Respond Wisely to Next Recession | Eastern North Carolina Now

    Publisher's note: This article appeared on John Hood's daily column in the Carolina Journal, which, because of Author / Publisher Hood, is linked to the John Locke Foundation.

    If I could predict the onset of America's next recession with precision, I wouldn't tell you about it. I'd become a money manager and make a pile of it by timing the market.

    But I can't, so I won't. Instead, I'll simply observe that based on historical precedent, another recession will come, sooner rather than later. Although the economic recovery from the Great Recession has been anemic by historical standards, it has been lengthy. Prudent policymakers need to start thinking about what will happen if the economy takes a dip.

    Fewer people will be working. The ones who retain their jobs will have less income to spend. Demand will surge for government services that are strongly countercyclical, such as public assistance. At the state level, that typically means a big jump in Medicaid enrollment and expenditure.

    Weaker revenue collections from income and sales tax coupled with higher expenditures for public assistance can produce sizable budget deficits even if a recession is relatively mild. In North Carolina, the deficit would be at least in the hundreds of millions of dollars and probably more than a billion.

    Should governments finance such recessionary deficits with borrowing or savings, or close them with a mix of tax hikes and budget cuts? For most states and localities, the first option is off the table. They are required by law to balance their operating budgets without issuing debt.

    Thanks to prudent decisions by the General Assembly and outgoing Gov. Pat McCrory, North Carolina's savings reserves are healthy. Even after withdrawals to help pay for disaster relief, the rainy-day fund and Medicaid reserves will total nearly $2 billion. Nevertheless, state lawmakers and incoming Gov. Roy Cooper are unlikely to cover a future recessionary deficit entirely with savings. That would leave the state too exposed if it endures a longer-than-expected recession, or sustains other financial hits from weather events or lawsuits.

    So that leaves the question of whether to tax more, spend less, or some combination to close the remaining budget gap. I think the evidence points strongly in favor of spending less. We've seen in North Carolina how "temporary" tax hikes during deficit years tend to last into periods of economic recovery, acting as a drag on that recovery. We've also seen lawmakers and governors make politically difficult budget decisions during recessions - such as merging agencies or eliminating outdated programs - that have proven to be in the long-term interest of taxpayers.

    There is emerging empirical evidence in favor of governments closing their budget gaps with spending restraint rather than tax increases. For example, a new study by economists from Harvard University, New York University, and Italy's Bocconi University studied fiscal adjustments in 16 countries over the period from 1981 to 2014. They found that the composition made a big difference in the economic effect. "Adjustments based upon spending cuts are much less costly than those based upon tax increases regardless of whether they start in a recession or not," the scholars concluded.

    To say that North Carolina's state and local leaders should respond to future budget gaps with spending restraint is not to say they ought to slash all programs and agencies by equivalent amounts. They should pick and choose. Core services such as public safety deserve the highest priority. Others should get cut not by five percent or 10 percent but by 100 percent.

    No matter how well-governed a state or locality is, a national recession is likely to throw its operating budget out of balance. The best way to head off an economically damaging tax increase while protecting core services is to keep overall spending growth modest during good economic times, rather than yielding to the temptation to plow the revenue growth into new programs. Such a policy reduces the size of the subsequent budget deficit while building up a substantial savings reserve.

    Fortunately, this is exactly the policy state government and many local governments in North Carolina have been adhering to since 2010. In the not-too-distant future, we'll be glad they did.