14 authors explain this seemingly counterintuitive finding as states that expect more
volatility in their revenues fund their rainy day funds at higher levels. Such results point to the difficulty in determining the causality between rainy day fund existence, use and
fiscal stress. Hou 2003 found a negative relationship between higher reserve fund balance and fiscal stress. This expected relationship may reflect the larger sample size 48
states over 21 years as well as the use of a different measure of fiscal stress. Douglas and Gaddie 2002 use the sum of tax increases and expenditure shortfall as a percentage of
general fund expenditures in one year as their measures of fiscal stress; in contrast, Hou 2003 uses general fund expenditure gaps as the dependent variable. Another factor,
demonstrated in the economic downturn in 2001, is that many states experienced budget shortfalls so large that rainy day funds were not able to make up the difference
Kalambokidis and Reschovsky 2005. These studies suggest that rainy day funds serve a countercyclical function and that their structures determine to their relative effectiveness.
These responses, especially spending cuts, tax increases, and rainy day fund use, do not operate in isolation. Use of rainy day funds may reduce the need to cut
expenditures and cutting expenditures may reduce the need for tax or user fee increases. In a review of state responses to the 2001 recession and its aftermath, Maag and
Merriman 2007 find that states with higher savings rainy day fund balances were able to weather the recession without tax increases or substantial spending cuts. These
findings suggest that states can engage in a trade-off among responses to successfully battle fiscal stress.
2.1.2 Effect of Budgetary Institutions and Politics on State Responses
A large body of research looks at how the interplay of politics and institutions e.g. tax and expenditure limitations, balanced budget rules, etc. affect state responses to
fiscal stress. This research highlights the additional constraints that state decision-makers face when dealing with fiscal stress – they must work within their own institutional
15 framework. Ignoring these institutions risks means glossing over major factors that
influence why states act as they do. This section focuses on the branch of research that is pertinent to U.S. states.
The general consensus among researchers investigating the role of budget institutions is that they do affect policy actions Poterba 1996; Bohn and Inman 1996;
Bayoumi and Eichengreen 1995; Fatas and Mihov 2006; Hou and Smith 2010. Research on balanced budget rules – these apply to 49 of 50 states – concerns the extent to which
different balanced budget rules affect the occurrence of budget deficits and how they influence state responses to these deficits. Alesina and Bayoumi 1996 found that states
with stricter balanced budget rules are less likely to run budget deficits and in the event that they do, the deficits tend to be smaller than in states with less stringent rules. Most
research focuses on how the budget rules affect the size and speed of state responses to deficits. Findings indicate that states with stricter budget rules are more responsive to
deficits and tend to address the problem faster than do states with weaker rules Poterba 1994; Bohn and Inman 1996; Alesina and Bayoumi 1996. Poterba 1994, specifically
looking at state responses during fiscal stress, found that states with weak anti-deficit rules also called balanced budget rules adjust spending less than those with stronger
anti-deficit rules. Anti-deficit rules did not appear to affect state tax response to fiscal stress.
The effect of balanced budget rules on state responsiveness to business cycles addresses the trade-off between fiscal discipline and the flexibility to spend more to
support the state economy. While Alesina and Bayoumi 1996 found balanced budget rules limit a state’s budget flexibility, they found no economic costs to this. In contrast,
Levinson 1998 notes, especially in larger states, that balanced budget rules may aggravate the effects of business cycle fluctuations.
Research on tax and expenditure limitations TELs concerns both their effect on state responses to fiscal stress and the broader effect these rules have on state ability to
16 respond to the business cycle. Poterba 1994 shows that states with TELs are less likely
than states without them to use a tax change in response to deficits. Others have found that TELs limit state ability to respond to budget deficits and business cycles Bayoumi
and Eichengreen 1995; Fatas and Mihov 2006. As with the balanced budget rules, the effect of these limitations depends upon one’s interpretation. Bayoumi and Eichengreen
1995 suggest state inability to alter spending and tax levels due to economic pressures may produce budget deficits or restrict ability to spend more on programs needed during
economic downturns. Fatas and Mihov 2006 suggest that while states with TELs have less discretion to respond to economic shocks, since their fiscal policy will be less
volatile, they may be less likely to experience volatile business cycles in the first place. The effect of politics, specifically the cooperation between the legislative and executive
branches held by different political parties, have also been found to influence the speed and type of response to budget deficits. States with governors from one party and
legislative houses in control of the other party are more likely to run budget deficits Alt and Lowry 1994 and less likely to respond aggressively to budget deficits with either
spending cuts or tax increases Poterba 1994. Taken together this research provides strong evidence that in analyzing states’
actions, and more importantly, the effect of different actions on states’ experience of fiscal stress – the institutional framework must be taken into account. Although the exact
relationship between the institutional framework, a state’s response, and their broader experience of fiscal stress is not entirely clear, it is evident that these factors have an
impact.
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2.2 Incrementalism 2.2.1 Background and Description of Theory
