27-30 January 2003 Santiago de Chile XV Seminario Regional de Política Fiscal Fabrizio Balassone, Daniele Franco, Stefania Zotteri Fiscal Rules for Sub-National Governments: Soundness, Stabilisation and Decentralisation

EMU: NEW HISTORICAL DEVELOPMENT EU fiscal rules have extensive implications: Stabilisation Allocation and distribution Long-term sustainability & intergenerational redistribution Relationships between levels of governments

Motivation: Evaluate implications of EMU fiscal rules for relationships between levels of government Structure: EU fiscal rules Critical issues for decentralisation What solutions can be considered? What solutions have been adopted? Are current solutions sustainable? MOTIVATION AND STRUCTURE

EU FISCAL RULES: A DESCRIPTION  Deficit should not exceed 3% of GDP unless: – Exceptional events – Excess temporary – Excess limited  Close to balance or in surplus  Multilateral surveillance  Excessive deficit procedure (sanctions related to excess )

Fiscal targets: Soundness (monetary-financial stability) - limits to deficit and debt ratios Flexibility (stabilisation policy) - medium-term position of ‘close- to-balance or in surplus’   Deficit fluctuates over cycle (automatic stabilisers can operate) INTERPRETING THE RULES: DISCIPLINE AND FLEXIBILITY SURPLUS 0 3% DEFICIT BAD TIMES GOOD TIMES LENGTH OF CYCLE

 Co-ordination between different government tiers at national level needed independently of EMU  Standard solutions: - central government control - formalised co-operation - rules (e.g., deficit limits) - exceptions allowed (e.g., capital outlays) - ex ante validity only National rules for sub-national governments

EU approach is stricter:  Rules defined as predetermined numerical parameters  Ex-ante and also ex-post compliance required  Flexibility margins defined ex-ante for exceptional factors  No provision for investment  Non-compliance triggers predefined monetary sanctions A COMPARISON WITH RULES AT NATIONAL LEVEL

 Asymmetry of constraints and incentives: local vs. central governments EU RULES & LOCAL GOVERNMENTS: THREE CRITICAL AREAS  Public investment: how can we carry out adequate investment at local level without deficit-finance?  Economic cycle: how can we avoid the need for pro- cyclical policies?

Compliance with EU rules evaluated with respect to the general government budget (central + local) ASYMMETRY OF CONSTRAINTS But in EU rules no role for sub-national government central gov. primarily responsible central gov. carries burden in terms of credibility, sanctions, etc. Risk: distortions in allocation (sub-national government free-riding)

PUBLIC INVESTMENT (I) Balanced budget  tax-finance for public investment Risk: reduction of public capital accumulation Common wisdom: easier to cut investment than current expenditure Political economy: policy makers with finite horizons (“if we cannot smooth the burden, we cut projects with deferred benefits”) Empirical evidence: fiscal consolidation often implies lower investment

Compression effect potentially stronger for local governments: peaks in expenditure mobility of citizens/taxpayers PUBLIC INVESTMENT (II)  risk: under-supply of public capital at local level

EU rules reconcile stability and flexibility via reference to structural budget balance EFFECTS OF THE CYCLE If this approach cannot be applied to sub-national governments, a risk of: either pro-cyclical policies at local level or central government compensating slippages (distortions in allocation)

Adapting existing rules Replicating the Stability and Growth Pact (SGP) A market for deficit permits SOLUTIONS IN THEORY (I)

Effects of the cycle: – ex-post nominal limits (pro-cyclical ?) – rainy-day funds (ESA95 ?) – tax-base selection (responsibility ?) SOLUTIONS IN THEORY (II) Solution 1: Adapting existing regulations Asymmetry of incentives: give equal responsibility to all gov. tiers + sanctions (implementation ?) Local investment: allow debt-finance with a ceiling (compensated golden rule) & rules to allocate outlays (allocation ?)

SOLUTIONS IN THEORY (III) Cycle: implementation problems for local governments (CABB?) Solution 2: National replicas of the SGP Asymmetry of incentives: implementation problems for local governments (CABB?) Local investment: problem remains (no debt-financing, peaks)

SOLUTIONS IN THEORY (IV) Cycle: total amount related to cyclical position (forecasts?) Solution 3: A market for deficit permits Asymmetry of incentives: a predetermined ceiling to overall deficit + market-based allocation to avoid free-riding Local investment: total amount related to investments needs (initial allocation of permits?)

SOLUTIONS IN THEORY (V) Solution 4: An eclectic solution Incentive & cycle: replicate SGP for larger government tiers ; proper choice of tax bases + budget rules in nominal terms (ex-post) for smaller government tiers Investment: ‘compensated’ golden rule and co-operation

Sample: Austria, Belgium, Germany, Italy, Spain (countries differ widely in size/institutions) SOLUTIONS IN PRACTICE (I)

Most countries have adopted new explicit rules/procedures No SGP replica (technical problems?) Most countries rely on co-operation between tiers of government SOLUTIONS IN PRACTICE (II)

Countries do not use CABB Insulation from cyclical effects via non cycle-sensitive tax bases and predetermined transfers (sometimes also for larger regional governments)  Limited autonomous revenues Different solutions for investments SOLUTIONS IN PRACTICE (III)

Federal State since 1920 Three government tiers Crucial role of co-operation and co-ordination between gov. tiers No explicit flexibility for investment and for the cycle Explicit Domestic Stability Pact: - targets - sanctions - ESA 95 AUSTRIA

BELGIUM 1980s-1990s: ‘federalisation’ 3 economic regions + 3 linguistic communities + provinces + communes Federal gov. responsible for most revenues. Regions insulated from cycle No predefined rules & no investment allowance Consensual approach: Conseil Superieur des Finances sets guidelines and targets Successfully combines decentralisation and fiscal consolidation

Federal State (new Constitution after WW2) Three government tiers Crucial role of co-operation between government tiers Golden rule (not very strictly defined)  flexibility for investment No explicit flexibility for the cycle No explicit Domestic Stability Pact, but an ‘implicit’ rule exists (bailing- out is constitutionally set) GERMANY

From centralised to decentralised (advances in 1990s) Three government tiers Commitment by central government not to bail-out Mixture of explicit and implicit rules, largely based on consensus Golden rule for local governments  flexibility for investment No explicit flexibility for the cycle (but borrowing limits can apply only ex-ante) SPAIN

ITALY From centralised to decentralised (advances in 1990s) Three government tiers Domestic Stability Pact (1999): - imposed by central government - not comprehensive (excludes investment & health) - not binding Increasing revenue responsibility of regions Debt financing only for investment 2001: change in Constitution  move to consensual approach

ITALY: DOMESTIC PACT Budget balance (cash terms, exclude financial transactions): = (R - T) - (S - K - I) R = total revenue T = central government transfers S = total expenditure K = capital account outlays I = interest payments Target: improve trend balance (t-1 deficit  (1+0.8 of GDP growth rate)) in proportion to (S - K - I) Sanctions: only if Italy sanctioned at EU level

ITALY: DOMESTIC PACT Budget balance : = (R - T - XR - HR) - (S - K - I - XS - HS) XR = exceptional revenues (asset sales) HR = health revenues XS = exceptional expenditure HS = health spending Target: as 1999 but must compensate for 1999 slippages

ITALY: DOMESTIC PACT / Target: deficit cannot exceed 103 % of 1999 deficit 2002 Target: deficit cannot exceed % of 2000 deficit 2002: additional limit on expenditure growth + sanctions for local govs (reduction of transfers)

ITALY: DOMESTIC PACT - PROBLEMS Many changes Targets proportional to expenditure or past deficit, not to gap with respect to budget balance Balance  EU relevant balance Double golden rule? No debt target Weak sanctions till Italy is sanctioned (credible?) Expenditure ceiling compatible with decentralisation? Asymmetry problem: not solved Cycle problem: not addressed Investment problem: odd solution

Robustness to economic shocks lengthy negotiations & adjustments SUSTAINABLE SOLUTIONS? (I) Robustness to further decentralisation larger autonomy requires more revenue power  more effects of cycle Effects on allocation local government insulated from cycle  distortions

SUSTAINABLE SOLUTIONS? (II) A rules+sanction based eclectic framework (regions : ‘domestic-SGP’ others: nominal budget balance & revenue structure all: compensated golden rule) may: - shorten reaction time to shocks - be robust to institutional changes - improve allocative efficiency through increased transparency and control of policy implementation Pre-requisite: common accounting standards for all government tiers

“The extent to which the liberty of experiments in taxation should be conceded to the subordinates bodies must, we believe, be carefully limited. For the smaller units the taxes should be absolutely laid down and also the maximum to be raised, but the opportunity of economy should not be denied on the condition that they duly discharge their necessary function. The larger circumscriptions are fairly entitled to great latitude. A higher standard of intelligence may be expected from their representatives, and their economic resources are more varied. But even with them the need for supervision cannot be said to be absent.” Pigou (1927) IN OTHER WORDS...

SOME DATA (I) Local gov. taxes as a share of general gov. revenues

SOME DATA (II) Local gov. expenditure as a share of general gov. expenditure

SOME DATA (III) Local gov. taxes as a share of local gov. overall revenues