While theoretical and empirical literature tends to focus on predicting and
discussing the types of responses states use to address fiscal stress (Dougherty and Klase 2009; Grizzle and Trogen 1994; Gold 1995; Finegold et al 2003), largely missing is an examination of the effectiveness of different responses – for example, a comparison of the effect of rainy day fund use, reductions in expenditures, and/or increases in taxes and other revenues on fiscal stress levels. With the exception of research on the effectiveness of using budget stabilization/rainy day funds to reduce gaps between expected and actual expenditures, the effects of state responses to fiscal stress are unexplored (Sobel and Holcombe 1996a; Douglas and Gaddie 2002; Hou 2003; Hou 2004). This leaves questions such as – will a certain response yield a quicker recovery or protection from fiscal stress in a subsequent period? – unanswered. The relative effectiveness of the range of possible responses – expenditure reductions, revenue increases, drawing on cash reserves – is not assessed, individually or as a group. In 1979, Levine called for more research on the effectiveness of responses to fiscal stress; more recently, a retrospective article identified effectiveness as a gap in state fiscal stress research (Scorsone and Plerhoples 2010). A review of the fiscal stress focused research provides some guidance as to the independent effects of different responses.
2.5.1 Rainy Day Funds
Studies on rainy day funds hint at the relationship between the existence of a rainy day fund, the size (as a percent of total expenditures) of the rainy day fund balance, the rules governing rainy day fund deposits and use, and fiscal stress levels (Hou 2003; Hou 2004; Douglas and Gaddie 2002; Sobel and Holcombe 1996a). The rules governing the
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funds were found to play a more important role in reducing fiscal stress levels than the presence of a rainy day fund or its funding level (Douglas and Gaddie 2002; Sobel and Holcombe 1996a). Indeed, Douglas and Gaddie (2002) found that having more than one fund designated as a rainy day fund reduced states’ fiscal stress levels significantly.
Using general fund expenditure gaps as the dependent variable, Hou (2003)’s findings are not directly applicable to fiscal stress levels. This research does suggest that higher rainy day fund balances reduce reliance on expenditure cuts by states during economic downturns. Other studies of rainy day funds focus on the appropriate size of the rainy day fund balance, not on the use of rainy day funds to address fiscal stress and budget shortfalls (Navin and Navin 1997; Joyce 2001). Confounding this analysis is these studies use different measures of fiscal stress – an issue discussed in the next chapter. The long-term effect of rainy day fund use on fiscal stress has not received significant empirical or theoretical attention. However, certain case study analyses suggest that the use of rainy day funds allows states to defer making crucial adjustments to spending and/or tax levels (Hackbart and Ramsey 2004; Gold 1995; Conant 2003). The finding that rainy day funds allow states to reduce expenditure cuts during economic downturns supports this analysis (Hou 2003). Therefore, choosing to use rainy day funds instead of cutting expenditures or increasing taxes and fees, may lead a state to perpetuate structural imbalance and make it more vulnerable to future fiscal stress.
2.5.2 Expenditure Cuts
Research on expenditure cuts during periods of fiscal stress focus on changes in patterns of spending and identifying which functional areas tend to receive the largest cuts (Finegold et al 2003; Dougherty and Klase 2009; Hackbart and Ramsey 2004). Case study research shows that not calibrating spending levels to revenue collections leads to extreme vulnerability to economic downturns (Gold 1995; Conant 2003; Finegold et al 2003). A general theme in this research is that fiscal stress arises in states that misjudged
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or willfully ignored the need to match spending levels with volatile tax collections in the years prior to fiscal stress (Gold 1995; Conant 2010). As such, to reduce fiscal stress in the future, balancing spending levels and tax levels is the recommended course of action for states.
Research on the long-term effects of fiscal stress induced changes in expenditures tends to concentrate on permanent changes in programs and staffing levels (Berne and Stiefel 1993). Drawing from the research focusing on short-term effects of expenditure cuts (Gold 1995; Finegold et al 2003) and research with a longer time frame (Hackbart and Ramsey 2004), expenditure cuts may be effective at reducing future levels of fiscal stress. To do so, the focus of cuts is important, as is the extent to which the expenditure cut balance overall spending and revenue levels.
2.5.3 Tax and Fee Increases
As with expenditure cuts, tax and fee increases affect fiscal stress levels by helping states achieve revenue and expenditure balance. The effectiveness of tax and fee increases depends on several factors including the diversification of revenue sources and the type of taxes and fees increased by states. Certain taxes (e.g. sales taxes, corporate income taxes, capital gains tax) may have dramatically reduced revenue collections during economic downturns (Sjoquist and Wallace 2003; Sobel and Holcombe 1996b; Suyerhoud 1994). While other taxes (e.g. alcoholic beverage taxes, motor fuels taxes, and personal income taxes) are less susceptible to cyclical variations (Suyerhoud 1994; Sobel and Holcombe 1996b). Other research explores differences in the cyclical variability of taxes depending on a state’s tax portfolio and finds that the same tax will have different cyclical variations depending on the suite of taxes employed by a state (Braun and Otsuka 1998). Based on research in this area, it appears that there is no single optimal portfolio of revenue sources (Braun and Otsuka 1998); however, there is evidence – although not entirely conclusive that having a mix of taxes able to adjust to cyclical changes may
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improve state fiscal performance or at the very least provide a more stable revenue baseline (Hendrick 2002; Braun and Otsuka 1998; Brinner and Brinner 2002).
As related to the effectiveness of tax and fee increases in reducing fiscal stress, this research has both short-term and long-term implications. In the short-term, especially during an economic downturn, tax and fee increases may not raise as much revenue as anticipated due to the cyclical variability of revenues. In the long-term, states that are willing to use tax increases may diversify their revenue base and enhance its flexibility in the face of cyclical variation. In addition, if the tax changes broaden the tax base or adjust previously inefficient tax systems, this may contribute to a more flexible tax system that then can protect the state against future periods of fiscal stress or reduce the severity of stress at a future period (Gold 1995).
A theme throughout the literature on state responses to fiscal stress is that certain responses have long-term effects (Levine et al 1981b; Druker and Robinson 1993; Greenhalgh and McKersie 1980; Berne and Stiefel 1993). This suggests an important distinction between the types of responses: whether a response improves the efficiency in either spending or taxation or rather is sufficient only in allowing the state to muddle through to the next crisis (Gold 1995). This research does suggest that the use of certain responses over others – rainy day funds instead of broadening tax bases or reassessing spending priorities – may not only ease states fiscal stress in the current year, but set states up for more troubles in subsequent years.