The Balanced-Budget Fallacy
It makes an appealing political pitch, but balancing the books can carry heavy hidden costs.
By Daniel Altman

(Business 2.0) – All campaign season, both President Bush and John Kerry have pledged to cut the federal budget deficit in half. That promise may sound impressive, but at the state level it likely has prompted a few guffaws. Because while the federal government is free to rack up deficits, nearly all of the states are legally bound to adhere to strict balanced budgets.

But is that really a good idea? Only two states, Indiana and Vermont, let the governor and the legislature get away with not balancing the books. In the other 48, the state government can propose to spend only what it expects to collect in taxes. The rule isn't always prudent, and since the 2001 recession, balanced-budget laws have produced some nasty side effects.

That slump hit states with a double whammy: Demand for entitlements like Medicaid rose, but tax revenues fell. The states had little choice but to raise taxes. More than half the states hiked at least one of the four biggest contributors to state coffers—corporate income tax, individual income tax, sales tax, and gasoline tax. Indiana, Nebraska, New York, North Carolina, and Ohio bumped up three of the four.

You probably noticed the effect of those increases on your wallet. Let's say that you earn $150,000 a year and spend $50,000 on purchases that carry sales tax (which in many states excludes food). Additionally, say you fill up the 20-gallon tank in your SUV once a week, for a little over 1,000 gallons a year.

How much has your state tax burden grown? If you live in North Carolina, your income tax rose by about $150. The sales tax rate rose from 4 to 4.5 percent, adding $250 to your expenses. In addition, gas taxes inched up about a penny a gallon, adding another 10 bucks or so to the cost of driving. All in all, your state taxes grew by more than $410.

There are also indirect costs you probably haven't thought about. Because balanced-budget rules are enforced every year, states have to raise and lower tax rates far more often than they otherwise would. Those rate changes cost time and money in all sorts of subtle ways, whether it's rewriting income tax forms, fixing sales tax settings on cash registers, or accounting for all the extra time and effort that politicians have to put into adjusting the rates and selling them to the public.

Constantly shifting tax rates can also hurt the economy directly. Economists know that raising the sales tax can dampen spending, and those negative impacts increase exponentially with the size of the tax hike. So doubling a tax rate more than doubles the amount of lost economic activity. For example, setting the sales tax rate at 2 percent one year and 4 percent the next leaves the state worse off than if the tax had stayed steady at 3 percent for two years.

Finally, from a political perspective, balanced-budget rules often leave the wrong person holding the bag. A governor may have to raise taxes if his or her predecessor failed to save for a rainy day, especially if the legislature is unwilling to cut spending. Without a doubt, that incumbent's challenger in the next election will point a finger and charge, "My opponent raised your taxes!" And, in the heat of a campaign, voters may not remember why.

The Ugly Side of Fiscal Prudence

Balanced-budget rules have forced more than half the states to raise taxes since 2001.

SOURCES: Federation of Tax Administrators; Tax Foundation