The recent financial crisis has brought the role of fiscal policy to the forefront of American politics. On February 17th, 2009, President Obama signed an economic stimulus package worth $787 billion into law. The package combined increases in fiscal expenditures with tax cuts, raising the federal primary deficit. The purpose of this stimulus was to "boost economic activity by increasing short term aggregate demand"(Congressional Budget Office 2008).
Whereas the federal government has the flexibility to run counter cyclical policy, state governments are more restricted in their options. This is because almost all states (the exception being Vermont) are bound by balanced budget restrictions. With varying de-grees of stringency, these rules restrict a state governments ability to run deficits and hence counter cyclical fiscal policy. One worry is that these constraints might exacerbate an economic downturn. That is, just as private demand has fallen, state governments are forced to reduce their spending and raise taxes to balance their budgets. As Robert Rubin has said, these actions "could turn slowdowns into recessions, and recessions into more severe recessions or even depressions".
This relationship between the cyclicality of fiscal policy and macroeconomic volatility has been extensively analyzed in the empirical literature. Examples include Fatas and Mihov (2006), Lane (2003), Levinson (1998), and Sorensen, Wu, and Yosha (2001). Little empirical work, however, has been devoted to studying whether the cyclicality of fiscal policy affects long run growth. This paper, using US state level data from 1977-1997, examines this topic. Specifically, we seek to answer the following question: does the cyclicality of fiscal policy affect long run growth within the US states?
One potential channel through which the cyclicality of fiscal policy could affect growth has been identified by Aghion and Howitt (2006). In their theoretical model, firms choose to invest in either capital or a productivity enhancing technology. This investment in technology is subject to liquidity shocks that must be paid by each firm. The firms, though, face a credit constraint and can only borrow up to a fraction of their earnings. This constraint tightens during recessions when firms have low earnings, limiting the ability of the firms to finance the liquidity shock in these periods. Anticipating this, firms reduce their investment in the productivity enhancing technology in earlier periods. As a result, long run growth slows.
Critically, the authors suggest that a counter cyclical fiscal policy could improve growth by relaxing the firmsocredit constraint in downturns. An example of a policy that accomplishes this goal would be for the government to implement a counter cyclical policy of public investment. This policy would raise the earnings of the firms during recessions and so ease their credit constraint. Forecasting the implications of this policy, firms would then increase their investment in the productivity enhancing technology, raising the growth rate. All else equal, this model implies that states running more counter cyclical fiscal policy should have higher growth rates than those running more procyclical fiscal policy.
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Fiscal Policy Cyclicality and Growth within the US States
