This week the House is expected to vote on a balanced budget amendment (BBA), introduced by Bob Goodlatte (R-VA), chairman of the Judiciary Committee. The amendment would require federal budget outlays to equal receipts each year.
Subjecting fiscal policy to rules, rather than allowing it to be driven purely by political impulse, would be a good idea, but not if the rules are the ones envisioned by this amendment. Far from stabilizing the economy, this kind of BBA would radically destabilize it, leading to dizzier booms and deeper recessions. Here is why.
How the budget affects the business cycle, and vice versa
To see why a balanced budget amendment would undermine stability, we need to understand how the budget affects the business cycle, and how the business cycle affects the budget. When we look at the pattern of federal receipts and outlays over time, as shown in the following chart, we see a lot of ups and downs. Where do they come from?
Three main factors account for the variations in outlays and receipts:
Politics. Members of Congress have an interest in pleasing their donors and constituents. One good way to do that is to cut their taxes and add spending for their favorite causes in the lead-up to an election. That is true regardless of party and regardless of the state of the economy.
Discretionary counter-cyclical policy. As every Econ 101 student learns, the government can soften recessions with tax cuts and spending increases, or cool off booms by cutting spending and increasing taxes. In practice, the tools of discretionary fiscal policy are not used consistently, but there are important exceptions, for example, the fiscal stimulus packages adopted by Congress under Presidents George W. Bush (2008) and Barack Obama (2009) to ease the worst effects of the Great Recession.
Automatic fiscal policy. Even when there are no changes in tax or spending laws, the government’s receipts and outlays vary over time according to the state of the economy. In a recession, tax receipts fall along with personal incomes and corporate profits. At the same time, outlays for unemployment insurance, food stamps, Medicaid, health care subsidies under the ACA, and other items increase. During a boom, tax receipts rise and outlays fall. We call those changes automatic fiscal policy or automatic stabilizers because they require no action by the administration or Congress.
The perverse effects of annual budget balance
If a balanced budget amendment did nothing but curb political impulse-spending and tax cuts tailored to the wishes of the donor class, it would be a good thing, but that is not how the BBA now under consideration would work. Instead, such a BBA would destabilize the economy in two important ways.
