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The Tax Policy Center's

Briefing Book

A citizen’s guide to the fascinating (though often complex) elements of the US tax system.

Tax Policy Center Briefing Book

The State of State (and Local) Tax Policy

  • Briefing Book
  • Fiscal Federalism and Fiscal Institutions
  • What are state balanced budget requirements and how do they work?
  • Chapters
    • Introduction
      • Introduction
        • Introduction
    • Some Background
      • Federal Budget
        • What are the sources of revenue for the federal government?
        • How does the federal government spend its money?
        • What is the breakdown of revenues among federal, state, and local governments?
        • How do US taxes compare internationally?
      • Federal Budget Process
        • How does the federal budget process work?
        • What is the history of the federal budget process?
        • What is the schedule for the federal budget process?
        • What is reconciliation?
        • How is a budget resolution enforced?
        • What is PAYGO?
        • What are rescissions?
      • Federal Budget Outlook
        • How accurate are long-run budget projections?
        • What have budget trends been over the short and long term?
        • How much spending is uncontrollable?
        • What are tax extenders?
        • What options would increase federal revenues?
        • What does it mean for a government program to be off-budget?
        • How did the TCJA affect the federal budget outlook?
      • Taxes and the Economy
        • How do taxes affect the economy in the short run?
        • How do taxes affect the economy in the long run?
        • What are dynamic scoring and dynamic analysis?
        • Do tax cuts pay for themselves?
        • On what do economists agree and disagree about the effects of taxes on economic growth?
        • What are the economic effects of the Tax Cuts and Jobs Act?
      • Economic Stimulus
        • What is the role of monetary policy in alleviating economic downturns?
        • What are automatic stabilizers and how do they work?
        • What characteristics make fiscal stimulus most effective?
      • Distribution of Tax Burdens
        • How are federal taxes distributed?
        • Are federal taxes progressive?
        • How should progressivity be measured?
        • What is the difference between marginal and average tax rates?
        • What criticisms are levied against standard distributional analysis?
        • How should distributional tables be interpreted?
        • Who bears the burden of the corporate income tax?
        • Who bears the burden of federal excise taxes?
        • How do financing methods affect the distributional analyses of tax cuts?
        • How do taxes affect income inequality?
      • Tax Expenditures
        • What are tax expenditures and how are they structured?
        • What is the tax expenditure budget?
        • Why are tax expenditures controversial?
        • What are the largest tax expenditures?
        • How did the TCJA affect tax expenditures?
      • Tax Gap and Tax Shelters
        • What is the tax gap?
        • What does the IRS do and how can it be improved?
        • What is a tax shelter?
      • Recent History of the Tax Code
        • What did the 2008–10 tax stimulus acts do?
        • What did the American Taxpayer Relief Act of 2012 do?
        • How did the Tax Cuts and Jobs Act change personal taxes?
        • How did the Tax Cuts and Jobs Act change business taxes?
    • Key Elements of the U.S. Tax System
      • Individual Income Tax
        • What is the standard deduction?
        • What are itemized deductions and who claims them?
        • How did the TCJA change the standard deduction and itemized deductions?
        • What are personal exemptions?
        • How do federal income tax rates work?
        • What are tax credits and how do they differ from tax deductions?
        • How do phaseouts of tax provisions affect taxpayers?
      • Capital Gains and Dividends
        • How are capital gains taxed?
        • What is the effect of a lower tax rate for capital gains?
        • What is carried interest, and how is it taxed?
        • How might the taxation of capital gains be improved?
      • AMT
        • What is the AMT?
        • Who pays the AMT?
        • How much revenue does the AMT raise?
        • How did the TCJA change the AMT?
      • Taxes and the Family
        • What is the child tax credit?
        • What is the adoption tax credit?
        • What is the earned income tax credit?
        • Do all people eligible for the EITC participate?
        • How does the tax system subsidize child care expenses?
        • What are marriage penalties and bonuses?
        • How did the TCJA change taxes of families with children?
      • Taxes and the Poor
        • How does the federal tax system affect low-income households?
        • What is the difference between refundable and nonrefundable credits?
        • Can poor families benefit from the child tax credit?
        • Why do low-income families use tax preparers?
        • How does the earned income tax credit affect poor families?
        • What are error rates for refundable credits and what causes them?
        • How do IRS audits affect low-income families?
      • Taxes and Retirement Saving
        • What kinds of tax-favored retirement arrangements are there?
        • How large are the tax expenditures for retirement saving?
        • What are defined benefit retirement plans?
        • What are defined contribution retirement plans?
        • What types of nonemployer-sponsored retirement savings accounts are available?
        • What are Roth individual retirement accounts?
        • Who uses individual retirement accounts?
        • How does the availability of tax-favored retirement saving affect national saving?
        • What’s the difference between front-loaded and back-loaded retirement accounts?
        • What is an automatic 401(k)?
        • How might low- and middle-income households be encouraged to save?
      • Taxes and Charitable Giving
        • What is the tax treatment of charitable contributions?
        • What entities are tax-exempt?
        • Who benefits from the deduction for charitable contributions?
        • How would various proposals affect incentives for charitable giving?
        • How large are individual income tax incentives for charitable giving?
        • How did the TCJA affect incentives for charitable giving?
      • Taxes and Health Care
        • How much does the federal government spend on health care?
        • Who has health insurance coverage?
        • Which tax provisions subsidize the cost of health care?
        • How does the tax exclusion for employer-sponsored health insurance work?
        • What are premium tax credits?
        • What tax changes did the Affordable Care Act make?
        • How do health savings accounts work?
        • How do flexible spending accounts for health care expenses work?
        • What are health reimbursement arrangements and how do they work?
        • How might the tax exclusion for employer-sponsored health insurance (ESI) be reformed?
      • Taxes and Homeownership
        • What are the tax benefits of homeownership?
        • Do existing tax incentives increase homeownership?
      • Taxes and Education
        • What tax incentives exist for higher education?
        • What tax incentives exist to help families pay for college?
        • What tax incentives exist to help families save for education expenses?
        • What is the tax treatment of college and university endowments?
      • Tax Complexity
        • Why are taxes so complicated?
        • What are the benefits of simpler taxes?
        • What policy reforms could simplify the tax code?
      • Wealth Transfer Taxes
        • How do the estate, gift, and generation-skipping transfer taxes work?
        • Who pays the estate tax?
        • How many people pay the estate tax?
        • What is the difference between carryover basis and a step-up in basis?
        • How could we reform the estate tax?
        • What are the options for taxing wealth transfers?
        • What is an inheritance tax?
      • Payroll Taxes
        • What are the major federal payroll taxes, and how much money do they raise?
        • What is the unemployment insurance trust fund, and how is it financed?
        • What are the Social Security trust funds, and how are they financed?
        • Are the Social Security trust funds real?
        • What is the Medicare trust fund, and how is it financed?
      • Excise Taxes
        • What are the major federal excise taxes, and how much money do they raise?
        • What is the Highway Trust Fund, and how is it financed?
      • Energy and Environmental Taxes
        • What tax incentives encourage energy production from fossil fuels?
        • What tax incentives encourage alternatives to fossil fuels?
        • What is a carbon tax?
      • Business Taxes
        • How does the corporate income tax work?
        • What are pass-through businesses?
        • How are pass-through businesses taxed?
        • Is corporate income double-taxed?
      • Tax Incentives for Economic Development
        • What is the new markets tax credit, and how does it work?
        • What is the Low-Income Housing Tax Credit and how does it work?
        • What are Opportunity Zones and how do they work?
      • Taxes and Multinational Corporations
        • How does the current system of international taxation work?
        • How do US corporate income tax rates and revenues compare with other countries’?
        • What are the consequences of the new US international tax system?
        • How does the tax system affect US competitiveness?
        • How would formulary apportionment work?
        • What are inversions, and how will TCJA affect them?
        • What is a territorial tax and does the United States have one now?
        • What is the TCJA repatriation tax and how does it work?
        • What is the TCJA base erosion and anti-abuse tax and how does it work?
        • What is global intangible low-taxed income and how is it taxed under the TCJA?
        • What is foreign-derived intangible income and how is it taxed under the TCJA?
    • How Could We Improve the Federal Tax System?
      • Comprehensive Tax Reform
        • What is comprehensive tax reform?
        • What are the major options for comprehensive tax reform?
      • Broad-Based Income Tax
        • What is a broad-based income tax?
        • What would and would not be taxed under a broad-based income tax?
        • What would the tax rate be under a broad-based income tax?
      • National Retail Sales Tax
        • What is a national retail sales tax?
        • What would and would not be taxed under a national retail sales tax?
        • What would the tax rate be under a national retail sales tax?
        • What is the difference between a tax-exclusive and tax-inclusive sales tax rate?
        • Who bears the burden of a national retail sales tax?
        • Would tax evasion and avoidance be a significant problem for a national retail sales tax?
        • What would be the effect of a national retail sales tax on economic growth?
        • What transition rules would be needed for a national retail sales tax?
        • Would a national retail sales tax simplify the tax code?
        • What can state and local sales taxes tell us about a national retail sales tax?
        • What is the experience of other countries with national retail sales taxes?
        • What did the President’s Advisory Panel on Federal Tax Reform say about the national retail sales tax?
      • Value Added Tax (VAT)
        • What is a VAT?
        • How would a VAT be collected?
        • What would and would not be taxed under a VAT?
        • What would the tax rate be under a VAT?
        • What is the difference between zero rating and exempting a good in the VAT?
        • Who would bear the burden of a VAT?
        • Is the VAT a money machine?
        • How would small businesses be treated under a VAT?
        • What is the Canadian experience with a VAT?
        • Why is the VAT administratively superior to a retail sales tax?
        • What is the history of the VAT?
        • How are different consumption taxes related?
      • Other Comprehensive Tax Reforms
        • What is the flat tax?
        • What is the X-tax?
      • Recent Comprehensive Tax Reform Proposals
        • Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System, Report of the President’s Advisory Panel on Federal Tax Reform, November 2005
        • The Moment of Truth: Report of the National Commission on Fiscal Responsibility and Reform, December 2010
        • Debt Reduction Task Force, “Restoring America’s Future,” Bipartisan Policy Center, November 2010
        • The Tax Reform Act of 2014: Fixing Our Broken Tax Code So That It Works for American Families and Job Creators, House Ways and Means Committee
        • The Graetz Competitive Tax Plan, Updated for 2015
      • Return-Free Tax Filing
        • What is return-free filing and how would it work?
        • What are the benefits of return-free filing?
        • What are the drawbacks of return-free filing?
        • How would the tax system need to change with return-free filing?
        • Who would qualify for return-free filing?
        • Would return-free filing raise taxes?
        • What was the experience with return-free filing in California?
        • What other countries use return-free filing?
    • The State of State (and Local) Tax Policy
      • State and Local Revenues
        • What are the sources of revenue for state governments?
        • What are the sources of revenue for local governments?
      • Specific State and Local Taxes
        • How do state and local individual income taxes work?
        • How do state and local sales taxes work?
        • How do state and local property taxes work?
        • How do state and local corporate income taxes work?
        • How do state estate and inheritance taxes work?
        • How do state earned income tax credits work?
        • How do state and local severance taxes work?
        • How do state and local soda taxes work?
        • How do marijuana taxes work?
      • Fiscal Federalism and Fiscal Institutions
        • How does the deduction for state and local taxes work?
        • What are municipal bonds and how are they used?
        • What types of federal grants are made to state and local governments and how do they work?
        • What are state rainy day funds, and how do they work?
        • What are tax and expenditure limits?
        • What are state balanced budget requirements and how do they work?
    • Glossary
      • Glossary
        • Glossary

What are state balanced budget requirements and how do they work?

Fiscal Federalism and Fiscal Institutions

<6/6
Q.

What are state balanced budget requirements and how do they work?

A.

Balanced Budget Requirements (BBRs) are constitutional or statutory rules that prohibit states from spending more than they collect in revenue. They vary in stringency and design, and some research finds that stricter BBRs can produce “tighter” state fiscal outcomes, such as reduced spending and smaller deficits. However, they can also contribute to volatility and force states to cut services or raise taxes when their economies are already hurting. The effects of BBRs also depend critically on the details of the laws and implementation.

background

Balanced Budget Requirements (BBRs) have become a pillar of state budgeting practice over the last thirty years, requiring states to balance projected revenue with expenditures. In general, stricter BBRs, which prohibit states from carrying deficits into the following fiscal year, are associated with tighter fiscal outcomes, such as smaller deficits and more rapid spending adjustments during recessions.

Although all states except North Dakota and Wyoming have some restrictions, the design and stringency of requirements varies across states. For example, although Minnesota and New Mexico require the governor to propose a balanced budget, they do not require the legislature to pass one. Texas and West Virginia, by comparison, require the legislature to pass a balanced budget, but they do not require the governor’s initial proposal to be balanced. In California, the governor must propose, the legislature must pass, and the governor must ultimately sign a balanced budget. In 2015, 38 states required the governor to submit a balanced budget to the legislature; 38 (though not necessarily the same 38) required the legislature to pass a balanced budget; and only one, California, required the governor to ultimately sign a balanced budget. BBRs typically only apply to states’ operating budgets, while capital and pension funds are usually exempt from these limitations.

While researchers have debated how to best classify the relative strength of a state’s BBR, recent research suggests a BBR is more binding if it meets at least one of the following requirements:

  • the governor must sign a balanced budget;
  • the state is prohibited from carrying over a deficit into the following fiscal year or biennium; or
  • the legislature must pass a balanced budget accompanied by either limits on supplementary appropriations or within fiscal-year controls to avoid a deficit.

Most states have a strong BBR per this classification system (figure 1), and in general states have tended to strengthen their BBRs over time.

BBRs can be either constitutional or statutory. While constitutional or statutory designations do not necessarily determine whether a rule is strong or weak, constitutional requirements can be more difficult to override, and may require a legislative supermajority or vote of the people to amend.

Circumventing Balanced Budget Requirements

Under some circumstances, state policymakers can circumvent their BBRs. These rules typically apply to a narrowly defined share of total state spending, and government fund accounting practices can provide opportunities to shift obligations between funds or years.

For example, because BBRs are applied on a cash rather than accrual basis, states can push a payroll or state aid payment from the last month of the current fiscal year into the first month of the next. This allows states to meet the legal requirement to balance their budgets while leaving actual resources and obligations out of balance. During the 2009–10 budget cycle, for example, California moved its payroll obligation by one day to balance its budget.

These actions only produce one-time savings, however, as the state simply transfers its obligation to the following fiscal year. If a shortfall results from sudden changes in economic conditions, this flexibility can allow a state time to recover economically and meet its fiscal obligations. However, it can also lead to ongoing reallocation of expenses to the next budget year.

Impact

Strong antideficit provisions, such as those in BBRs, are associated with:

  • reduced spending;
  • smaller deficits;
  • more rapid spending adjustments during recessions;
  • less debt;
  • lower borrowing costs; and
  • higher surpluses, which states can then deposit into a budget stabilization fund to smooth over gaps in spending at later dates.

Fiscal and budgetary institutions like BBRs, particularly when enforced strongly, influence both the size and composition of states' responses to fiscal deficits.

Poterba (1994), for example, found that states with strict BBRs, which prohibited them from running deficits into the following year, were better able to adjust to deficit shocks, especially if one political party controlled both the governorship and the state house of representatives. States with weak antideficit provisions reduced spending by $17 for every $100 deficit overrun, comparedd with $44 in strong antideficit states (Poterba 1994).

More recent research continues to show that states with relatively strong BBRs cut their budgets more in response to deficits than states with weaker rules. This was true for the two decades preceding the 2008 recession, with even more pronounced effects between 2008 and 2015 (Rueben, Randall, and Boddupalli 2018) Additionally, in more recent years, states with strong balanced budget rules bridged less of their gap with revenue increases than in years prior, leaning more on spending cuts or possibly reserve funds to bridge gaps.

However, strict BBRs can also increase states’ fiscal and economic volatility, since they force a state to enact spending cuts or revenue increases when a state’s economy is already contracting (Bayoumi and Eichengreen 1995; Levinson 1998, 2007). These actions exacerbate, rather than counter, the effects of an economic contraction. During and following the Great Recession, for example, states with strong BBRs cut their budgets and raised revenues precisely when the economy and residents would benefit from states spending more and easing taxes.

Updated May 2020
Data Sources

Hou, Yilin, and Daniel L. Smith. 2006. “A Framework for Understanding State Balanced Budget Requirement Systems: Reexamining Distinctive Features and an Operational Definition.” Public Budgeting & Finance 26 (3): 22–45.

NCSL (National Conference of State Legislatures). 2010. "State Balanced Budget Requirements: Provisions and Practice." Denver, CO: NCSL.

Smith, Daniel L., and Yilin Hou. 2013. “Balanced Budget Requirements and State Spending: A Long–Panel Study.” Public Budgeting & Finance 33 (2): 1–18.

Further Reading

Bayoumi, Tamim, and Barry Eichengreen. 1995. “Restraining Yourself: The Implications of Fiscal Rules for Economic Stabilization.” Staff Papers - International Monetary Fund 42, no. 1: 32.

California Legislative Analyst’s Office. 2010. “The 2011–12 Budget: California’s Fiscal Outlook.” Sacramento: California Legislative Analyst’s Office.

Levinson, Arik. 1998. “Balanced Budgets and Business Cycles: Evidence from the States.” National Tax Journal, 715–732.

———. 2007. “Budget Rules and State Business Cycles: A Comment.” Public Finance Review 35 (4): 545–549. doi:10.1177/1091142107301758.

Poterba, James M. 1994. “State Responses to Fiscal Crises: The Effects of Budgetary Institutions and Policies.” Journal of Political Economy 102 (4): 799–821.

Randall, Megan, and Kim Rueben. 2017. “Sustainable Budgeting in the States: Evidence on State Budget Institutions and Practices.” Washington, D.C.: Urban Institute.

Rueben, Kim, Megan Randall, and Aravind Boddupalli. 2018. “Budget Processes and the Great Recession: How State Fiscal Institutions Shape Tax and Spending Decisions.” Washington, D.C.: Urban Institute.

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