Perhaps the biggest surprise in Wednesday’s Throne Speech was the federal government’s plan to introduce a balanced-budget rule. The devilish details will follow, but the idea is to adopt a law that requires balanced budgets in normal economic times. The federal government could run occasional deficits, but only when growth is very slow and when a clear timeline to return to balance is given.
A common reaction to balanced-budget laws is that they’re not worth the paper they’re written on. Indeed, many people view them as irrelevant because future governments can repeal or simply ignore the law when meeting it becomes difficult. Such rules might even make things worse – if governments use “creative accounting” to make it look they’re complying, or if governments cut spending in bad times to comply, which would worsen a recession.
Proponents of balanced-budget rules are in the minority. They stress that rules can help strengthen the government’s resolve to make tough budget choices and provide a target that gives fiscal policymakers a sense of direction.
So will this rule work in practice, or is it nothing more than a splashy announcement and a budgetary gimmick? I think it may actually help improve Ottawa’s budgetary situation – which, it must be acknowledged, is far from dire or needing significant restraint.
Sure, similar rules were missed in the past. Armed with these deviations, it’s tempting to conclude that the rules don’t work. The natural instinct is to compare the target (balance the budget!) and the outcome (balance the budget?). This view gives the interpretation that hitting the target means success and missing it means failure.
But a broader pool of evidence is needed to assess whether these laws generally work, not just a few counter-examples. Luckily, this isn’t the first time that such rules have been tried. Canadian provinces have plenty of past experience, as do U.S. states. We’ve had similar laws in eight provinces at various times in the past few decades (Newfoundland and PEI are the exceptions). In addition, one could argue that the federal government had an unwritten budget-balance rule for many years before the global recession in 2008.
When looking at this broader evidence, it’s also crucial to measure success properly. The correct comparison (the so-called counterfactual) isn’t the target itself, it’s what would have happened without the target. (This outcome can’t be observed because it didn’t happen, so it must be inferred somehow).
Consider this example: it’s New Year’s Eve and your resolution is to lose 10 pounds next year. So you start exercising and eating better, but after all of this work you only lose five pounds. Did you fail?
Maybe, maybe not. You certainly failed to achieve your stated goal. But if you would have gained two pounds that year without your resolution and the diet and exercise that it spurred, the resolution actually helped you drop seven pounds.
The accompanying table shows some results from an article where I analyzed budget balance targets for Canadian provinces between1981 and 2007. The easiest approach is to split the provinces into two groups: those that adopted rules and those that didn’t. In this case, rule adopters improved their budget balances as a share of GDP by an impressive 1.8 percentage points on average (moving from a modest deficit of 1.6 per cent to a slight surplus of 0.2 per cent). Budget balances also improved for non-adopters, but by only 0.2 percentage points. This means that the (difference-in-difference) impact of budget-balance rules was to improve budget balances by 1.6 percentage points of GDP.
This isn’t the best estimate, because it fails to account for other differences between the two groups. More sophisticated approaches try to account for additional complications, and these estimate that the impact of budget balance rules was still positive, but by half of what meets the eye: about 0.8 percentage points.
In any fiscal context, such an improvement would be considerable, let alone in today’s economy.
Another relevant finding of this study was that rules seemed to be more effective when they had clear objectives and timelines for policy actions and outcomes. This finding would support the use of the timeline requirement in the federal government’s proposed rule.
Of course, past performance doesn’t tell us about the future. The time period used in these results also featured pretty good economic performance when the rules were applied. It remains an open question how such rules have fared since, when many were discarded in the Great Recession – and whether Ottawa’s focus on deficit reduction is the right approach at a time when the economic recovery remains too slow.
So while this announcement was surprising, it’s certainly not new. We’ve seen this movie before, but perhaps the sequel is worth watching after all. Just because we don’t always achieve everything we set out to do (e.g., lose all of the weight we wanted to or balance the budget), doesn’t mean that we didn’t do better by trying.
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