What Is a Fiscal Imbalance?
Fiscal imbalance is a measure of fiscal sustainability. It refers to a situation that occurs when a government's future spending obligations don't match its future income streams.
Obligations and income streams are measured at their respective present values and discounted at the risk-free rate plus a certain spread. If a government incurs a sustained fiscal imbalance, tax burdens will likely increase in the future, causing current and future household consumption to fall.
Fiscal imbalances can be either horizontal or vertical. Both can impact a government's revenue and spending.
Key Takeaways
- A fiscal imbalance occurs when there is a mismatch between a government's future spending and debt obligations and future income streams.
- Vertical and horizontal fiscal imbalance are the two types of imbalance that can impact a government's expenditures and revenues.
- A vertical fiscal imbalance occurs when revenues do not match expenditures for different government levels.
- A horizontal fiscal imbalance occurs when revenues do not match expenditures for different regions of the country.
- A fiscal imbalance can affect future household consumption.
Understanding Fiscal Imbalances
A fiscal imbalance occurs when a government's future debt obligations don't align with its future revenues. Put simply, a government's future spending and future income don't match.
A fiscal imbalance generally occurs when a government's spending (and resulting debt) outstrips its long-term ability to raise revenue to finance its spending and debt.
Fiscal imbalances typically are the result of taking on long-term spending obligations based on overly optimistic estimates of:
- The cost of the obligations
- The ability and/or willingness of taxpayers to finance them
What Can Happen
A fiscal imbalance may occur when governments commit to expensive defined-benefit pensions for public employees without considering the possibility of future economic downturns that may impact tax revenue and pension fund investment values.
This situation led to fiscal imbalances for some states and municipalities in the U.S. Basic public services like policing saw budget cuts and there were demands for state or federal bailouts for fiscally mismanaged government units. Chapter 9 bankruptcy proceedings resulted in more drastic cases.
Fiscal imbalance equals current government debt plus the present value of future expenditures minus the present value of future receipts.
Types of Fiscal Imbalances
Horizontal Fiscal Imbalance
A horizontal fiscal imbalance occurs when revenues do not match expenditures for different regions across the country. This type of imbalance is often used to justify equalization transfers or payments to a state or province from the federal government to offset monetary imbalances between different parts of the nation.
A horizontal fiscal imbalance results when sub-national governments lack the capabilities to raise funds from their tax bases to provide for public services.
It creates differences in net fiscal benefits, which are a combination of levels of taxation and public services. These benefits are often used as part of the justification to require transfer payments and redistribution of wealth from some regions to others.
Vertical Fiscal Imbalance
A vertical fiscal imbalance occurs when revenues do not match expenditures for different levels of government. It is a structural issue that can be resolved if revenue and expenditure responsibilities can be reassigned.
For example, a state may require its towns and cities to provide educational services. The source of funding for those services may be local property or other taxes that municipalities must collect and which may not be sufficient.
A vertical imbalance may result unless the state also contributes funding to help meet the fiscal obligation it created for its towns and cities.
Example of Fiscal Imbalance
Greece joined the European Community in 1981 at a time when its economy and finances were in good shape. However, the country's financial situation deteriorated dramatically over the next 30 years. This period was rife with wasteful government spending, which eventually led to the Greek debt crisis.
Over the decades, control of the government went back and forth between the leftist Panhellenic Socialist Movement and the New Democracy Party. Both parties enacted liberal welfare policies that created an inefficient economy.
The government resorted to a massive debt binge to stay afloat in the face of low productivity, eroding competitiveness, and rampant tax evasion.
Greece's admission into the Eurozone in 2001 and its adoption of the euro made it far easier for the government to borrow. Greek bond yields and interest rates declined sharply as they converged with those of strong European Union members such as Germany.
As a result, the Greek economy boomed, with annual gross domestic product growth peaking at 5.7% in 2006.
The 2008 financial crisis led investors and creditors to focus on the massive sovereign debt loads of the U.S. and Europe. With default a real possibility, investors began demanding much higher yields for sovereign debt issued by Greece as compensation for this added risk.
As Greece's economy contracted in the aftermath of the crisis, its fiscal imbalance was evident as its debt-to-GDP ratio skyrocketed.
What's the Difference Between Horizontal and Vertical Fiscal Imbalance?
The simple difference between horizontal and vertical fiscal imbalances lies in whom they affect. With a horizontal fiscal imbalance, revenues and spending are mismatched for different regions of the country. In a vertical fiscal imbalance, revenue and spending are mismatched for different government levels.
Is a Fiscal Imbalance the Same as a Fiscal Deficit?
No. A fiscal imbalance is a measure of financial sustainability. It occurs when future debts aren't balanced with future revenue streams. A fiscal deficit, on the other hand, is the actual shortfall in a country's revenue compared to its spending. A country runs a fiscal deficit when it spends more money than it earns. Fiscal deficits don't include a nation's debts.
Does the U.S. Government Face a Fiscal Imbalance?
According to a study by research initiative Penn Wharton Budget Model at the University of Pennsylvania, the U.S. faces a permanent fiscal imbalance because "future federal spending outpaces tax and related receipts." The study estimated that this imbalance represents 10.2% of all future GDP or $244.8 trillion.
The Bottom Line
Fiscal imbalances occur when a government's future debts and future income streams aren't balanced. This usually happens when government leaders are far more optimistic about the cost of long-term spending obligations than they should be.
According to a study at the University of Pennsylvania, the U.S. faces a permanent fiscal imbalance of more than 10% of all future GDP.
