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CHAPTER 4 CONSTRUCTING AND TESTING A FISCAL STRESS MEASURE
4.1 Introduction
Given an understanding of fiscal stress, a definition and measurement aspects, we now must determine how to express the concept numerically with the available data. This
chapter focuses on the second research question of this analysis - is there a better measure of fiscal stress than has been presented in the past, and why is this new measure valid and
reliable? In this case, a measure of fiscal stress is constructed from financial indicators that operationalize the following definition of the term: a government’s inability to meet
its short or long run financial obligations, as they arise, that may also be accompanied by an inability to raise revenues or provide determined levels of goods and services. The
definition of fiscal stress is then broken into various components. The first component, a state’s ability or inability to meet short run financial obligations as they arise, is captured
by a cash solvency index. The second component, a state’s ability or inability to meet long run financial obligations as they arise, is measured by a long-run solvency index.
The third component, a state’s ability or inability to raise revenue, is captured by a budget solvency index. And finally, the fourth component, a state’s ability or inability to provide
a previously determined level of goods and services, is measured by a service-level index.
There are many financial indicators that can measure aspects of a state’s financial condition and by extension, fiscal stress. The eleven financial indicators used in this
chapter are based on prior research and data availability. Using these financial indicators, four indices – cash, budget, long-run and service-level – are constructed. The reliability
and validity of these indices as measures of fiscal stress will also be assessed. Once these indices are constructed, tested and combined, a measure of fiscal stress exists that allows
76 comparison across years and among the American states. This will improve scholars’
ability to conduct time series and panel analysis of the state experience of fiscal stress and their responses to fiscal stress as well as policy makers’ ability to make judgments
about policies affecting the financial condition of their specific government.
4.2 Financial Indicators and Index Construction