The Macroeconomic Effects of Fiscal Rules in the US States

Abstract: Fiscal policy restrictions are often criticized for limiting the ability of governments to react to business cycle fluctuations. Therefore, the adoption of quantitative restrictions is viewed as inevitably leading to increased macroeconomic volatility. In this paper we use data from 48 U.S. states to investigate how budget rules affect fiscal policy outcomes. Our key findings are that (1) strict budgetary restrictions lead to lower policy volatility (i.e. less discretion in conducting fiscal policy); (2) fiscal restrictions reduce the responsiveness of fiscal policy to output shocks and decrease the persistence of spending fluctuations. These two results should have opposite effects on output volatility. While less discretion should reduce volatility, less responsiveness of fiscal policy might amplify business cycle. Our analysis shows that the first effect dominates and that restrictions on fiscal policy lead to less volatility in output.