crisis.

In our study, we estimate the potential impact of new fiscal rules on the U.S. economy over the next two decades. The new rules would require a cyclically balanced budget and an expenditures limit. The study shows that over the forecast period, the budget could be balanced and the total debt-to-GDP ratio reduced to the 60 percent tolerance level under this scheme, but this fiscal consolidation can only be achieved using a combination of fiscal reforms that go far beyond what’s been proposed by the Trump administration.

The centerpiece of the fiscal reforms proposed by our study is a spending limit. It brakes growth in discretionary spending based on the size of the debt and actual deficits, including unplanned spending. Because the total debt is far above the consensus tolerance level of 60% of GDP, the spending limit holds the rate of growth in discretionary spending below 1 percent per year. Even with this stringent limit on discretionary spending, it would be impossible to balance the budget without other fiscal reforms. A prerequisite is the reform of entitlement programs, including Social Security and Medicare.

Following the precedent set in the Congressional Budget Office’s forecasts, we estimate the magnitude in federal savings required to balance the budget and reduce the debt-to-GDP ratio to tolerance levels over the forecast period. In the most likely scenario, it will take the spending limit based on the debt and deficit levels, plus $600 billion per year in combined entitlement savings and federal asset sales.

We recognize that $600 billion in annual savings will be difficult to achieve. Indeed, some will argue that it is impossible. But the path to a sustainable fiscal policy is clear. Reforms of the needed magnitude have been identified. The Congressional Budget Office has shown that Social Security and Medicare reforms can generate hundreds of billions in savings each year (Congressional Budget Office. 2017). Trump will not be able to achieve his ambitious fiscal targets without fundamentally reforming these entitlement programs.

Republicans in Congress appear to be at an impasse (Bydlak 2017) in their efforts to reform Health Care Programs. After a concerted effort to reform Social Security during the George W. Bush presidency, the Party has virtually abandoned efforts to reform that entitlement program. Republicans are in a prisoner’s dilemma in which there is agreement that these entitlement programs are not sustainable, yet they cannot find a pathway to reform.

This prisoner’s dilemma over entitlement reform was anticipated more than half a century ago by the great Austrian economists Friedrich Hayek (Hayek 1944, 2010). His views on social insurance have been the focus of a heated controversy. Hayek suggested that a program of social insurance is not incompatible with a competitive capitalist system. However, he identified the fatal flaw in current social insurance programs.

“Though a redistribution of income was never the avowed initial purpose of the apparatus of social security, it has now become the actual and admitted aim everywhere. No system of monopolistic compulsory insurance has resisted this transformation into something quite different, an instrument for the compulsory redistribution of income (Hayek 2010)…”

Hayek argued that the attempt to redistribute income through the welfare state is simply an alternative way to replace a competitive capitalist system with monopoly capitalism or socialism.

“Seen as an alternative to the now discredited method of directly steering production, the technique of the welfare state, which attempts to bring about a “just distribution” by handing out income in such proportions and forms as it sees fit, is indeed merely a new method of pursuing the old aim of socialism. (Hayek 2010)”.

Libertarians are searching for reforms to provide effective and low cost social services targeting the poor. As Hayek argued, those entitlement reforms must be consistent with a vigorous competitive capitalist system. Progressives view social insurance programs as a means to redistribute income, consistent with a dirigiste state. They do not seem to be too concerned by the fact that these social insurance programs are not sustainable.

Readings (10)

  • Bydlak, J. 2017. If ObamaCare repeal fails, blame all the false promises, The Hill, https://thehill.com/blogs/pundits-blog/healthcare/341333-if-obamacare-repeal-fails-blame-all-the-false-promises?mc_cid=7c8813c3c2&mc_eid=006ffe2550)
  • Congressional Budget Office. 2017. Long Term Budget Outlook, Washington DC, March.
    https://www.cbo.gov/publication/52480
  • Hayek, F. 2010. The Constitution of Liberty, Institute of Economic Affairs, London.
    Hayek, F. 1944. The Road to Serfdom. University of Chicago Press. Chicago.
    Kotlikoff, L. and A. Michel. 2015. “Closing America’s Enormous Fiscal Gap: Who Will Pay?”, Mercatus Center, George Mason University, Arlington, Virgina, June.
  • Merrifield, J., and B Poulson. 2017. Restoring America’s Fiscal Constitution, (forthcoming), Lanham, Lexington Press.

Discussion Folder (10)


(11) How can the U.S. Generate Savings from Privatization and Asset Sales Required to Meet the Debt Target?

Synopsis (11)

Privatization and private public partnerships will play a crucial role in President Trump’s infrastructure planning (Wall Street Journal 2017). The administration proposes $200 billion in new federal funding, as part of a $1 trillion plan to improve the nation’s infrastructure. Most of the $200 billion will be allocated to state and local governments to match their own funding for these projects. Cities and states are encouraged to turn to private sector financing, and levying tolls and taxes to fund the projects, as an alternative to traditional reliance on funding that relied heavily on the Federal Highway Trust Fund and federal grants. State and local governments are expected to compete for the federal funding by offering to accept a smaller share of federal dollars. The federal government will also expand a low cost federal loan program to help pay for major projects.

Federal asset sales made to pay down the national debt was not part of Trump’s budget proposal, but during his presidential campaign, candidate Trump promised a ‘deal’ to sell mineral rights and use the proceeds to pay down the debt (Brandus, P. 2017). He argued this ‘deal’ could make America energy independent. In our research, we find that this kind of sale of federal assets is also necessary to solve the debt crisis.

We propose the sale of a broader range of federal assets that are now under-utilized (Merrifield, J., and B Poulson. 2017a, 2017b). For instance, Congress could pass a new Homestead Act, thereby selling federal land, real estate, and mineral rights. This Homestead Act could improve the nation’s finances in several ways. The revenue generated from the asset sales could be earmarked for debt reduction. As assets are transferred into the private sector, profit-maximizing owners and entrepreneurs would bid for the resources, ensuring they will be allocated toward their most productive uses. The more efficient allocation of these resources would generate higher levels of income and tax revenues.

While the proposed new Homestead Act could achieve multiple objectives, the primary objective would be debt reduction. To determine the potential for federal asset sales to reduce the national debt requires an inventory of federal assets, and several studies provide such estimates. The Federal Real Property Council (2006) estimated the value of all federal land, buildings, and infrastructure at $1.3 trillion. One class of property not included in that estimate is the value of oil, natural gas, and coal on federal property. Shughart and Close (2017) estimate the value of these mineral deposits at $55.6 trillion.

Clearly, federal asset sales could play an important role in reducing debt. However, selling federal assets in a discontinuous way could disrupt resource markets. But our proposed new Homestead Law would link such asset sales to debt reduction in the long term. Because federal assets could be sold over many decades, they could be sold at a rate that would not significantly distort resources markets.

Readings (11)

  • Brandus, P. 2017. Opinion: Trump’s intriguing idea, cut debt by selling off federal assets, MarketWatch, https://www.marketwatch.com/story/trumps-intriguing-idea-cut-debt-by-selling-off-federal-assets-2017-03-28.
  • Federal Real Property Council. 2006. FY 2005 Federal Real Property Report: An Overview of the U.S. Federal Government’s Real Property Assets, June.
    https://www.gsa.gov/portal/mediaId/198883/fileName/2005_FRPP_Data_Dictionary_July_2005.action
  • Merrifield, J., and B Poulson. 2017a. Restoring America’s Fiscal Constitution, (forthcoming), Lanham, Lexington Press.
  • Merrifield, J., and B Poulson. 2017b. Can a New Homestead Act Solve the Debt Crisis?, American Spectator, May 31.
  • Shughart, W., and C. Close. 2017. Liquidating federal assets: a promising tool for ending the debt crisis, Executive Summary, Independent Institute.
    https://www.independent.org/publications/article.asp?id=9008
  • Wall Street Journal. 2017, Rebuilding Plan Shifts Burden to States, Saturday/Sunday September 2-3, p. A2.

Discussion Folder (11)


(12) Should New Fiscal Rules Apply to Sub-National Units?

Synopsis (12)

“Finally, the consolidation strategy should involve all levels of government. During past consolidation episodes, sub-central governments helped stabilise general government debt. In general, consolidation at the state and – albeit less – at the local level increased the success of debt stabilisation at the general government level (Blöchliger et al., 2012) (Fall et al. 2015 p.38).”

As the federal government is downsized, there will be pressure to shift programs to state and local governments. The precedent for this shift is unfunded liabilities in the Medicaid program. Even states that have had success in reforming Medicaid to reduce costs, must allocate larger shares of their budgets to fund a greatly expanded Medicaid program.

The $1 trillion plan for infrastructure investment depends on the ability of state and local governments to generate the matching funds required for private public partnerships in building these projects. Cities and states will have to rely on private sector financing, and levying tolls and taxes to fund the projects, as an alternative to traditional reliance on funding that relied heavily on the Federal Highway Trust Fund and federal grants.

State and local governments are concerned that the outcome of this devolution of federal programs will be massive unfunded mandates. Unfunded mandates on state and local governments could undermine support for a rules based fiscal policy at both the federal and state level.

The solution to this fiscal dilemma is a ‘Grand Bargain’ in the form of a new Homestead Act. We estimate that the federal government must generate more than half a trillion dollars in savings each year, earmarked for debt reduction, to reach a tolerable level of debt over the next two decades (Merrifield, J., and B Poulson. 2017a).

A new Homestead Act could help solve the debt crisis in several ways. The revenue from asset sales can be earmarked for debt reduction, reducing the negative impact of debt overhang on economic growth. Shifting resources from the public sector to the private sector would result in a more efficient allocation of resources. Indeed, we should expect that the privatization of fifty five trillion dollars of in energy resources would be accompanied by a revolution of innovation and technological change in the energy industries. Higher rates of economic growth will be essential in bringing the debt-to-GDP ratio down to tolerable levels.

This ‘Grand Bargain’ would strengthen finances at the state and local level. With energy resources and other federal assets shifted to the private sector, the tax base for state and local governments would expand significantly. That would generate the tax revenues to at least partially offset the financial burden resulting from devolution of federal programs to state and local governments.

We should expect this expanded role for state and local governments to result in greater efficiency in the provision of government services. The precedent for this productivity advance was the modest devolution of federal programs during the Reagan Administration. With block grants replacing direct federal funding, state and local governments responded with reforms to deliver government services at lower cost.

An indirect effect of this ‘Grand Bargain’ would be a restoration of the balance between the federal government, the states and the people envisioned in the 10th amendment to the constitution. Our state and local governments have learned to live with a balanced budget for several centuries; it is time for the federal government to learn to live with a balanced budget as well.

Readings (12)

  • Blöchliger, H., D. Song and D. Sutherland (2012), “Fiscal Consolidation: Part 4. Case Studies of Large Fiscal Consolidation Episodes”, OECD Economics Department Working Papers, No. 935, OECD Publishing, Paris.
  • Merrifield, J., and B Poulson. 2017a. Restoring America’s Fiscal Constitution, (forthcoming), Lanham, Lexington Press.
  • Merrifield, J., and B Poulson. 2017b. Can a New Homestead Act Solve the Debt Crisis?, American Spectator, May 31.

Discussion Folder (12)


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