Revenue rules set limits or a target for the level or rate of growth of revenue (Ayuso 2012; Fall and Fournier 2015; Fall et al. 2015; Debrun 2014, 2015).. Revenue rules are often designed to constrain a specific tax burden, e.g. property taxes. Such rules are likely to change the composition of tax revenues as well as total tax revenue. Elected officials often respond to limits on specific taxes by substituting other taxes that are not constrained by the limit.
When revenue limits are imposed on total revenue, their impact depends upon linkages to other fiscal rules. In some states, such as Colorado, the revenue limit is combined with a balanced budget requirement. In that case the revenue limit can act as an expenditure limit as well, and this is how the courts in Colorado have interpreted it. Such revenue limits can be an effective constraint on spending, especially when surplus revenue above the limit must be rebated to taxpayers. Surplus revenue may also be earmarked for debt reduction.
The impact of a revenue limit on macroeconomic stabilization is ambiguous. When revenue rules are linked to balanced budget requirements they can constrain the growth in revenue and spending in periods of rapid economic growth. This is especially true with a progressive tax system. This impact may stabilize the growth in spending over the business cycle.
However, a revenue limit linked to a balanced budget requirement could also ratchet down revenue and spending in periods of recession. If the revenue limit is imposed on the lower level of revenue and spending during a recession, this so called ratchet effect could be pro-cyclical.
In the new era of fiscal rules most governments have chosen to rely on expenditure rules rather than revenue rules. Whereas revenue rules allow elected officials indirect controls over the budget, expenditure rules give them more direct controls over spending and budgets. This involves forecasting revenues and then adjusting expenditures relative to forecast revenue.
In recent years expenditure rules have been the focus of rules based approaches to fiscal policy at both the national and subnational level (Ayuso 2012; Fall and Fournier 2015; Fall et al. 2015; Debrun 2014, 2015). Expenditure rules have proven to be the most effective way to anchor a fiscal framework. Expenditure rules may target nominal or real expenditures. The target may be defined with reference to total expenditure, expenditure as a share of GDP, or the rate of growth of expenditures.
Expenditure rules are the most effective way to achieve debt targets because they constrain the main source of deficits and debt, i.e. debt biased fiscal policies. The effectiveness of expenditure rules also depends upon linkages to other fiscal rules. The most effective way to reduce debt burdens is to impose an expenditure limit linked to a balanced budget requirement. This is especially true when surplus revenue above the expenditure limit is earmarked for debt reduction
A well designed expenditure rule can also contribute to macroeconomic stabilization.
Expenditure rules should constrain the growth of spending in periods of rapid economic growth and provide for more stable growth in expenditures over the business cycle. When surplus revenue above the expenditure limit is earmarked for a budget stabilization fund this will facilitate a countercyclical fiscal policy.
However, there is likely to be a tradeoff in using the expenditure limit to target debt, and using the rule for macro-economic stabilization. When surplus revenue above the limit is returned to the general fund this will weaken the effectiveness of the rule in targeting debt. Thus the impact of the expenditure rule depends upon the design of both the expenditure limit and links to other fiscal rules such as budget stabilization funds.
Expenditure rules are linked to different measures of aggregate economic activity. The most widely used design links the expenditure limit to measures of output. Some proposals call for a limit on expenditures as a share of GDP. Such proposals are motivated by a desire to downsize government relative to the private sector. Given the volatility in output it is not surprising that such proposals have failed to gain much traction.
The most widely used expenditure limit links it to measures of the rate of growth in output. With this limit in place government spending would grow at the pace of output growth in periods of expansion and fall with the contraction in output in periods of recession. The volatility in output growth over the cyclical would be matched by volatility in government spending. Since most societies do not tolerate such volatility in government spending these expenditure limits are frequently suspended or simply ignored.
Greater success has been achieved in linking expenditure limits to measures of the trend rate of growth in output. The expenditure limit will then track the smoother trend rate of growth rather than the more volatile actual rate of output growth over the business cycle. This requires a methodology for estimating the trend rate of growth in output, and there is some disagreement regarding this methodology.
An alternative approach is to link the expenditure limit to the rate of growth in potential output. Potential output is measured as the full employment level of output. This measure also eliminates cyclical changes in output and provides for a more steady growth in expenditures. There is disagreement regarding measures of potential output, and it is often difficult to separate out the cyclical from the longer term factors influencing output. Nonetheless, a number of countries have had success in using this type of expenditure limit in recent years.
The most stringent expenditure limit is one linked to the rate of growth in population and inflation (Merrifield and Poulson 2016 a, 2016b, 2017). This expenditure limit freezes the level of real per capita government expenditures. In the long term this expenditure limit allows the private sector to expand relative to the public sector. For this reason this is the most effective limit in constraining government spending and reducing deficits and debt. Because population growth and inflation are less volatile than output growth, this expenditure limit will provide macro-stability over the business cycle. The effectiveness of this expenditure limit in stabilizing government spending over the business cycle depends upon how it is linked with other fiscal rules. This type of expenditure rule has been used successfully at the subnational level in the U.S.