Abstract
This paper analyzes the impact of a balanced budget rule (BBR) on government financing costs and its implications for the government balance sheet. Exploiting the variation in BBR implementation across US states, we find that states with more stringent BBRs exhibit significantly lower bond spreads and credit default swap spreads, demonstrating the crucial role of default risk. A sovereign default model, which features long-term debt, endogenous investment and output, as well as a BBR, aligns with the empirical result. Calibrated to Illinois, our quantitative analysis suggests that implementing a BBR could dramatically decrease the state bond spread, gradually lower the debt, and improve welfare in the long run. • US states with more stringent BBRs have significantly lower state bond spreads. • BBRs are also associated with lower default risks. • A default model captures the interplay of BBR, debt, investment, and default risk. • BBRs improve government balance sheet and welfare in the long run.