Fiscal Imbalance

What Is Fiscal Imbalance?

Fiscal imbalance occurs when a government's future debt obligations are not in balance with its future income streams. There are two types of imbalances that can impact a government's expenditures and revenue: vertical fiscal imbalance and horizontal fiscal imbalance.

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, then tax burdens will likely increase in the future, causing current and future household consumption to fall.

Understanding Fiscal Imbalance

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. This often occurs when a government takes on long-term spending obligations based on overly optimistic estimates of the cost of the obligations, or the ability or willingness of taxpayers to finance them.

One common example is when governments commit to expensive defined-benefit pensions for public employees without considering the possibility of future economic downturns that might impact tax revenue and the value of pension fund investments. This scenario has played out at some U.S. state and municipal governments, leading to budget cuts to basic public services such as policing, demands for state or federal bailouts for fiscally mismanaged government units, or in some cases Chapter 9 bankruptcy proceedings.

A horizontal fiscal imbalance describes a situation in which revenues do not match expenditures for different regions of the country. Horizontal fiscal imbalances are 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 country. 

A horizontal fiscal imbalance occurs when sub-national governments do not have the same capabilities in terms of raising funds from their tax bases to provide public services. This type of fiscal imbalance creates differences in net fiscal benefits, which are a combination of levels of taxation and public services. These benefits are also often used as part of the justification to require transfer payments and redistribution of wealth from some regions to others.

A vertical fiscal imbalance describes a situation in which revenues do not match expenditures for different levels of government. A vertical fiscal imbalance is a structural issue that can be resolved if revenue and expenditure responsibilities can be reassigned. For example, if a state requires its towns and cities to provide educational services but leaves responsibility for funding up to local property or other taxes, this can create a vertical imbalance unless the state also contributes funding to help meet the fiscal obligation it created for its towns and cities. 

Real World Example of Fiscal Imbalance 

The Greek debt crisis had its origins in the fiscal profligacy of previous governments. After Greece joined the European Community in 1981, its economy and finances were in good shape, but its financial situation deteriorated dramatically over the next 30 years. 

Over the decades, control of the government went back and forth between the leftist Panhellenic Socialist Movement and the New Democracy Party. In an attempt to keep the populace happy, both parties enacted liberal welfare policies that created an inefficient economy. As a result of low productivity, eroding competitiveness, and rampant tax evasion, the government resorted to a massive debt binge to keep the government afloat. 

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 5.65% in 2006. 

However, 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 debt-to-GDP ratio skyrocketed.