Annually Balanced Budget Rules
Budget balance rule set a numerical target for the budget either in nominal terms or as a share of GDP (Asatryan et al. 2016). The most ubiquitous of these is the annually balanced budget rule, requiring expenditures equal to revenues for a given budget year. This type of budget balance rule is simple to understand and communicate to elected officials and citizens. It is also easy to monitor and hold elected officials accountable. This is why annually balanced budget rules have been incorporated as constitutional or statutory law in state and local governments extending back to the early 19th century. The most stringent of these rules require a zero budget balance at the end of the year. Less stringent rules allow for some carry over of deficits to the next year.
If annually balanced budget rules eliminate deficits, this can be effective in targeting debt. However, annually balanced budgets can be achieved by adjusting expenditures or revenues, or some combination of these policies. If elected officials respond to fiscal stress by raising taxes and revenue this could make it more difficult to achieve a debt target in the long run. That policy could also conflict with other objectives such as macroeconomic stability and economic growth.
The major disadvantage of annually balanced budget rules is that they tend to be pro-cyclical. These rules allow for expansionary fiscal policies in periods of economic growth, which then requires more restrictive fiscal policies in periods of recession. This is especially true in countries relying on progressive tax systems.
Over the past half century annually balanced budget rules have proven to be less effective in constraining deficits and the accumulation of debt. Elected officials have found many ways to evade and ignore these rules. In order to meet annually balanced budget requirements elected officials have an incentive to shift expenditures off budget, rely on user fees, and use accounting gimmicks. Therefore, many governments have enacted new fiscal rules designed to impose more fiscal discipline.
Budget balance rules may set a numerical target for deficits or surpluses in the annual budget. Members of the European Union must commit to reduce deficits below 3% of GDP within a specified time period. Some European countries, such as Sweden have enacted fiscal rules requiring a surplus in the annual budget. The goal is to incur a fiscal surplus in the near term in order to create more fiscal space for discretionary fiscal policies in the long term
High debtor countries, such as the U.S., may find that they lack fiscal space to pursue discretionary fiscal policies in response to a recession and revenue shortfall. For this reason more countries are shifting to budget balance rules that adjust for cyclical changes in economic activity.
Structural Budget Rules
Structural balance rules impose a spending limit which is adjusted for cyclical changes in output (Ayuso 2012; Fall and Fournier 2015; Fall et al. 2015; Debrun 2014, 2015). The spending limit may be adjusted based on the ratio of actual output to the long run trend in output. When actual output exceeds the long run trend, the spending limit is adjusted downward. When actual output is below the long run trend, the spending limit is adjusted upward.
An alternative structural budget rule adjusts the expenditure limit based on the ratio of actual output to potential output. Potential output is measured as the full employment level of output. When actual output is above the full employment level the expenditures limit is adjusted downward. When actual output is below the full employment level the expenditures limit is adjusted upward.
Structural budget rules provide fiscal space for countercyclical fiscal policy, including discretionary policy as well as the automatic stabilizers. When applied effectively these rules should achieve macroeconomic stabilization. However, there is likely to be a tradeoff between fiscal rules to achieve macroeconomic stabilization, and rules targeting debt. Because structural balance rules are less binding on expenditures than annually balanced budget rules, they may be less effective in reducing debt. Structural budget rules adjust the spending limit for changes in output over the business cycle, but they do not guarantee a balanced budget.
Cyclical Balance Budget Rules
Cyclical balance rules mandate a balanced budget over the business cycle (Casals 2012; Fall and Fournier 2015; Fall et al. 2015; Debrun 2014, 2015). Deficits incurred during periods of recession must be offset by surplus revenue in periods of economic expansion. These rules in effect freeze the level of debt at the time they are enacted. Cyclical balanced budget rules provide fiscal space for countercyclical fiscal policy. They may also be effective in reducing debt burdens. This is especially true in low debtor countries experiencing high rates of economic growth; as output expands, the ratio of debt-to-GDP will decline in the long run.
Cyclical balance rules may be less effective in high debtor countries. These countries may lack the fiscal space to pursue countercyclical policy. This is especially true if the high debtor country experiences low rates of economic growth. In that case, attempts to pursue an expansionary fiscal policy in response to recession may push the country to its debt limit.
Cyclical balance budget rules also pose measurement and monitoring problems. It is often difficult to separate out cyclical changes from transitory factors influencing output.