LOSS AVERSION AND STRATEGIC CHOICES IN CUTTING BUDGETS.

Author:Bourdeaux, Carolyn
Position:Report
 
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  1. INTRODUCTION

    The Great Recession has generated critical assessments of state fiscal decision-making, such as the Volcker Alliance (2015), as well as numerous case studies that document a variety of often problematic strategies to balance the budget (Deschenaux and Juppe, 2015; Bifulco et al., 2012; Bunch 2010; Conant 2010a, 2010b; Dautrich, Robbins and Simonsen 2010; Lauth 2010). The literature on cutback budgeting, as well as various state and local surveys, has developed a fairly complete list of the strategies used (see Table 1). What is less clear is why policymakers often appear to make fiscally damaging choices and how these strategies might fit into the overall universe of retrenchment strategies in a particular budget year. One theory is that policymakers might be opting for choices that attempt to manage the political conflict associated with fiscal retrenchment (Wolman, 1980; Levine, Rubin, and Wolohojian, 1981). But why would a particular choice be more likely to generate conflict? For instance, why would an across-the-board cut or a hiring freeze be more politically palatable than the elimination of a non-performing program or prioritization of cuts to less essential programs? This question is particularly salient given that carefully administered, targeted cuts might be better for the long-term health and organizational capacity of the government as a whole. (1)

    This analysis examines the choices surrounding cutback budgeting, with a particular focus on expenditure-side strategies and the choices made as part of a state-level legislative budget approval process. Drawing on behavioral economics theories around loss aversion, fiscal illusion, fairness, and time-discounting, this study examines the question of why policymakers might be more likely to choose particular cutback strategies. Using this theoretical framework, commonly observed cutback budgeting strategies are categorized to build a typology of budgetary choices. The analysis then examines the universe of fiscal choices made by policymakers in Georgia in the fiscal year (FY) 2009 amended and FY 2010 general budgets. Results show that at least in this case, the patterns of fiscal decision-making mirror those predicted by the theory. The contextual detail offered by the case also allows further exploration of the theoretical framework.

  2. THEORIES OF CUTBACK BUDGETING

    Perhaps the most intuitive idea about cutback budgeting is that policymakers want to avoid political conflict. This desire creates a bias against the types of cuts that are likely to emerge from program evaluations or strategic planning processes, such as targeted cuts, cuts organized around program or service prioritization, program or facility closure, and layoffs. Research from the 1970s and 1980s highlighted the conflict created by such cuts (Bardach, 1976; Behn, 1978, 1985; Levine 1978, 1980; Wolman, 1980). Thus, elected officials are likely to only make these kinds of cuts when other options have been foreclosed, potentially because of prolonged or deep fiscal stress. Instead, they tend toward less contentious options. Such policy choices often trade short-term benefits for long-term costs through the use of debt or loans, or by under-funding pensions or curtailing investment in maintenance or capital spending. Favored cuts may also focus on back office operations rather than frontline agency activities. Policymakers might opt for personnel attrition and layoffs to new employees rather than more senior workers. Another popular choice is across-the-board cuts that "spread the pain" (Levine, Rubin, and Wolohojian, 1981; Dougherty and Klase, 2009; Klase, 2011).

    Levine, Rubin, and Wolohojian (1981) hypothesized that rational, strategic cuts are associated with more serious fiscal stress, and that policymakers tend to follow a strict sequence of cutback choices. In response to mild fiscal stress, policymakers would then be likely to delay or ignore the problem. According to the authors, this strategy is associated with the use of debt, internal transfers, reserves, and other forms of organizational "slack." If a fiscal crisis worsens or policymakers face more moderate fiscal stress, they would tend to ration or stretch resources. Associated cutback strategies include across-the-board cuts, hiring freezes, and efficiency measures. Finally, if the fiscal crisis were more prolonged or severe, only then would policymakers make deep selective cuts and try to smooth operations. While the authors' sample period was not long enough to fully test their theory, they generally found that governments did not follow a strict sequence. They did find though that more serious stress seemed to induce more strategic targeted cuts, and that governments widely used temporizing, mid-range measures.

    More recent case studies examining state-level fiscal stress and policy choices have found no evidence of a strict sequence of strategies. However, the deeper the fiscal crisis, the more likely states are to engage in more severe and targeted cuts, or furloughs and layoffs. Under such conditions, states are also like to use a more diverse set of strategies. In response to more mild fiscal stress, states appear to engage in early-stage strategies such as across-the-board cuts, use of reserves, and hiring freezes (Dougherty and Klase, 2009; Kravchuk and Stone, 2010; Klase, 2011). Some initial reviews of international strategies found similar results (Raudla and Kattel, 2013).

    While the extant literature makes important observations about cutback budgeting, a fundamental question remains: Why might a particular strategy create more political conflict than another? Why would policymakers only choose to make certain types of cuts when under duress? The theories of interest group politics, decrementalism, and fiscal illusion attempt to answer this question for some selected cutback budgeting strategies. However, many commonly observed strategies, such as hiring freezes or cutting new initiatives and capital outlay, remain largely unexplained. This study looks to theories of loss aversion, framing, fairness, and time-discounting to explain many cutback strategies. Elected official in particular take advantage of these nonrational features of human decision-making to alter or mitigate perceptions of loss.

    2.1 INTEREST GROUP POLITICS

    The arguments of scholars such as Levine, Rubin, and Wolohojian (1981) are based on interest group politics theory, which is grounded in the incentives created by the political process. A political process is likely to be affected by politically powerful interest groups who control money and votes and use these resources to affect policy. This theory has been used to explain cuts to service areas such as social services, economic development, or education (Glassberg, 1978; Wolman, 1980). However, the theory has not proven as successful in explaining the structure of cuts, such as hiring freezes, issuance of debt, across-the-board cuts, and targeted cuts. Levine, Rubin, and Wolohojian (1981) developed a complex set of ideas about fiscal stress and interest group politics but ultimately reached a much more general conclusion: Policymakers appear to avoid making targeted cuts, while professional managers, somewhat removed from political pressures, are more likely to propose targeted cuts. More recently, Jimenez (2014) examined whether strategic planning processes will lead to more targeted (and potentially strategic) cuts. He found that the more political mayor-council governments are less likely to implement targeted cuts than council-manager forms of government. (2) While providing valuable insight, these analyses do not tackle the question of how or why increased exposure to the electoral process would create an aversion to targeted cuts as opposed to other types of cuts. Additionally, there is no clear link between interest group politics and the range of other strategies used in a cutback environment.

    2.2 DECREMENTALISM

    Several studies in the 1970s and 1980s posited that "decrementalism," or small across-the-board cuts, are the counterpart to incremental strategies during times of fiscal retrenchment (Lambright and Sapolsky, 1976; Lewis, 1984). Such cuts would be less likely to undermine consensus or draw charges that policymakers were singling out a particular policy for an undue share of cuts. Some broad, limited research provides evidence that cuts by state and local governments during periods of fiscal stress are made decrementally (Lewis, 1984; Braun, Johnson and Ley, 1993). However, the majority of studies have not found cuts to be administered evenly across budgets; in fact, from a highly aggregated level, cuts may appear entirely haphazard (Downs and Rocke, 1984; Bartle, 1996). Most of the case study research (e.g., Wolman, 1980; Levine et al., 1981; Klase, 2011) as well as national surveys, such as the National Association of State Budget Officers, Fiscal Surveys of the States, and the National League of Cities, City Fiscal Conditions surveys, show that this strategy is used, but that it is just one of many strategies deployed in a cutback environment. It is not clear how significant the strategy is in overall efforts to balance the budget.

    The larger point behind incrementalism is not that one should observe small across-the-board increases or decreases, but that budget processes are not rational. Instead, they are heavily colored by satisficing, consensus-building, and norms of "fairness" (Wildavsky, 1969, 1988, 1992). The base budget is largely stable, and changes are mostly at the margins. In addition, budget changes that are perceived by policymakers, agencies, and the public more generally as fair will be less likely to generate conflict or controversy in the political process, leading to the use of across-the-board strategies. Possibly other strategies

    that are widely perceived to be low conflict, such as government-wide furloughs, are used...

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