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We test a positive model of government spending and savings, where jurisdictions seek to stabilize spending growth and where revenue growth and savings are assumed to be continuous-time stochastic processes, the Dothan-Thompson optimal budget model. Our empirical tests address two reduced-form specifications derived from this model, each applied to two different subsets of municipalities. For each of the two specifications, we first estimated models using data for all available municipalities (more than 20,000) covered by the U.S. Census government finance data, and then tested them again on a much smaller balanced subset of the full panel. We find that municipalities do not, on average, optimally stabilize spending in the face of revenue volatility, nor do they consistently use savings to do so. There is, however, at least modest statistical evidence that savings reflect revenue volatility at typical levels of volatility. For all model specifications tested, the single greatest determinant of savings at the municipal level is the state in which the municipality is located. The next challenge is to identify and measure the impact of the underlying factors that explain the dramatic state-to-state differences observed in municipal savings patterns. [ABSTRACT FROM AUTHOR]

This article uses simple and self-contained optimal control theory and martingale methods to find optimal government expenditure consistent with present value balance and, implicitly sustainable saving, borrowing, and tax levels as well, since long-term sustainable paths are, in principle, not different from optimal paths. Our approach identifies time-consistent budget rules, where most other efforts to do so have not, because it makes the reasonable assumption that the stochastic nature of revenues is more or less given, and ignores the relationship between the level and kind of taxes employed and revenue growth. Further allowing the government to invest in risky as well as risk-free financial assets, we derive explicit formulas for optimal expenditure and the parameters of its future stochastic evolution, expected surpluses and deficits and their dependence on model parameters, and the probability of sustained long-term growth and its dependence on the initial size of the reserve account. [ABSTRACT FROM AUTHOR]

Debt limits, interest coverage ratios, one-off balanced budget requirements, pay-as-you-go rules, and tax and expenditure limits are among the most important fiscal rules for constraining intertemporal transfers. There is considerable evidence that the least costly and most effective of such rules are those that focus directly on the rate of spending growth, even with their seemingly ad hoc nature and possibilities for circumvention. In this paper, we use optimal control theory and martingale methods to justify a transparent, nonarbitrary rule governing maximum sustainable rate of spending growth, treating the revenue structure of a jurisdiction as a given continuous-time stochastic process. Our results can be used to determine whether a proposed rate of spending growth is sustainable or not. © 2009 by the Association for Public Policy Analysis and Management [ABSTRACT FROM AUTHOR]