Associated Programs

Federal Budget Policy

Federal Budget Policy

The demographic shift resulting from the aging of the baby boomer generation presents a number of potential dilemmas for policymakers. Whether a shrinking working-age population can support its own dependents, in addition to retirees, has led to debates about the increasing size of Social Security, Medicare, and Medicaid budgets—now and in the future. Questions have been raised about whether these government programs can continue to function in the same manner, and achieve the same goals, as they do today. Will structural reform be necessary? Do we wish to provide the same, or a higher, level of support equally throughout the aging population? Should some, or all, benefits be “income tested”? What can be done today to offset the problems of the future?

In aggregate terms, fiscal debates have turned from what to do about growing federal budget surpluses to what constitutes the necessary size and composition of a stimulus package. Some economists have argued that, by creating a wider pool of funds available for investment, “fiscal responsibility” resulted in greater access to investment funds by private sector firms, which, in turn, stimulated economic growth. Others contend that the unprecedented growth of the 1990s happened in spite of budget surpluses, and that if the composition of private versus public funding had been more in balance, growth and employment would have expanded even further. These debates are related to those that surround the current demand shortfall and to calls for fiscal stimulus: if budget surpluses were the cause of economic growth, an argument can be made that fiscal stimulus should focus on investment-targeted tax cuts. If, however, surpluses were the result of economic growth, then demand-led fiscal policies, such as spending programs and tax cuts aimed broadly over the income distribution, should be the focus.

In responding to the above-listed issues, Levy Institute scholars have concentrated recent research on evaluating proposals that would alter the structure of Social Security to deal with future funding shortfalls, privatize any or all of the Social Security program, and restructure Medicaid financing to widen the availability of funding for long-term care. Other recent analyses deal with specific budgetary issues, such as tax-cut proposals and evaluation of the causes and effects of federal budget surpluses.

Research Program

Economic Policy for the 21st Century



Program Publications

  • One-Pager No. 64 | August 2020
    As congressional negotiations stall and state governments are poised to enact significant austerity, Alex Williams argues that fiscal aid to state governments should be tied to economic indicators rather than the capriciousness of federal legislators. Building this case for reform requires confronting a common objection: that state fiscal aid creates situations of moral hazard. This objection misconstrues the agency of state governments and misunderstands the incentives of federal politicians, according to Williams. There is a serious moral hazard problem involved here—but it is not the one widely claimed.

  • Public Policy Brief No. 152 | August 2020
    The mainstream fiscal federalism literature has led to an instinctive belief that states receiving fiscal aid during a recession are taking advantage of the federal government in pursuit of localized benefits with dispersed costs. This policy brief by Alex Williams challenges this unreflective argument and, in response, offers a novel framework for understanding the relationship between the business cycle and fiscal federalism in the United States.

    Utilizing the work of Michael Pettis, Williams demonstrates that a government unable to design its own capital structure is not meaningfully an agent with respect to the business cycle. As such, they cannot be considered agents in a moral hazard problem when receiving support from the federal government during a recession.

    From the perspective of this policy brief, the operative moral hazard problem is one in which federal-level politicians reap a political benefit from a seemingly principled refusal to increase federal spending, while avoiding blame for crisis and austerity at the state and local government level. Williams’ proposed solution is to impose macroeconomic discipline on federal policymakers by creating automatic stabilizers that take decisions about the level of state fiscal aid in a recession out of their hands.

  • Working Paper No. 964 | July 2020
    Analyzing the Fiscal Forecasting Errors of 28 States in India
    Budget credibility, or the ability of governments to accurately forecast macro-fiscal variables, is crucial for effective public finance management. Fiscal marksmanship analysis captures the extent of errors in the budgetary forecasting. The fiscal rules can determine fiscal marksmanship, as effective fiscal consolidation procedures affect the fiscal behavior of the states in conducting the budgetary forecasts. Against this backdrop, applying Theil’s technique, we analyze the fiscal forecasting errors for 28 states (except Telangana) in India for the period 2011–16. There is a heterogeneity in the magnitude of errors across subnational governments in India. The forecast errors in revenue receipts have been greater than revenue expenditure. Within revenue receipts, the errors are more significantly pronounced in the grants component. Within expenditure budgets, the errors in capital spending are found to be greater than revenue spending in all the states. Partitioning the sources of errors, we identified that the errors were more broadly random than due to systematic bias, except for a few crucial macro-fiscal variables where improving the forecasting techniques can provide better estimates.

  • Policy Note 2020/5 | July 2020
    In this policy note, Jan Toporowski provides an analysis of government debt management using fiscal principles derived from the work of Michał Kalecki. Dividing the government’s budget into a “functional” and “financial” budget, Toporowski demonstrates how a financial budget balance—servicing government debt from taxes on wealth and profits that do not affect incomes and expenditures in the economy—allows a government to manage its debts without compromising the macroeconomic goals set in the functional budget. By splitting the budget into a functional budget that affects the real economy and a financial budget that just maintains debt payments and the liquidity of the financial system, the government can have two independent instruments that can be used to target, respectively, the macroeconomy and government debt—overcoming a dilemma that makes fiscal policy ineffective. This analysis also explains how pursuit of supply-side policies that result in a financial budget deficit and functional budget surplus can lead to slow growth, rising government debt, and financial instability.

  • Policy Note 2020/2 | April 2020
    The federal government appears to have abandoned the idea of a coordinated public health response to the COVID-19 pandemic, leaving the entirety to state and local governments. Meanwhile, the economic standstill resulting from necessary public health measures will soon cripple state and local budgets. Alexander Williams outlines a proposal for an intragovernmental automatic stabilizer program that would provide a backstop for state and local finances—both during the pandemic and beyond. Without this program, states will be severely constrained in their ability to respond to COVID-19, and balanced budget requirements will force them to cut jobs and raise taxes during the deepest recession in living memory.

  • Working Paper No. 933 | July 2019
    Making Sense of the Barro-Ricardo Equivalence in a Financialized World
    The 2008 crisis created a need to rethink many aspects of economic theory, including the role of public intervention in the economy. On this issue, we explore the Barro-Ricardo equivalence, which has played a decisive role in molding the economic policies that fostered the crisis. We analyze the equivalence and its theoretical underpinnings, concluding that: (1) it declares, but then forgets, that it does not matter whether the nature of debt and investment is public or private; (2) its most problematic assumption is the representative agent hypothesis, which does not allow for an explanation of financialization and cannot assess dangers coming from high levels of financial leverage; (3) social wealth cannot be based on any micro-foundation and is linked to the role of the state as provider of financial stability; and (4) default is always the optimal policy for the government, and this remains true even when relaxing many equivalence assumptions. We go on to discuss possible solutions to high levels of public debt in the real world, inferring that no general conclusions are possible and every solution or mix of solutions must be tailored to each specific case. We conclude by connecting different solutions to the political balance of forces in the current era of financialization, using Italy (and, by extension, the eurozone) as a concrete example to better illustrate the discussion.
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    Author(s):
    Lorenzo Esposito Giuseppe Mastromatteo
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  • Working Paper No. 883 | February 2017
    An Empirical Analysis of G20 Countries

    This paper analyzes the effectiveness of public expenditures on economic growth within the analytical framework of comprehensive Neo-Schumpeterian economics. Using a fixed-effects model for G20 countries, the paper investigates the links between the specific categories of public expenditures and economic growth, captured in human capital formation, defense, infrastructure development, and technological innovation. The results reveal that the impact of innovation-related spending on economic growth is much higher than that of the other macro variables. Data for the study was drawn from the International Monetary Fund’s Government Finance Statistics database, infrastructure reports for the G20 countries, and the World Development Indicators issued by the World Bank.

  • Working Paper No. 874 | September 2016
    Is There a Case for Gender-sensitive Horizontal Fiscal Equalization?

    This paper seeks to evaluate whether a gender-sensitive formula for the inter se devolution of union taxes to the states makes the process more progressive. We have used the state-specific child sex ratio (the number of females per thousand males in the age group 0–6 years) as one of the criteria for the tax devolution. The composite devolution formula as constructed provides maximum rewards to the state with the most favorable child-sex ratio, and the rewards progressively decline along with the declining sex ratio. In this formulation, the state with the most unfavorable child-sex ratio is penalized the most in terms of its share in the horizontal devolution. It is observed that the inclusion of gender criteria makes the intergovernmental fiscal transfers formula more equitable across states. This is not surprising given the monotonic decline in the sex ratio in some of the most high-income states in India.

  • Working Paper No. 872 | August 2016
    Do Fiscal Rules Impose Hard Budget Constraints?

    The primary objective of rule-based fiscal legislation at the subnational level in India is to achieve debt sustainability by placing a ceiling on borrowing and the use of borrowed resources for public capital investment by phasing out deficits in the budget revenue account. This paper examines whether the application of fiscal rules has contributed to an increase in fiscal space for public capital investment spending in major Indian states. Our analysis shows that, controlling for other factors, there is a negative relationship between fiscal rules and public capital investment spending at the state level under the rule-based fiscal regime.