The evidence from Europe shows that in many cases, limits to budget deficits can be ineffective because it is easy to tinker with projections to appear to come into balance, when a deficit limit is in fact going to be breached. Limits to budget deficits also have the disadvantage that they require agreement on both spending and revenue, without providing a guide to the proper level of either. This creates a situation where one side favors lower taxes and lower spending, for example, while the other side favors a higher tax and higher spending level – and each can point to their own plan as meeting the deficit ceiling.
Perhaps because of these problems, countries have increasingly begun to rely on specific expenditure targets, either top line numbers, or as a percentage of GDP. The adoption of such targets makes a great deal of sense. Some policymakers may like the government to be larger, some might like it to be smaller, but everyone should agree that bills eventually have to be paid. By focusing budget rules on the key variable in dispute, countries around the world are beginning to assure that the focus of policy debate is on the actual substance of the debate.
The data suggest, then, that we might well seek to adopt a new set of budget rules that set a limit on spending, and then agree to automatically pass continuing resolutions and debt limit increases, provided that the government is spending at or below the target. While establishing that target would certainly be difficult, existing proposals, such as one put forward several years ago by Chairman Brady, provide a useful guide to the possible concerns.
A hard limit on spending is impractical, because the cost of providing government would necessarily increase as the economy and wages grow. As such, I encourage you to consider a policy that limits spending as a share of GDP. A direct limit on such spending would also be poor long run policy, since a contraction in GDP might lead spending, which includes built in stabilizers, to increase as a share of GDP in a desirable fashion. There are several possible methods to adjust for this. One is to cyclically adjust the variables, another is to rely on spending as a share of potential GDP. Potential GDP is a measure calculated by the Congressional Budget Office that estimates the level that GDP in the U.S. economy would be if the economy were operating at a high level of resource use (including full employment). It is meant to be a measure of a sustainable output. In a recession, GDP generally falls below potential GDP as resources remain unused. Potential GDP then allows the estimate of GDP to be smoothed over peaks and troughs in the business cycle. [Emphasis added]
I’ve been critical of expenditure targets in the past, as they risk encouraging the expansion of off-budget spending vehicles. But limiting spending to a fixed share of potential GDP might be worth the potential downsides if the limit were tied to an agreement on automatic debt limit increases.