States' Responses to Fiscal Droughts and Riches

Abstract

In the last twenty years, state revenues have increased for long stretches and then suffered drastic declines. We seek to determine whether asymmetric responses to these revenue swings lead governments to grow and to change their spending allocations. We find that general government spending and Medicaid and hospital spending increase in response to positive swings, but change little in response to negative swings. This asymmetry explains increases over time in general, Medicaid, and hospital spending. Concerns over excessive and wasteful government spending have led economists to advocate policies that “starve the beast,” such as constitutional amendments that limit the governments' ability to raise taxes, tax cuts, or higher deficits. However, we provide evidence that higher deficits lead to cuts in government services that have been found to be beneficial, such as community college education. Further, even though the Medicaid program has grown, decreases in state balances lead to reductions in Medicaid benefits for children, which have been shown to be welfare improving.

Keywords: Public sector growth, political economy

JEL Classification: H11, H72