Why Passing the State Budget on Time is a Must for Stabilizing Market Conditions

In recent years, the number of government budgets that are passed on time has declined. The period of time that the federal government has relied on continuing resolutions to provide interim funding is steadily increasing with each year. This result consistently leads to panic about a government shutdown. The impact of a federal government shutdown to the national and global economy is not obscure. However, the issue is pervasive at the state and local levels as well.

In “The Impact of Late Budgets on State Government Borrowing Costs,” the authors measure the detriment to the economy from passing a budget after the start of the fiscal year. They find that enacting a budget late affects general obligation bond yield spreads that states issue. An increase in the yield spread indicates greater risk for holding investors, such as the issuer defaulting on future payments. While the bond yield spread may not be as visible to the general public as a government shutdown, the cumulative impact caused by late budgets may result in restricted government borrowing for future public expenditures.

Existing literature finds that budgets are often passed late due to a divided government and changes in the state unemployment rate. The authors further these results by examining the impact of this type of fiscal governance on the state’s fiscal health. To explore the impact of fiscal governance, the authors count the days relative to the new fiscal year in which the budget is enacted. The authors measure fiscal health by collecting data on the state’s borrowing costs, suggesting that a late premium on state bonds signals that the state is facing solvency issues, fiscal imbalances, or a divisive government.

The study uses the Chubb survey data on government bond yield spreads. The data consist of bond yield estimates for 20-year general obligation bonds across 39 states relative to comparable bonds issued by the state of New Jersey. Any differences that arise in the survey estimates reveal the perceived riskiness of the debt and not issues tied to the mechanics of the bond. To analyze the data, the authors use the GMM procedure against dynamic panel data.

The authors find that between the years of 1988 and 1997, there are 79 instances in which the state enacted the budget after the start of the new fiscal year (29.7 percent of the budgets analyzed). The average delay for enacting the budget is around 25.3 days.

The effect of the late enactment of the state budget on bond yield spreads (versus the New Jersey 20-year GO debt) is positive and highly significant for several key variables. Specifically, if a budget is enacted late and there are changes in the unemployment rate within the state, then the effect on the bond yield spread increases from 0.14 to 0.21. Interestingly, if the late budget occurs under a Democratic governor, then the effect on the bond yield spread increases from 0.072 to 0.183. This may be more of an indication about investor confidence regarding how a Democratic governor plans to pass the budget by trading off decisions between public services versus advantages to bondholders, rather than a signal about market conditions within the state.

The authors show that a budget enacted after the fiscal deadline under a unified government decreases the bond yield spread from 0.682 to 0.143, a relatively large effect. This may signal that a unified government is more equipped to mitigate budget issues. However, the overall change in the yield spread still is indicative of perceived riskiness by investors and does not indicate that a unified government produces a good result in the market.

The authors find that a one-time, 30-day budget delay causes the bond yield spread to rise by approximately 10 basis points. Disturbingly, this impact is still persistent three years after the late budget, though at about half the size of the initial shock. The authors estimate that it takes about 10 years to recover from the effects of the full shock. Moreover, different socioeconomic factors inflate, or deflate, this effect.

Significant factors that lower the effect of the yield spread include strong credit ratings and high end-of-year balances, signaling solvency and stability. The authors note that even though the rule of thumb for state governance is that end of year balances (reserves) should exceed the combined general fund and budget stabilization fund by five percent, investors’ standards can be stricter, especially in light of the Great Recession.

Given these results, it is crucial that state governments understand the repercussions of enacting their budgets after the new fiscal year starts. Even though the impacts to bond yield spreads are not glaring, the impact to the economy, especially when late budgets occur in periods of fiscal stress, has far-reaching implications. State government officials must take fiscal governance seriously because of the pervasive and compounding effects it can have on individuals and institutions. By passing a budget on time and eradicating the current, normative procedure in most states to consider the new fiscal year a “soft deadline,” states can better serve their economies and improve confidence in market conditions.

Article Source: The Impact of Late Budgets on State Government Borrowing Costs; Asger Lau Anderson, David Dreyer Lassen, and Lasse Holboll Westh Nielsen, Journal of Public Economics; Volume 109, January 2014, Pages 27-35.

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