Cyclical Asymmetry in State Fiscal Policy: Is It Biased Toward Big or Small Government?

Abstract

Recent research has shown that fluctuations in revenue availability over the business cycle cause the adoption of fiscal policy that amplifies economic cycles. Building on theoretical models that address the political economy of fiscal expansions and adjustments and the fiscal policy preferences of voters and policymakers, this article examines whether those procyclical effects are symmetric between boom and recession. The analysis reveals that the procyclical effects of cyclical revenue increases (in upturn years) on expenditures are smaller than those of cyclical revenue decreases (in downturn years), whereas the procyclical effects of cyclical revenue increases on tax rates are larger than those of cyclical revenue decreases. That is, policymakers prefer tax cuts to spending increases in pursuing expansionary fiscal policy during booms and spending cuts to tax increases in making fiscal adjustments during recessions. Taken together, the results suggest that cyclical fluctuations in revenue availability have procyclical effects on state fiscal policies in a manner that is asymmetric between boom and recession and fiscally conservative.

Keywords

state fiscal policy cyclical asymmetry tax base gap political economy

The tax smoothing model of fiscal policy advanced by Barro (1979) and Lucas and Stokey (1983) has served as a normative benchmark against which fiscal policies are assessed (Alesina & Perotti, 1995). Taking into account intertemporal budget constraints, the model predicts that governments—which are assumed to be a benevolent social planner—will keep the tax rates constant over time to help consumers smooth their own consumption and minimize the distortionary effects of taxes on labor supply. In practice, tax smoothing can be achieved by saving cyclical budget surpluses in booms as a buffer against adverse fiscal shocks in recessions. Furthermore, modern economics generally holds that governments should serve as a counter to the business cycle (i.e., countercyclical conduct of monetary and fiscal policy) so as to prevent the economy from overheating in booms while helping it recover in recessions (Krugman, 2000; Stiglitz, 2010). In a similar vein, the fiscal management literature links countercyclical fiscal capacity to government performance, arguing that governments should keep fiscal reserves to maintain fiscal stability and policy predictability over the business cycle (Dothan & Thompson, 2009; Hou, 2006; Hou & Moynihan, 2008; Thompson & Gates, 2008).

Although these normative theories and prescriptions stress the countercyclicality of fiscal policy, that is, the role of governments in stabilizing the business cycle, state governments have exhibited procyclical patterns in conducting fiscal policy (i.e., spending increases and tax cuts in booms and spending cuts and tax increases in recessions). A number of studies observe that, in aggregate, state spending grew faster than income during the expansion periods of the 1980s, 1990s, and 2000s (Edwards, Moore, & Kerpen, 2003; Moore, 1991; Schunk & Woodward, 2005; Stansel & Mitchell, 2008), whereas others report that many states enacted large tax cuts during the growth periods of the mid- to late 1990s (Johnson, 2002; Knight, Kusko, & Rubin, 2003). In addition, McNichol (2003a) and Ruffing and Van de Water (2012) report that in response to the fiscal crises of the early and late 2000s, states raised taxes and/or cut expenditures. Kwak (2014) provides empirical evidence suggesting the procyclical effects of business cycles on state fiscal policies. Using state panel data, he finds that cyclical fluctuations in tax revenues are positively correlated with changes in per capita expenditure and negatively to changes in the overall level of taxation.

Although these studies differ in scope and approach, they consistently suggest that procyclical fiscal policy occurs due to the so-called voracity effect. The basic argument is that voters value expansionary fiscal policy (in both spending and taxation), specifically its macroeconomic consequences, and that as a result of a common pool problem, improved revenue availability in booms leads to more-than-proportional increases in fiscal appropriations and unaffordable tax cuts. Such boom-induced procyclical fiscal actions, in turn, produce a structural deficit and ultimately lead to fiscal crisis in the following recession involving a recession version of procyclical fiscal actions, that is, spending cuts and tax increases.

Although ample evidence has accumulated on the procyclicality of state fiscal policies, important questions remain to be answered. Are those procyclical effects symmetric between boom and recession? If they are not symmetric, in what fashion does the cyclical asymmetry occur? These questions are motivated by the fact that fiscal systems are largely based on two fiscal policy tools, spending and taxation, and by a unifying theme of political economy models of fiscal policy that fiscal choices are influenced by voters’ fiscal policy preferences (Alesina, Perotti, Tavares, Obstfeld, & Eichengreen, 1998; Brender & Drazen, 2005; Buchanan & Wagner, 1977; Drazen & Eslava, 2010; Nordhaus, 1975; Peltzman, 1992). For example, if voters are fiscally conservative and favor small government and a reduction in the size of the budget, for boom-driven expansionary fiscal policy, tax cuts may be preferred to expenditure increases, whereas, for recession-driven contractionary fiscal policy, expenditure reductions may be preferred to tax hikes. In this case, the size of spending increases induced by cyclical revenue increases in upturn years is likely to be smaller than that of spending cuts caused by cyclical revenue decreases in downturn years. Meanwhile, the size of tax cuts that induced by cyclical revenue increases in good years is likely to be larger than that of tax increases due to cyclical revenue decreases in lean years.

This article tests the asymmetric effects of cyclical revenue fluctuations on state fiscal adjustments by analyzing a panel data set, which includes 49 states (excluding Alaska)¹ and 19 fiscal years from 1992 to 2010. State governments exhibit large variations in the extent to which tax revenues fluctuate over the business cycle, as they use different tax structures and bases. The time frame is also relevant, because it covers approximately two business cycles (two sets of boom–bust cycle) and the tendency to reduce taxes or increase spending may well have changed in recent decades. For the accurate measurement of the ceteris paribus effects of cyclical revenue fluctuations, the study also controls for other relevant factors, which include fiscal institutions and rules, budget agency functions, partisan control, election cycle, and demographic-economic characteristics. Variations in revenue volatility, institutional design, political circumstances, and fiscal outcomes are combined to offer a unique opportunity to examine the dynamics of state fiscal behavior over the business cycle.

The next section discusses the political economy of fiscal expansions and adjustments and the fiscal policy preferences of voters and policymakers as a theoretical basis. By identifying other relevant factors, the section that follows develops an empirical model to estimate the effects of the key explanatory variable, and presents the data and methods used in the empirical analysis. The last sections discuss analysis results and their theoretical implications.

Cyclical Asymmetry in State Fiscal Policy: Two Competing Hypotheses

This study is based on the premise that cyclical fluctuations in revenue availability and fiscal condition induce states to adopt fiscal policy that reinforces the business cycle. Thus, before developing a theoretical framework for this article’s main thesis, cyclical asymmetry in state fiscal policy, it is necessary to discuss why procyclical fiscal policy occurs. A number of political economy models of fiscal policy focus on the interplay between increased revenue availability during booms and the opportunistic behavior of policymakers seeking to increase electoral support. Battaglini and Coate (2008) explicate the mechanism underlying this fiscal phenomenon by developing a dynamic political economy model of public spending, taxation, and debt. Basically, they attempt to integrate the political economy of fiscal policy with the tax smoothing approach to it. They incorporate the idea that legislators can distribute tax revenues back to their constituents through pork-barrel spending into a dynamic general equilibrium model that contains the key assumptions of the tax smoothing model. Their model predicts that in booms, public spending will increase and tax rates will fall, whereas in recessions, public spending will decrease and tax rates will increase. This also suggests that government debt—which is an indicator of the overall fiscal position—decreases in booms and increases in recessions. Barseghyan, Battaglini, and Coate (2008) calibrate the model to the U.S. economy and find that the empirical distribution of debt is consistent with the theoretical prediction.

Tornell and Lane’s (1999) voracity effect suggests that competition for common pool resources among multiple interest groups interacts with revenue windfalls in booms to lead government spending to increase more than proportionally relative to an increase in income. Building on the tragedy of the commons framework, Velasco (1999) makes the point that interest groups attempt to exploit government resources to finance their preferred programs, and this eventually results in fiscal deficits and debt accumulation even when there is no need for consumption smoothing. Brubaker (1997) calls this phenomenon “the tragedy of the public budgetary commons,” and he explains,“This occurs when the absence of private property rights to a depletable resource creates incentives for potential users to exploit the resource excessively” (p. 355).

Talvi and Végh (2005) further explore mismanagement of economic booms with suboptimal fiscal policy by focusing on dysfunctional political systems that pervade developing countries. They put forward an optimal fiscal policy model, which holds that during booms, running budget surpluses becomes politically costly as pressures for public spending increase. The model predicts that due to political distortions, developing countries with volatile tax bases will find it optimal to run procyclical fiscal policies, even though it is suboptimal for the society as a whole. They assess their model through a cross-country regression, which reveals that output volatility is positively associated with procyclicality in fiscal policy. Similarly, Alesina, Campante, and Tabellini (2008) provide a political economy explanation for the procyclicality of fiscal policy, with a particular focus on corruption. They develop a political agency framework, which predicts that voters will demand higher spending or lower taxes during booms because they recognize that corrupt governments can use public money for political rents in the form of policy favors paid to special interests.

Posner and Gordon (2001) focus attention on the political economy of budget surpluses. In a discussion of the politics of budget surpluses, they argue that as the economy improves, it is increasingly difficult for politicians to run budget surpluses. They explain that this is because the benefits achieved by maintaining surpluses generally are spread across the society as a whole and over time, and thus perceived as vague and remote. On the contrary, arguments for tapping into budget surpluses increasingly gain public support, because the benefits achieved by increasing expenditures and reducing tax burdens are perceived as tangible and immediate and often concentrated on specific geographic regions and subpopulations. Moreover, fiscal fatigue that arises from continued fiscal restraint makes it difficult for legislators to keep resisting the spending demands of their constituents. Alesina (2000) points out that it is particularly difficult to make sound fiscal decisions in countries with a high degree of political fragmentation. Such a situation, he argues, acts as an obstacle to the implementation of appropriate fiscal actions, as various interest groups“fight over the allocation of the costs of adjustment or the benefits of the common pool of resources” (p. 12).

Taken together, the political economy models reviewed above suggest that budget participants’ desire to obtain the maximum advantage from their common pool resources interacts with rapid, sustained revenue growth in booms to lead to excessive spending increases and unaffordable tax cuts. When governments reduce taxes and increase expenditures in the absence of adequate savings, it is only natural that structural deficits occur. Such structural problems, however, are likely to be left unchecked, because, during booms, budget balances normally remain in surplus at least nominally due to cyclical factors—cyclical decreases in expenditures and cyclical increases in revenues. However, the problems are eventually brought to surface when a recession hits, ultimately forcing the states required to balance their budgets into a recession version of procyclical fiscal actions.

Based on the premise that cyclical revenue fluctuations have procyclical effects on state expenditures and tax rates, this article raises the following follow-up questions: Are those procyclical effects symmetric between boom and recession? If not, that is, if state fiscal policy is asymmetric over the business cycle, in what manner does the cyclical asymmetry occur? As noted in the introduction, these questions are motivated by the fact that fiscal policy choices are influenced by voters’ fiscal policy preferences, on which two contrasting views have been developed.

The first view holds that voters value spending programs and distributive policies in their own favor (Buchanan & Wagner, 1977; Nordhaus, 1975). In this view, voters are described as naïve: They are assumed to be subject to fiscal illusion and lack the ability to monitor and assess fiscal choices. As such, voters underestimate the future costs of current spending programs in terms of tax burden and inflation and support politicians who provide (or promise to provide) high government expenditures in their favor. This generates incentives for incumbent policymakers, who are assumed to try to maximize votes rather than social welfare, to increase expenditures without adequate consideration of the long-term fiscal implications of those budgetary decisions (Kau, Keenan, & Rubin, 1982; Lott & Reed, 1989).

Policymakers’ tendency to value spending programs may be reinforced by the political costs and benefits of expenditure and tax changes (Sobel, 1992, 1998). Many spending programs generally provide specific policy benefits to particular geographic regions or subpopulations (e.g., via pork-barrel spending), whereas changes in tax burden affect all taxpayers in the jurisdiction. In other words, the political benefits and costs that result from changes in expenditures are concentrated on particular constituents, whereas those from changes in tax rates are spread across the jurisdiction. Intuitively, it is likely that legislators who are elected by single-member, geographically defined districts will prefer fiscal expansions using spending increases that can better deliver policy benefits to their electoral supporters and fiscal adjustments using tax increases whose political costs are spread across the whole legislature and, as a result, diluted.

The second view of voters’ fiscal policy preferences suggests that voters are fiscally conservative and, as such, dislike budget deficits and favor small government (Alesina et al., 1998; Brender & Drazen, 2005; Drazen & Eslava, 2010; Peltzman, 1992). In this view, voters are described as sophisticated: They are not necessarily assumed to be repeatedly fooled by opportunistic policymakers; rather, they are believed to gradually learn about the fiscal and macroeconomic implications of budgetary decisions over time and punish incumbents who are not fiscally conservative. Fiscal conservatism can arise in various ways, one of which is antipathy toward and disapproval of budget deficits. For example, Alesina et al. (1998) find that deficit reductions do not adversely affect reelection chances, and similarly, Brender and Drazen (2005) find that budget deficits reduce the probability of reelection. Another form of fiscal conservatism is support for small government. The case for a reduction in the overall size of the budget has been articulated by the so-called starve-the-beast approach. The basic argument is that government has the tendency to spend whatever is made available; thus, spending grows if tax revenues increase (Friedman, 2003). Starve-the-beast proponents therefore argue that to limit the size of government, tax revenues available should be reduced, that is, taxes should be cut.

These two contrasting views on voters’ fiscal policy preferences offer two distinct scenarios as to in what manner cyclical asymmetry in state fiscal policy is played out. If the first view that voters value spending programs is true, policymakers are likely to prefer expenditure increases to tax cuts in pursuing expansionary fiscal policy during booms and tax increases to expenditure reductions in making fiscal adjustments during recessions. In this case, the following hypothesis is possible:

Hypothesis 1 (fiscal expansion hypothesis): The procyclical effects of cyclical revenue increases on the level of spending are larger in magnitude than those of cyclical revenue decreases, whereas the procyclical effects of cyclical revenue increases on the level of taxation are smaller than those of cyclical revenue decreases (i.e., spending increases during booms > spending cuts during recessions, and tax cuts during booms < tax increases during recessions).

If the second view that voters want small government holds, the opposite preferences are likely to prevail. Policymakers are likely to prefer the adjustment of tax rates rather than that of spending levels in seeking fiscal expansions in upturn years and incline toward expenditure reductions rather than tax hikes in adopting austerity measures in downturn years. In this view, the corresponding hypothesis is as follows:

Hypothesis 2 (fiscal contraction hypothesis): The procyclical effects of cyclical revenue increases on the level of spending are smaller in magnitude than those of cyclical revenue decreases, whereas the procyclical effects of cyclical revenue increases on the level of taxation are larger than those of cyclical revenue decreases (i.e., spending increases during booms < spending cuts during recessions, and tax cuts during booms > tax increases during recessions).

Each view and the corresponding hypotheses have a plausible theoretical basis, but which one provides a more accurate picture of state fiscal behavior is not clear a priori. This difficulty in theoretical reasoning is reflected in the results of a recent poll conducted by the Pew Research Center (2013). The survey finds that on the whole, people believe that the overall level of spending should be cut, but when asked about spending for individual budget functions, they support increasing or maintaining it at current levels in most of the categories. These results show people’s contradictory attitudes about the government’s spending level and budget size. Given the theoretical plausibility of both hypotheses, the present study leaves it an open question as to in what manner cyclical asymmetry in state fiscal policy arises.

Empirical Analysis

To test the asymmetric effects of cyclical fluctuations in revenue availability on the level of state spending and taxation, this study employs the following panel data model:

\begin{array}{l} e x p g a p_{i t} (o r t a x r a t e_{i t}) = β_{0} + β_{1} t b g a p_i n c_{i t} + β_{2} t b g a p_d e c_{i t} + ψ (c o n t r o l s : f i s c a l \\ i n s t i t u t i o n s / r u l e s; b u d g e t a g e n c y f u n c t i o n s; p a r t y c o n t r o l / p o l i t i c s; d e m o g r a p h i c - \\ e c o n o m i c c h a r a c t e r i s t i c s; y e a r d u m m i e s)_{i t} + ε_{i t}, \end{array}

where the subscript i and t denote panel (state) and time period (year), respectively; expgap and taxrate indicate expenditure gap and overall tax rate; tbgap_inc_it is the cumulative sum of increases in tax base gap for state i up to and including period t; and tbgap_dec_it is the cumulative sum of decreases in tax base gap for state i up to and including period t; thus, tbgap_i1 + tbgap_inc_it + tbgap_dec_it = tbgap_it.² (Please see Appendix A for a stylized example.) Controls and ε refer to control variables and the error term, respectively. The following delineates the individual variables employed in this specification.

Tax Base Gap (Cyclical Component of Tax Base)

To measure cyclical fluctuations in revenue availability, this study develops a measure termed tax base gap. Tax base, as opposed to tax revenue, is used, because the former is not directly affected by tax rate changes and therefore better suited for the exclusion of revenue changes due to tax rate adjustments (Bruce, Fox, & Tuttle, 2006). The concept of tax base gap is essentially the same as that of output gap—the difference between actual output and potential output³: Tax base gap is defined conceptually as the cyclical component of tax base and operationally as the difference between actual and potential tax base.

Specifically, for each tax, the study measures the tax base gap using the deviation-from-trend approach (Braun & Otsuka, 1998; Dye & McGuire, 1991; Hou, 2005; White, 1983), which can be illustrated as in Appendix B. Tax base undergoes cyclical fluctuations around the long-term growth trend. The deviation-from-trend approach involves two steps: first, deriving the linear long-term trend from the observations by regressing tax base on year, and then calculating the gap between the actual and expected (fitted) tax base for each year. In short, tax base gaps are the residuals from the fitted regression line.

State governments use a variety of taxes to raise revenue. Therefore, each tax’s base gap is weighted according to its relative importance in the total tax revenue and then combined to form a composite index.⁴ Tax base gaps differ in size or unit and therefore need to be standardized before being weighted and combined. For standardization, tax base gaps are divided by their respective average tax bases. Thus, tax base gap is expressed as a proportion (percentage). In sum, for a given state and year, tax base gap is the weighted sum of (standardized) deviations of tax bases from the respective long-term growth trends. In mathematical terms, it is defined as follows:

T B G A P = \sum_{i = 1}^{n} (\frac{T B_{i} - {\hat{T B}}_{i t}}{{\bar{T B}}_{i t}} \times W F),

where TBGAP is tax base gap, TB_i is observed tax base for tax, ${\hat{T B}}_{i t}$ is fitted tax base for tax (a linear approximation of long-run growth trend in tax base), ${\bar{T B}}_{i t}$ is the arithmetic average of tax bases for tax during the study period, WF is the weighting factor for tax, and n is the number of taxes.

In measuring tax bases, this study uses, among others, five major state taxes: general sales tax, personal income tax, corporate income tax, motor fuel tax, and alcohol tax.⁵ For personal income tax, the tax base is calculated by dividing total income tax revenue by the average income tax rate (as tax liability is determined by multiplying tax base [taxable income] by tax rate).⁶ Revenue data are collected from the State Government Finance series published by the U.S. Census Bureau, and average income tax rates are obtained from the TAXSIM website.⁷ By running the TAXSIM program with survey data, the National Bureau of Economic Research (NBER) calculates state income tax liabilities, which take into account states’ income tax codes regarding what is taxable. The ratio of initial liability to initial adjusted gross income (AGI) is the average rate.

For corporate income tax, gross corporate surplus is used, and the data are also from the Bureau of Economic Analysis (BEA) website. According to the BEA, gross operating surplus is a profits-like measure of enterprise income, which is obtained by subtracting the costs of compensation of employees and taxes on production and imports less subsidies from gross product.⁸

For sales tax, actual tax base is used, because no viable alternative (such as retail sales data by state) is available. Sales tax base is obtained by dividing total sales tax collection by the statutory sales tax rate. Data on sales tax collections and tax rates are obtained from the State Government Finance series published by the U.S. Census Bureau and the State Tax Reporter series published by the Commerce Clearing House, respectively.

For motor fuel tax, the net volume of motor fuel taxed is used as the tax base, and the data are drawn from the Highway Statistics series published by the Federal Highway Administration (FHA). Last, for alcohol tax, total alcohol consumption is used as the tax base, and the data are drawn from LaVallee, LeMay, and Yi (2013).

The primary purpose of this study is to test the asymmetric effects of tax base gap on fiscal adjustments. For this, following previous studies (e.g., Gately & Huntington, 2002), tax base gap is broken down into two variables: the cumulative sum of increases in tax base gap (tbgap_inc_it) and the cumulative sum of decreases in tax base gap (tbgap_dec_it). The former represents cyclical changes in revenue availability in upturn years, whereas the latter represents cyclical changes in revenue availability in downturn years. The budgetary process requires consensus building among various participants; thus, it may take more than a year for tax base gap to have effects on fiscal decisions. To capture the possible lagged effects of tax base gap, three lags of tax base gap increase and decrease are also included.

Figures 1 and 2 illustrate the difference between an asymmetric and symmetric fiscal response to changes in tax base gap. If the fiscal response is symmetric, the slopes will be the same as shown in Figure 1. The procyclical effects of cyclical revenue increases on expenditure and tax rate are likely to be equal in magnitude to those of cyclical revenue decreases. However, if it is asymmetric, the slopes will be not the same as in Figure 1. The procyclical effects of cyclical revenue increases on the level of spending and taxation will be larger or smaller than those of cyclical revenue decreases. The blue lines in Figures 2a and 2b reflect Hypothesis 1 based on preferences for spending increases, whereas the red lines illustrate Hypothesis 2 based on preferences for tax cuts.

Figure 1.

Symmetric fiscal response to tax base gap changes.

Figure 2.

Asymmetric fiscal response to tax base gap changes.

Expenditure Gap and Overall Tax Rate

Two dependent variables are employed: per capita direct general expenditure (DGE) and overall tax rate. The Census Bureau defines DGE as state/local governments’ programmatic and operational spending, which includes capital spending and excludes intergovernmental expenditure and nongeneral expenditure like utility expenditure, liquor store expenditure, and social insurance and trust expenditure. As with tax base gap, expenditure is transformed into expenditure gap.⁹ Using expenditure gap, as opposed to expenditure as it is, has two methodological merits. One is that the variable better captures the effects of legislated changes in the level of spending by excluding the trend component of DGE, and the other is that it allows for intuitively clearer interpretation of regression results by using the same unit of measurement as the key independent variable, tax base gap.¹⁰ Data on DGE are obtained from the State Government Finance series.

The second dependent variable, overall tax rate, is measured by the weighted sum of the statutory tax rates of three major state revenue sources: general sales tax, personal income tax, and corporate income tax. The rates of individual taxes are weighted by their shares in the total tax revenue and added together. For income taxes with progressive tax rate structure, top-bracket tax rates are used. Annual tax rates for each tax are collected from the State Tax Reporter series.

Fiscal Institutions and Rules

It is widely believed that institutions and rules define the way collective decisions are made and therefore have influences on policy outcomes (Buchanan & Tullock, 1962). This view has been applied to state budget processes and created various fiscal institutions and rules (Bails & Tieslau, 2000; Knight & Levinson, 1999; Smith & Hou, 2013), which, if properly enforced, are likely to have effects on fiscal decisions in a way that promotes fiscal health. For example, no-deficit-carryover requirements are expected to constrain spending and increase tax rates, as they are not allowed to run budget deficits. As the terms suggest, having tax and expenditure limits in place is predicted to restrain the levels of spending and taxation, while rainy-day funds will likely play a role particularly in limiting spending.

Although this study focuses mainly on ascertaining the asymmetric effects of cyclical revenue fluctuations on state spending and taxation, empirically it is important to control for all other relevant factors, among which fiscal institutions and rules are considered of great importance at least in theory. Even if there are public preferences for fiscal expansion during booms, they may not be realized as the state strictly abides by the formal rules of fiscal policy. Conversely, even if there are public demands for deficit spending in recessions, the strict enforcement of balanced budget requirements may force the government into contractionary fiscal adjustments.

There are several types of fiscal institutions and rules, among which this study focuses on no-deficit-carryover requirement, tax and expenditure limitations (TELs), budget stabilization funds, gubernatorial line item veto, and biennial budget cycle which have been found to have effects on fiscal behavior and outcomes. Each variable is measured as a dummy variable: 1 if in place, and 0 otherwise. Data on fiscal institutions and rules are collected from the Budget Processes in the States series published by the National Association of State Budget Officers (NASBO).

Budget Agency Functions

Another factor that may be of relevance is the role that budget agencies play in making fiscal decisions. Budget agencies perform various functions, which, according to the NASBO’s categorization, include revenue estimating, fiscal notes, review legislation, accounting, preaudit, management analysis, contract approval, and so on. These functions, if properly performed, are likely to lead the states to make fiscally sound decisions by providing policymakers with information on fiscal conditions (Schick, 2001). This study uses, among the budget agency functions mentioned above, revenue estimating which provides to the legislature a prediction of how revenue will change from the current baseline and fiscal notes which provide the estimated cost of various proposed bills. These two functions are chosen, because they are considered to provide the most essential data and information needed to assess the fiscal impact of policy decisions. Each variable is measured as a dummy variable: 1 if in place, and 0 otherwise. Data on budget agency functions are collected from the Budget Processes in the States series published by the NASBO.

Party Control

Based on the prevailing notion that political circumstances potentially have influences on policy decisions, five political controls are employed: Republican majority in the Senate (with Democratic majority in the Senate as the base group), Republican majority in the House (with Democratic majority in the House as the base group), Republican Governor, Independent Governor (with Democratic Governor as the base group), and divided government. Each variable is measured as a dummy variable, with 1 indicating yes and 0 otherwise. Data for these variables are obtained from the Book of the States series published by the Council of State Governments (CSG).

Election Cycle

The political business cycle hypothesis suggests that incumbent policymakers engage in preelectoral fiscal manipulation by increasing expenditures and cutting taxes before or during election years in an attempt to gain votes and increase their reelection chances (Drazen 2008; Drazen & Eslava, 2010). Expansionary fiscal policy changes may also arise after elections, as those newly elected put into action the fiscal policy plans that they made during their election campaigns. To capture pre- and postelectoral fiscal manipulation, gubernatorial election years (current and 1-year lead and lag) are included as a dummy variable (1 if yes, 0 otherwise), and the data are collected from the Book of the States series.

Federal Grants

Matching grants are predicted to have price effects stimulating government expenditures (Inman, 2008). The flypaper effect predicts that lump-sum grants cause the recipients to increase expenditures using the intergovernmental revenues rather than reducing tax burdens (Bradford & Oates, 1971; Gramlich & Galper, 1973). To account for the effects of grants-in-aid, per capita revenue from federal grants is included, and the data are from the State Government Finance series.

Demographic-Economic Characteristics

Last, a host of control variables related to demographic-economic characteristics are included: population, per capita income, the proportion of population aged over 65, and the proportion of population below the federal poverty level. Data for these variables are collected from the Statistical Abstract of the United States series published by the U.S. Census Bureau.

The empirical model is tested using a state panel data set, which covers 49 states (excluding Alaska) and 19 fiscal years from 1992 to 2010. All monetary figures are converted into 2007 constant dollars. Summary statistics are presented in Table 1.

Table 1.

Summary Statistics.

Variables	Mean	SD	Minimum	Maximum
Expenditure gap	−0.03289	5.576153	−19.6262	24.39757
Overall tax rate	6.192295	1.310244	3	10.74118
Cumulative increase in tax base gap	14.97553	10.80795	0	57.64029
Cumulative decrease in tax base gap	−11.68366	11.86209	−71.16042	0
No-deficit-carryover	0.721805	0.448351	0	1
Tax limitation	0.105263	0.307057	0	1
Spending limitation	0.459721	0.498643	0	1
Budget stabilization fund	0.933405	0.249453	0	1
Line item veto	0.84855	0.35868	0	1
Biennial budget cycle	0.422127	0.494164	0	1
Revenue estimating	0.75579	0.429844	0	1
Fiscal notes	0.822105	0.382626	0	1
Republican Senate	0.479055	0.49983	0	1
Republican House	0.43609	0.496165	0	1
Republican Governor	0.526316	0.499575	0	1
Independent Governor	0.016112	0.125973	0	1
Divided government	0.548491	0.497911	0	1
Election year	0.277121	0.447818	0	1
Per capita revenue from federal government	1,312.837	469.6758	570.4871	4,133.838
Population	5,668,192	6,216,214	466,251	3.73E + 07
Per capita income	34,081.14	5,640.231	21,683.48	55,859
Population over 65	12.72047	1.876794	4.3	18.6
Population under poverty	12.79168	3.454273	5.3	26.4

This study estimates the model using the fixed effects estimator¹¹ with year dummies to control for both state- and year-specific unobserved factors. The study also performs diagnostic tests for heteroscedasticity and serial correlation (the modified Wald test for groupwise heteroscedasticity and the Wooldridge test for serial correlation), which indicate that both problems are present.¹² To correct for heteroscedasticity and serial correlation, this study uses clustered robust standard errors which have been found through Monte Carlo simulations to be robust to both heteroscedasticity and serial correlation (Bertrand, Duflo, & Mullainathan, 2004; Petersen, 2009).

Given the fact that changes in fiscal variables have effects on economy activities, it is reasonable to suspect that endogeneity due to simultaneity (i.e., causality running the other way from the dependent variable to the independent variable) may exist. Simultaneity, however, is not an issue in this study, because, as previously mentioned, tax base gap is not used as it is; instead, it is broken down into the two new variables—the cumulative sum of tax base gap increases and decreases—that differ essentially from tax base gap and are not systematically related to fiscal variables. Figure 3 displays changes in the aggregate cumulative sum of tax base gap increases and aggregate cumulative sum of tax base gap decreases over the study period. The graph shows that these variables diverge from each other over time and their longitudinal movements differ widely from that of tax base gap as shown in Figure 4.

Figure 3.

Changes in aggregate cumulative sum of tax base gap increases and decreases.

Figure 4.

Changes in aggregate tax base gap and expenditure gap.

Results

The results of regression results are reported in Table 2. Overall, the empirical model performs well: The key explanatory variables are statistically significant with the expected signs. The first result to note is the positive, statistically significant coefficients on the tax base gap variables in the spending model and the negative coefficients in the taxation model. The former suggests that cyclical increases in tax revenues induce states to increase the level of spending, whereas cyclical revenue decreases cause them to lower it. To put it in another way, states tend to increase expenditures during booms and reduce them in recessions. By contrast, the latter result shows that cyclical increases in tax revenues lead to lower tax rates, whereas cyclical revenue decreases result in higher tax rates. Taken together, these results clearly show that cyclical revenue fluctuations have procyclical effects on state fiscal policies over the business cycle (i.e., they lead to the economy further expanding in good times and further contracting in lean times).

Table 2.

Regression Results.

Variables	Expenditure gap		Overall tax rate
Variables	Coefficient	t statistics	Coefficient	t statistics
Key explanatory variable
Tax base gap increase	−0.00442	−0.06	−0.01784***	−2.77
Tax base gap increase (L1)	0.12957*	1.74	−0.00143	−0.56
Tax base gap increase (L2)	0.038595	0.4	−0.00821	−1.58
Tax base gap increase (L3)	0.110883	1.19	0.007783	1.4
Tax base gap decrease	−0.02367	−0.23	−0.00234	−0.52
Tax base gap decrease (L1)	0.051595	0.64	−0.00773*	−1.89
Tax base gap decrease (L2)	0.196261**	2.34	−0.00102	−0.16
Tax base gap decrease (L3)	−0.02327	−0.22	−0.00116	−0.23
Fiscal institutions and rules
No-deficit-carryover	3.344719	1.65	0.030337	0.17
Tax limitation	1.541274	0.93	0.231554	1.41
Spending limitation	1.307446	0.87	0.110077	0.47
Budget stabilization fund	−0.49171	−0.23	−0.0318	−0.14
Line item veto	0.020055	0.02	−0.01582	−0.24
Biennial budget cycle	−1.16513	−1.21	0.027827	0.36
Budget agency functions
Revenue estimating	−1.91036	−1.1	−0.05954	−0.65
Fiscal notes	2.041751	1.21	−0.11886	−1.59
Party control
Republican Senate	0.435027	0.59	−0.05567	−1.2
Republican House	−1.48795**	−2.24	−0.09389*	−2
Republican Governor	−0.39015	−0.66	0.037394	0.68
Independent Governor	2.632206	1.3	0.319438**	2.41
Divided government	0.026262	0.04	−0.03222	−0.81
Election cycle
Election year (F1)	0.38978	1.19	−0.01063	−0.96
Election year	0.273435	0.54	−0.02821*	−1.94
Election year (L1)	0.388418	0.72	−0.03626**	−2.31
Federal grants
Per capita revenue from federal government	0.01147***	4.91	−2.68E − 06	−0.03
Demographic-economic characteristics
Population	−3.93E − 07	−0.91	6.33E − 08	1.36
Per capita income	−0.00104***	−4.13	−1.65E − 06	−0.12
Population over 65	−1.22214**	−2.56	0.047397	0.91
Population under poverty	0.168683	0.99	0.017726	1.54
Number of observations	733		733
Number of groups	49		49
R² (within)	.4918		.1744

Note. Year effects are not reported.

p < .1. **p < .05. ***p < .01.

In addition to the results of regression analyses, it is worth examining changes in the main variables over the study period. First, Figure 4 shows changes in aggregate state revenue and expenditure. Both the revenue and expenditure line depict the business cycles that have occurred during the study period. States have seen their tax revenues grow and expenditures fall during the booms of the mid- to late 1990s and mid-2000s. With the 2001 and 2008 recessions, however, state tax revenues have plummeted, while expenditures have escalated. From the regression results, it can be inferred that the expenditure line would have been lower during the boom periods and higher during the recession periods than reported in the figure, if there had not been the procyclical impacts of cyclical fluctuations in tax base gap on expenditures.

Meanwhile, annual percentage changes in overall tax rate are shown in Figure 5. During the upturn years of the 1990s and 2000s, states have reduced their tax rates, but in the 1991-1992, 2001, and 2008 recession and subsequent years, they have increased the tax rates significantly. These results clearly confirm procyclical patterns in state tax rate adjustments.

Figure 5.

Annual percentage changes in overall tax rate.

Although these are important findings, the primary focus of this study is to expand the theory beyond procyclicality to account for cyclical asymmetry in state fiscal policy. Comparison of the coefficients on tax base gap increase and decrease reveals that cyclical asymmetry is present in both spending and taxation. The results indicate that holding other variables constant, a one percentage point increase in 1-year lagged tax base gap causes expenditure gap to increase, on average, by 0.130 percentage points. Meanwhile, a one percentage point decrease in the 2-year lag of tax base gap leads to a 0.196 percentage point decrease.¹³ That is, the procyclical effect of a tax base gap decrease on the level of spending is larger than that of a tax base gap increase, providing support for Hypothesis 2. Assuming that the sum of tax base gap increases is equal to that of tax base gap decreases over the business cycle, this implies that the level of recession-driven spending cuts is higher than that of boom-driven spending increases.

Cyclical asymmetry is found in tax policy as well. The results indicate that holding other factors fixed, a one percentage point increase in (current) tax base gap causes overall tax rate to decline by 0.018 percentage points, whereas a one percentage point decrease in (1-year lagged) tax base gap leads to the dependent variable rising by 0.008 percentage points.¹⁴ That is, the procyclical effect of a tax base gap increase on the level of taxation is larger than that of a tax base gap decrease, once again, lending support to Hypothesis 2. This suggests that the level of tax cuts induced by an improved revenue condition in booms is higher than that of tax hikes caused by a worsening fiscal condition in recessions.¹⁵

Taken together, these results provide support for the second scenario which is based on the view that voters are fiscally conservative and want small government. That is, policymakers prefer tax cuts to spending increases for expansionary fiscal policy during booms, and spending cuts to tax increases for fiscal adjustments during recessions. This implies that the size of government diminishes as the state responds asymmetrically to the ups and downs of business cycles over time. In other words, the procyclical effects of cyclical revenue fluctuations on state fiscal policies are biased toward the shrinkage of government.¹⁶

Procyclical fiscal policy tilted toward fiscal conservatism, in fact, has been hinted at by a few fiscal analyses. For example, McNichol (2003b) suggests that the main component of procyclical fiscal responses in upturn years is not spending increases. He refutes the argument that the state fiscal crisis of the early 2000s is the result of overspending by the states. He argues that state spending did increase during the expansionary period of the 1990s, but the rate of the spending growth was modest in absolute terms and low by historical standards, adding that during that period, states built rainy-day funds and cut taxes. Meanwhile, Johnson (2002) points out that state tax policy was asymmetric over the boom–bust cycle from the mid-1990s through the early 2000s and that the main cause of the state fiscal crises of the early 2000s was the large tax cuts of the preceding growth period. He argues that motivated by the rapid, sustained revenue growth in the mid- to late 1990s, states enacted very large tax cuts and those tax reductions have proven unsustainable. Furthermore, he argues that despite the fact that tax cuts were to blame for the early 2000s fiscal crises, states have reversed few of those tax cuts.

Procyclical fiscal policy inclined toward fiscal conservatism is indirectly suggested by the results on the effects of elections as well. As shown in both the spending and tax model, elections have no impact on expenditures (although the signs of the coefficients are all positive, consistent with the political budget cycle theory) but statistically significant impacts on tax rates (contemporaneously and with a lag). The results indicate that in a year there is an election and 1 year after the election, overall tax rate drops by 0.028 and 0.036 percentage points, respectively. Consistent with the political budget cycle theory, this suggests that around election years, incumbents engage in fiscal manipulation in an attempt to garner votes and this fiscal manipulation focuses on tax cuts rather than spending increases, proving support for the fiscal conservative voters’ view.

Among the control variables, consistent with the conventional notion that the Republican Party advocates free market, fiscal conservatism, and small government, Republican control of the House is found to have the effect of reducing both expenditures and tax rates. Also, it is found that when Independent Governor is in office, tax rates increase.¹⁷ Federal grants are found to be positively related to the level of spending, providing evidence in support of the flypaper effect. Biennial budget cycle is found to have the effect of constraining spending, supporting the view that it produces a more fiscally responsible budget by bringing a longer term perspective to the budgetary process and by allowing more time for legislative deliberation and oversight (Fisher, 1997). An interesting result is that no fiscal discipline mechanism has a statistically significant effect. This is noticeable, given that many previous studies have found evidence of the effects of fiscal discipline mechanisms in restraining spending and improving tax effort. This result may suggest that the mere presence of fiscal rules does not guarantee desired effects and that what matters is the specific characteristics and stringency of them (Hou & Smith, 2010).

Conclusion

Building on theoretical models that address the political economy of fiscal expansions and adjustments and the fiscal policy preferences of voters and policymakers, this article has tested the asymmetric effects of cyclical fluctuations in revenue availability on the level of state spending and taxation across the booms and busts of business cycles. The analysis reveals that cyclical revenue fluctuations have procyclical effects on both expenditures and tax rates, and more importantly that the procyclical effects of cyclical revenue increases (in upturn years) on expenditures are smaller than those of cyclical revenue decreases (in downturn years), whereas the procyclical effects of cyclical revenue increases on tax rates are larger than those of cyclical revenue decreases. That is, policymakers prefer tax cuts to spending increases in pursuing expansionary fiscal policy during booms and spending cuts to tax increases in making fiscal adjustments during recessions. Taken together, the results suggest that cyclical fluctuations in revenue availability have procyclical effects on state fiscal policies in a manner that is asymmetric between boom and recession and fiscally conservative.

An important theoretical implication is drawn from these findings. As introduced earlier, political economy models of fiscal behavior (Alesina et al., 2008; Alesina & Perotti, 1995; Battaglini & Coate, 2008; Tornell & Lane, 1999) predict the dynamic pattern of fiscal policy over the business cycle by accounting for the “dynamics of legislative policymaking . . . [and the] mix of public spending between pork and public goods” (Battaglini & Coate, 2008, p. 202). The first main finding of this study that state fiscal policies display procyclical patterns provides empirical support to these theories, highlighting the importance of bringing a political economy perspective to the fiscal policy and behavior research.

More importantly, the second main finding that cyclical revenue fluctuations have procyclical effects on fiscal policies in a manner that is asymmetric between boom and recession and fiscally conservative highlights the importance of taking into account the fiscal dynamics that varies across the two basic phases of business cycles, boom and recession, as well as the procyclicality of fiscal policy. Cyclical asymmetry in fiscal policy stems from the varying political consequences of fiscal policy choices. Fiscal policy largely consists of two policy tools, spending and taxation, which differ in the political benefits and costs that result for individual elected officials. By offering a more detailed description of the procyclicality of state fiscal policy, this study demonstrates that political considerations exert influences on the ways policymakers make fiscal policy choices over boom–bust cycles.

This main finding has practical implications for state governments. It is understandable that the cyclical asymmetry of state fiscal policies is tilted toward less taxes and less spending, given an ever-present antitax sentiment and growing skepticism toward big government in the United States. However, it is neither sustainable nor desirable in the long run. States cannot continue to repeat this pattern going through business cycles. Public programs and services require a certain level of funding. The optimal size of government varies depending on how the society defines government responsibilities and functions; therefore, small government does not necessarily mean good government. Thus, it is expected that at some point in the future, state governments will need to give serious thought on the size and scope of the public services they wish to provide and the corresponding level of spending and taxation required.

Although these findings provide important implications for the development of fiscal policy theories, further studies are warranted to answer some emerging questions. The present study has focused on the overall level of spending and taxation in examining the cyclicality and cyclical asymmetry of state fiscal policies; therefore, the specific composition of fiscal expansions and fiscal adjustments is unexplained. The emerging questions are, for example, what types of spending programs or budget functions are particularly influenced by increased revenue availability in booms? What kinds of program expansions in booms are particularly difficult to reverse in recessions? What types of taxes are mainly used for fiscal adjustments in recessions? What factors influence the choices between spending increases or tax cuts in booms (or choices between spending cuts or tax increases in recessions)? In addition, the effects of state politics are worthy of more work. Is the cyclical asymmetry of fiscal policy more pronounced in states with a Democratic or Republican governor and legislature? Is it more prevalent in states with unified or divided government? Furthermore, what effects do procyclical fiscal policies have on the economy? Are recessions more severe in states that adopt a procyclical fiscal policy? These questions will be instrumental in developing more sophisticated models of state fiscal behavior.

Finally, some potential limitations of the study should be noted. As discussed earlier, few of the institutional and political variables are found to have a statistically significant effect. This limits the contributions of the research to this literature, unless one takes the lack of impact of these variables as an important theoretical finding. Although it is quite common in the fields of public budgeting and finance to use binary variables for fiscal institutions and rules, the use of more sophisticated measures might improve the statistical significance of their effects. For example, although no-deficit-carryover rule is considered the most stringent among balanced budget requirements, the inclusion of the full range of balanced budget requirements might produce different results. Similarly, the effects of rainy-day funds could be better captured by employing more detailed measures such as saving rates rather than simply measuring whether they are in place. This concern applies to the state politics variables as well. For example, the dummy variables used for party control and dominance may not be sensitive enough to fully account for the complex sociopolitical circumstances under which state governments are operating. Further research is warranted to resolve these deficiencies.

Footnotes

Appendix

Appendix A

A Stylized Example of the Cumulative Sum of Tax Base Gap Increases and Decreases.

t	tbgap	Δtbgap	tbgap_inc	tbgap_dec
1	−3		0	0
2	−2	1	1	0
3	−1	1	2	0
4	0	1	3	0
5	1	1	4	0
6	2	1	5	0
7	3	1	6	0
8	2	−1	6	−1
9	1	−1	6	−2
10	0	−1	6	−3
11	−1	−1	6	−4
12	−2	−1	6	−5
13	−3	−1	6	−6

Note. Δtbgap is the annual difference in tbgap. tbgap_inc is the cumulative sum of tax base gap increases, and tbgap_dec is the cumulative sum of tax base gap decreases. If Δtbgap is greater than 0, it is cumulatively added to tbgap_inc. If less than 0, then it is added to tbgap_dec.

Acknowledgements

The author would like to thank the anonymous reviewers and editors for their insightful comments and suggestions.

Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author(s) disclosed receipt of the following financial support for the research, authorship, and/or publication of this article: This work was supported by Hankuk University of Foreign Studies Research Fund of 2015.

Notes

Author Biography

Sunjoo Kwak is an assistant professor in the Department of Public Administration at the Hankuk University of Foreign Studies. His research interests include public budgeting and finance, fiscal health, and the political economy of fiscal policy.

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