Ed Dolan's Econ Blog

Yes, The U.S. Needs Fiscal Policy Rules, but Not Hatch-Lee

Sometimes the United States is slow to join a global trend. Fiscal policy rules are a case in point. Economists love the idea of rules that decouple tax and spending policies from short-term politics and focus instead on long-term growth and sustainability. Such rules used to be rare; as recently as 1990, they were in effect in only 7 countries, according to an IMF survey. By 2009, the number had grown to 90. Aside from failed attempts like the Gramm-Rudman-Hollings Act of 1985, the United States has been missing from the list.

It won’t be missing for long if Utah Senators Orin Hatch and Mike Lee have their way. They are pushing a set of budget rules in their Hatch-Lee Balanced Budget Amendment, which was introduced on March 31 with the backing of the entire Senate Republican delegation. Just this week, Senator Lee gave it added momentum by including it in his Cap, Cut and Balance Act. That new proposal would require the Hatch-Lee amendment to be passed, along with a set of short-term cuts and caps, before the debt ceiling could be raised.

Linking long-term rules to a short-term increase in the budget ceiling is an excellent idea. The IMF cites several examples, from Sweden to Bulgaria to New Zealand, where a fiscal crisis provided the impetus for the adoption of successful budget rules. But is Hatch-Lee the right kind of rule? Unfortunately it is not.

The first problem is that Hatch-Lee caps federal spending at 18 percent of GDP, a level that is simply too low to be politically viable. Orin Hatch himself has admitted as much. Until recently, the two Utah Senators backed dueling budget amendments, Hatch’s version aiming for 20 percent of GDP and Lee’s holding out for 18. At the end of March, they compromised on 18 percent—a deal that says much about what compromise means in today’s Republican party. As I have blogged before, even 20 percent is probably unrealistic, given U.S. demographic trends.

The second problem is that Hatch-Lee calls for an annual balanced budget. Rules calling for strict annual balance are inherently procyclical. They require tax increases or spending cuts during a recession, just when they hurt the most, but allow spending to rise, instead of requiring a surplus, during booms. With many states already operating under such rules, adding an annual balance rule at the federal level would be strongly destabilizing.

There would be many ways to take the edge off the strict annual balance requirement while retaining the desired fiscal discipline. One would be to balance only the cyclically adjusted budget; another would be to aim for balance over the cycle rather than year by year; and still another would be a rule requiring missed targets to be made up automatically, but over a horizon of more than a year. Unfortunately, Hatch-Lee does not incorporate any of them.

The third problem is that Hatch-Lee is asymmetrical in its treatment of revenues and expenditures. Only a simple majority of votes is required to cut expenditures to meet the deficit target, but raising revenue requires a two-thirds majority of all sitting members of each house of Congress, a very high hurdle in today’s political climate. Furthermore, revenue increases are strictly interpreted to include reductions in tax expenditures as well as rate increases, so closing tax loopholes is off the table as a deficit-reduction strategy. That is a great pity, since across the board tax reform that broadens the tax base and reduces top rates is by far the best path to growth-friendly fiscal consolidation.

The asymmetrical treatment of revenues and expenditures combined with the annual balance requirement means that the effective expenditure ceiling is not really 18 percent of GDP, but rather, the smaller of 18 percent or the forecast of revenue for the year, given prevailing tax rates. For example, the same set of tax rates that captured over 18 percent of GDP in 2006 and 2007 brought in less than 15 percent in 2009 and 2010. Without a supermajority in both houses of Congress, the only way to have complied with Hatch-Lee would have been to cut expenditures below 15 percent of GDP, as well. Since the 18 percent ceiling would be binding during expansions, the effective average level of expenditures over the business cycle would probably end up in the 16 to 17 percent range.

The fourth problem with Hatch-Lee is that, ironically, it would make it extremely difficult ever to reduce the federal debt. True, the amendment allows any revenue collected in excess of the 18 percent spending ceiling to be used to pay down principal on the debt, but under the asymmetrical revenue-expenditure mechanism described above, it is unlikely that surpluses would emerge often. It would be easy, one would think, to work out some incentive to pay down the debt faster without weakening the desired budget discipline. For example, instead of requiring the same supermajority for closing tax loopholes as is required for raising tax rates, Congress might be allowed to close loopholes by simple majority if the resulting revenue were dedicated to paying off the debt.

The point is an important one because of still another feature of Hatch-Lee: The fact that it makes no distinction between the overall deficit and the primary deficit. (The latter is the deficit excluding interest on the debt; see here for a full discussion.) With the debt held by the public already at 60 percent of GDP, debt service is not a trivial amount. Furthermore, it is far from clear that debt held by the public is the right measure under Hatch-Lee. Article 9 of the amendment reads “Total receipts shall include all receipts of the United States Government except those derived from borrowing. Total outlays shall include all outlays of the United States Government except those for repayment of debt principal.” On the face of it, that would seem to place interest paid on debt owned by the Fed, the social security trust fund, and other government funds under the 18 percent expenditure ceiling, despite the fact that those payments are recycled right back into the revenue side of the budget. Gross debt is now just shy of 100% of GDP. If interest rates rose even to the modest level of 2.5 percent used in recent budget forecasts, which is well below their historical average nominal rate, the government would be limited to spending just 15.5 percent of GDP on all programs combined.

The bottom line: The Hatch-Lee Balanced Budget Amendment is completely unworkable. That does not mean, though, that long-term fiscal policy rules are a bad idea. Quite the contrary: They are a very good one. Future posts will show how other countries have introduced more intelligent rules that allow them to enjoy prosperity with fiscal sustainability while escaping the problems that plague Hatch-Lee.


One Response to “Yes, The U.S. Needs Fiscal Policy Rules, but Not Hatch-Lee”

NancyOctober 21st, 2012 at 11:25 am

Thank you for this informative and interesting article. My current debate topic is on whether on not the United States should require a balanced budget amendment (though it doesn't specifically have to be the Hatch-Lee plan) and I found this piece extremely helpful, especially when read in conjunction with your writing on Sweden's fiscal policy.

Excellently said – thank you!

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Richard has published papers on wages policy, the taxation of financial arrangements and macroeconomic issues in Pacific island countries. Views expressed in these articles are his own and may not be shared by his employing agency. He is the author of How to Solve the European Economic Crisis: Challenging orthodoxy and creating new policy paradigms