Fiscal Federalism - Stanford University

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					Fiscal Federalism

     Jonathan Rodden
    Stanford University
      August 8, 2011
                         Part 1:
                     Broad Overview


• Intellectual history
  • From welfare economics and public choice to political
    economy

• Stylized facts and trends
  • Partial decentralization
  • Incomplete contracts

• An example: The study of intergovernmental grants
                   Part 2:
          Macroeconomic management


• State/local budgets and the business cycle
  • Pro-cyclical fiscal flows and borrowing

• Fiscal discipline in multi-layered systems
  • The end of market discipline?
  Intellectual history
From “First Generation” to “Second Generation” fiscal
                     federalism
      Welfare economics
• Coherent logic connecting Montesquieu, Rousseau,
  Tocqueville, Madison, Musgrave, Oates:
  • To achieve simultaneously the advantages of large and
    small governmental units by solving the “assignment
    problem.”
  • Oates: “The provision of public services should be
    located at the lowest level of government
    encompassing, in a spatial sense, the relevant benefits
    and costs.”
  Welfare economics, cont.
• Assume that political leaders are benevolent despots
  who maximize the welfare of their constituents.

• Presumption in favor of decentralization because of:
  • stronger incentives
  • better information about preferences
  • above all, greater homogeneity of preferences at lower
    levels of government
   Competition and sorting

• Tiebout (1956): Key advantage of decentralization is
  the market analogy.
  • Citizen land-owners sort into communities that offer
    desired levels of taxes and bundles of goods.
  • Provides a powerful preference-revelation mechanism
    beyond voting and lobbying.
 Competition as a restraint on
        government
• Leviathan (Hayek 1939, Brennan and Buchanan
  1980)
  • Tax competition prevents revenue-hungry politicians
    and bureaucrats from consuming too much.

• Persson and Tabellini (2000), Weingast (1995)
  • Decentralization with capital mobility allows
    government to commit not to over-tax capital or over-
    regulate the economy.
Broad consensus circa 1990:

• Based on theory literature, virtual consensus about
  potential benefits of decentralization, especially in
  developing countries in late 1980s
           What went wrong?

• The obvious things:
  •   Corruption, clientelism, elite capture
  •   Accountability problems
  •   Challenges for safety nets and poverty reduction
  •   Macroeconomic management:
      • Specifically, soft budget constraints and bailouts
What was the theory literature
         missing?
• Decentralization in practice rarely resembles the
  type of decentralization imagined in the theory
  literature.

• “Partial Decentralization”
  • Grants and shared taxes rather than autonomous local
    taxation
  • Muddy division of authority
  • Politicized resource distribution
What do we know?
 Trends and stylized facts
      Percent of countries with elected subnational
              governments (43 countries)


  1
0.8                                    local
0.6
0.4                                            regional
0.2
  0
  1965         1975          1985              1995
      Average Expenditure Decentralization, 29
                   countries


0.5
0.4
0.3
0.2
0.1
  0
  1965           1975         1985          1995




                                                 Source: GFS
      Correlates of expenditure
          decentralization
• Panizza 1999, Garrett and Rodden 2005:
  •   Country size
  •   GDP per capita
  •   Democracy
  •   Federal constitution
  •   Ethno-linguistic heterogeneity?
But what about the revenue
          side?
          Kernel density of expenditure and tax decentralization in 40
                                countries, 1990s

           3
           2
Density




           1
           0




                 0             .2              .4                .6              .8
                                        Share of total

                         State-local expenditure/total, GFS
                         State-local own-source revenue/total, country sources
               Histogram, Subnational tax autonomy in OECD
               countries (full rate and base autonomy), 1990s
          30
          20
Density



          10




                                     Switzer-
                                                                       Canada
                                     land        USA
           0




               0                  .1                     .2                     .3
                      State-local autonomous taxation/total revenue

                                                                      Source: OECD
               Federalism vs.
              decentralization
• Federalism has roots in a bargain or contract
  • Coming together vs. holding together

• To be credible, the contract usually requires
  institutional protections:
  • Unit-based rather than population-based representation
  • Supermajority requirements
  • Courts with judicial review
  • Explicit delimitation of powers & responsibilities,
    residual powers
The division of expenditure
      responsibilities
      Percent of countries with decentralized primary
              education policy (43 countries)


0.6

0.4

0.2

 0
  1965           1975         1985                          1995


                               Shared between center and subnational govts.


                               Shared between 2 or more subnational tiers


                               One subnational tier alone




                                            Source: Henderson (2000)
      Percent of countries with decentralized
        infastructure policy (43 countries)


0.6

0.4

0.2

 0
  1965           1975         1985                           1995


                               Shared between center and subnational govts.


                               Shared between 2 or more subnational tiers


                               One subnational tier alone




                                            Source: Henderson (2000)
Pathologies of partial fiscal
     decentralization
• Limited accountability
• Local governments direct resources to clients and
  blame higher-level governments for poor service
  provision.
• Offloading and unfunded mandates
• Stringent conditions for grants
• Incentives for local governments to hide information
  and dissemble
• Politicized transfers
Rethinking fiscal federalism in
       the last decade
• Motivations of politicians
  • Electoral and other political motivations replace
    benevolent despots and Leviathans.

• Focus on institutions of representation
  • E.g., the nature of legislative bargaining: Persson and
    Tabellini (1996), Inman and Rubinfeld (1997), Dixit
    and Londregan (1998), Besley and Coate (2003),
    Lockwood (2002).
  Rethinking federalism, cont.

• Sharper focus on “fiscal interests”
  • Taxes and fees vs. grants
  • Types of grants, formulas

• Incomplete contracts
  • The ultimate locus of authority is often unclear and
    contested.

• Principal-agent relationship
  • Focus on crafting better incentives for subnational
    governments
         Re-centralization?

• Central governments are seeking out new ways of
  structuring the principal-agent relationship
  • Replacing discretion with rules
  • Audits
  • Enhanced central monitoring and data collection

• But challenges remain:
  • Example: difficulty of data collection in decentralized
    environments
  Who gets what?
Empirical studies of intergovernmental transfers
                    Motivation


• The trend toward fiscal decentralization is funded
  primarily by a combination of formulaic and
  discretionary transfers.

• Grants and fiscal flows shape incentives of regional
  governments and central legislators.

• By what logic are they distributed?
     Studies of intergovernmental grants

• First generation: Welfare economics and fiscal
  flows
• Second generation: Political economy of fiscal
  flows
  • Partisan dictators
  • Legislative bargaining
• Fiscal flows and inter-regional redistribution:
  When and where are grants progressive?
• Representation and redistribution
        Welfare economics
• Central government is a benevolent dictator
• Uses inter-regional fiscal flows to:
  • Capitalize on economies of scale in
    taxation
  • Internalize externalities
  • Facilitate inter-governmental competition
  • Stabilize asymmetric shocks
           Partisan dictators
• Cox and McCubbins (1986):
  • Core support
  • Key assumptions: Risk-averse incumbent
• Dixit and Londregan (1996):
  • “Swing voters”
• These theories are not necessarily about geography
  or districts, but the application is natural
• Partisan alignment
             Empirical literature
• Scattered evidence for all these propositions
  • Usually an empirical focus on one relatively small,
    discretionary part of the budget (e.g. environmental grants
    in Sweden, infrastructure grants in Spain).
  • “Core vs. swing” debate unresolved: Basic story is that
    incumbents favor some combination of marginal and core
    districts, direct resources away from the opponent’s core
    support districts.
  • Strong support for the partisan alignment hypothesis
  • Formulaic transfers are not immune
• Challenges:
  • Measuring ideological indifference
  • Endogeneity: Do fiscal flows actually buy votes?
Big questions left unanswered:
• What happens when we drop fixed effects
  and examine long-term cross-section
  variation?
• Are fiscal flows progressive?
  • When and where?
  • Implications for European idea of a “transfer
    union.”
      Empirical analysis of fiscal
                flows
• MacDougall Report (1977)
• Renewed interest due to optimal currency
  area literature, e.g. Sala-i-Martín and Sachs
  (1992); Bayoumi and Masson (1995)
• Broadest comparative work builds on
  Bayoumi and Masson (1995): Espasa
  (2001); Barberán, Bosch, Castells, Espasa
  (2000); Bosch, Espasa, Sorribas (2002)
  Income elasticity of fiscal
           flows
        Bi                Yi 
ln 10 
             ai  bi ln    ei
                          Y 
        Bm                m
      i refers to region
      m refers to average of all regions
      B  real per capita fiscal balance
      Y  real per capita income
     Income elasticity of grants in 9 federations,
 2
 0
-2
-4
-6                    1990-2005




     ARG   AUS   BRA   CAN    DEU      ESP   EU   IND   USA
                             Country
Average income and transfers (1990-2005)
            To sum up:
• Considerable redistribution through
  intergovernmental grants in Canada,
  Spain, Germany, and Australia
• Very little redistribution in Argentina,
  Brazil, Mexico, Switzerland, the United
  States, and the EU.
• Why?
 The representation of regions

• Some state receive far more representation per capita
  than others.

• There are good reasons to believe that over-
  represented states will do well in the game of
  legislative bargaining
Legislative representation and transfers
              (1990-2005)
Average income and transfers (1990-2005)




                                 Size of marker reflects
                                 relative per-capita
                                 representation
 Another possible explanation:

• Classic political economy theory about the income
  distribution:
  • Does the skew in the inter-regional income distribution
    predict redistribution?
  • If the policy is set by the median state, we should
    expect to see large redistribution when median state is
    poor relative to the mean.
                              Argentina, 1990-2001                                                                                 Brazil, 1990-2001




                                                                                               2.5
          2.5




                                                                                                     2
                2




                                                                                               1.5
          1.5




                                                                                 Density
Density




                                                                                                     1
                1




                                                                                               .5
          .5




                                                                                                     0
                0




                    0     1                  2                   3                         4             0                 1                   2                3               4
                                 Share of national average                                                                         Share of national average

                        GDP per capita                 Expenditures per capita                                           GDP per capita               Expenditures per capita



                                                                            USA, 1990-1997
                                         2.5
                                               2
                               Density



                                         1.5
                                               1
                                          .5
                                               0




                                                   0                 1                 2                           3                   4
                                                                           Share of national average

                                                                  GDP per capita                         Expenditures per capita
          5           Australia, 1990-2001                                                                         Canada, 1990-1997




                                                                                       5
          4




                                                                                       4
          3
Density




                                                                     Density




                                                                                       3
                                                      Note: NT
          2




                                                                                       2
                                                      dropped
          1




                                                                                       1
          0




                                                                                       0
              0   1                2                  3                        4             0                 1               2                  3   4
                       Share of national average                                                                   Share of national average

                            GDP per capita                                                                              GDP per capita
                            Expenditures per capita                                                                     Expenditures per capita



                                                                                   Germany, 1990
                                           5
                                           4
                                           3




                                                                                           Note: city-states
                               Density




                                                                                           dropped
                                           2
                                           1
                                           0




                                               0                 1                         2                   3              4
                                                                               Share of national average

                                                                                     GDP per capita
                                                                                     Expenditures per capita
    But what is the politically
  relevant income distribution?
• Perhaps in the parliamentary federations without
  much inter-provincial bargaining, the relevant
  distribution is the (highly skewed) inter-personal one,
  and high levels of inter-personal and inter-regional
  redistribution go hand in hand.

• But an interesting thing happens when the
  geography is divided into winner-take-all districts or
  states…
                      Distribution of Median Income in U.S. Congressional Districts
          .00006                             and U.S. States


                                                                  Median/Mean Ratios:
                                                                  Individuals: .74
                                                                  Cong. Dist.: .95
                                                                  States:      .98
             .00004
      Density
.00002



                      0




                            20000               40000              60000                80000
                                    Households: Median household income in 1999

                                                U.S. House District Medians
                                                U.S. State Medians
A different perspective on unit-based
vs. population-based representation

• Perhaps this helps explain why federations, and
  countries with single-member districts, demonstrate
  lower levels of redistribution

• The politically relevant median voter (the median
  income in the median state) is not very poor relative
  to the mean
      A related observation:

• All of the redistributive federations are parliamentary
  systems with strong and disciplined political parties.

• The non-redistributive federations are presidential
  systems with weaker parties and region-based coalition
  building in the legislature, especially the upper chamber.

• A similar story emerges from Persson and Tabellini
  (1996), who show that inter-regional bargaining leads to
  lower levels of risk-sharing than majority rule
                 Summing up:
• The “first generation” literature taught lessons about the
  optimal distribution of authority that are still relevant
• But it ignored questions related to institutional design and
  political economy
• After addressing these questions, we now know more
  about the incentives generated by fiscal and political
  institutions for voters, creditors, elected officials, and
  bureaucrats.
• This helps provide a clearer sense of the conditions under
  which decentralization might facilitate or undermine
  service delivery and macroeconomic management.
       Summing up (cont.):

• Much literature now focuses on strategies to
  minimize the “dangers” of decentralization

• Not much focus on the impact of decentralization
  per se

• Instead, focus on incentives created by the
  intergovernmental framework

• Transition from observational to experimental
  empirical research
             Looking ahead

• Macroeconomic management in a world of:
  • Partial decentralization
  • Incomplete contracts
  • Politicized transfers
Coffee Break
                   Overview

• Fiscal federalism and the business cycle

• Fiscal adjustment in a multi-layered system: the
  moral hazard problem

• Paths to fiscal discipline
  • Hierarchy
  • Markets

• Can market discipline survive?
Fiscal federalism and
  the business cycle
Some important questions:

• How do local budgets respond to the business cycle?

• With what implications for macroeconomic
  management?

• If central government attempts to generate fiscal
  stimulus during recession, to what extent do credit-
  constrained subnational governments undermine
  this?
   Provincial-level time series data
(real local currency units per capita):

• Variables:
  • Total revenue
    • Grants (discretionary and formulaic)
    • Total taxes and fees
  • Total expenditures
  • Deficit
  • Provincial GDP

• Federations:
  • Canada, USA, Germany, Australia, Argentina, Brazil,
    India
   What should we expect?

• Revenues:
  • Highly pro-cyclical taxes
  • Grants?
   • First generation fiscal federalism literature seems to imply
     counter-cyclical grants
   • Literature on optimal currency unions
   • But second generation political economy perspective leads
     to skepticism
   What should we expect?

• Expenditures and borrowing
  • Barriers to borrowing (and saving):
    • USA: Balanced budget rules and revenue restrictions
    • Canada is at the opposite extreme: No centrally- or self-
      imposed restrictions
    • Centrally-imposed and cooperative restrictions in each of
      the other federations
      • But many loopholes (e.g. German “golden rules,” Brazilian
        Senate oversight)
    • Voracity effect, credit crunch problem
Figure 1: Elasticity of Budget Items
Figure 1, cont.
              Summing up:

• Provincial fiscal behavior is highly pro-cyclical
  everywhere
• Grants do not smooth symmetric shocks in
  federations (except perhaps Australia)
• Some modest smoothing through saving and
  borrowing in OECD federations
• But ultimately, expenditures are generally pro-
  cyclical, which complicates efforts at stimulus.
  • See Aizenman & Pasricha (2011).
Fiscal federalism and
   fiscal discipline
                                    Dynamic Bailout Game

                                          EA
                     Adjust                                                            LA
                                                                     Adjust
              SNG                                              SNG   C
                                                                                                         D
                                                 No Bailout                                 No Bailout
                                                              G
        p                                                                Debt     CG
                    Unsustainable    CG                                  Crisis
                    Borrowing                                                               Bailout
                                                 Bailout
        C                                 
                                                                                                         LB
                                                              EB
                                          EA
hanc                   Adjust
       1-p                                                                            LA
                                                                     Adjust
 e
                                                                                                         D
                                                                                            No Bailout
              SNG                              No Bailout     SNG
                                                                     Debt
                                                                     Crisis
                    Unsustainable
                                                                                  CG          Bailout
                    Borrowing
                                     CG          Bailout
                                                                                                         LB
                                                              EB
Usng(EB) = 1 >Usng(LB)> Usng(EA)> Usng (LA)>Usng(D) = 0.




Ucgr(EA) = 1 > Ucgr(LA)> Ucgr(D)> Ucgr(EB)> Ucgr(LB) = 0.

Ucgi(EA) = 1 > Ucgi(LA)> Ucgi(EB)> Ucgi(LB)> Ucgi(D) = 0.
       Dynamic bailout game
• First, consider equilibria under perfect information
  • If p=1 (SNG believes with certainty that center is resolute),
    adjust immediately. SNG is a sovereign. Market discipline.
  • If p=0, SNG avoids adjustment and immediate bailout ensues.

• Under incomplete information, SNGs are semi-sovereigns
  • No separating equilibrium in pure strategies. SNG cannot
    ascertain center’s type after first round.
  • This can lead to “resolve-testing” equilibria.
What drives perceptions of the
      center’s resolve?
• Basic powers and obligations of the center

• Externalities and the structure of jurisdictions

• Identity of debt holders

• Legislative representation of solvent and insolvent
  states

• Court decisions

• Revenue sources and autonomy
      When the center cannot
            commit:
• Fully credible commitment is rare
• Unitary systems: Lack of commitment is common
  knowledge, and center confronts moral hazard
  problem through hierarchy:
  • Strict debt limits, administrative controls
  • Centralized credit allocation

• Empirical regularity: transfer-dependence is
  associated with borrowing restrictions (e.g. Von
  Hagen and Eichengreen 1995)
    Commitment problems in
         federations
• Recall that federations emerged from historical
  bargains with institutional legacies that make
  hierarchical control difficult:
  • Brazilian Senate
  • EU Council of Ministers

• Dysfunctional federalism: Center can neither
  commit nor regulate
  • Argentina and Brazil early 1990s
  • European Union today
 What went wrong in Europe?

• Half-hearted attempts at markets (no-bailout clause)
  and hierarchy (excessive deficit procedure).
  • The latter undermined the former

• The identity of debt holders, externalities

• Banking sector

• Uncertainty
  • Both about bailouts and defaults
            European Monetary Union and the
               Convergence of bond yields
15
10
 5




     February 7 1992                  January 1 1999

                       Belgium       Germany
                       Italy         France
                       Netherlands   Portugal
                       Spain         Sweden
                       Denmark       UK
              Debt crisis and divergence in 2010
12
10
 8
 6
 4
 2




 April 2009                        May 10 2010      Nov 12 2010

                        Belgium       Germany
                        Italy         France
                        Greece        Netherlands
                        Portugal      Spain
                        Sweden        UK
                        Ireland
The way forward in Europe

• A moment for centralization?

• Can market discipline function again?
  • Toward an orderly default procedure
  • European bankruptcy?
What about the United States?

• On one hand, some market analysts believe default
  is imminent.

• On the other hand, Roubini and Buffet tell us that in
  the wake of Bear Stearns and GM, federal
  government already provides an implicit guarantee.
150       Debt/GDP ratios for European countries and U.S. states



                                     GRE



                                            ITA
100




            BEL




                                FRA HUN
                                                               POR
                        DEU

           AUT                                          MAL                 UK
                                           IRE
                                                             NET
                  CYP
                         ESP
                                                              POL
  50




                               FIN
                    DEN                                                  SWE

                                                       LVA
                   CZR                                                SVK
                                                                     SLJ

                                                 LTA
                                                                                                                    KY MA                              RI
                                                                                                                                               NY
                                                                   ROM                                                                               PA SC
                                                                                 AK      CO     FL        IL IN              MI              NV                     WA
                                                                                   AL AZCA CT                       KS          MO MT  NE NJ
                                                                                                                                         NH NM      OR        TX   VT WI
                                                                                                  HI                          MN                                       WV
             BUL                                  LUX                               AR       DE GA
                                                                                                                           ME
                                                                                                                       LA MD     MS              OH       SDTN UTVA
                                                                                                                                    NCND
                                                                                                     ID           IO                              OK
                                                                                            DC
                              EST                                                                                                                                      WY
      0




                                Europe                                                                                        USA
        But this is deceptive

• Unfunded pension liabilities

• Implicit responsibility for municipal debt

• Insolvency is probably not imminent, but if
  conditions deteriorate, will states be allowed to
  default? Will the federal government provide a
  bailout?
      Market discipline in U.S.
            federalism
• Begins with aftermath of 1840s debt crisis

• Throughout 20th century, rapid response to negative
  revenue shocks, especially in states with most stringent
  balanced budget requirements (e.g. Poterba 1995).

• Bond yields and ratings quickly very responsive to
  changes in debt/GSP ratio and other indicators

• Default extremely rare

• No federal debt assumptions
     But much has changed

• Beginning with the New Deal, creeping
  centralization.

• States are increasingly used as agents of the federal
  government
                 Federal grants as share of state-local
.25                      current expenditures
  .2
.15
  .1
.05
      0




          1920           1940   1960          1980   2000   2020
                                       year
           Source: BEA
Response to recent recessions:

• Inefficient and painful expenditure cuts
• Requests for implicit bailouts:
  • Medicaid assistance
  • Infrastructure stimulus
  • Build America bonds

• These are delayed, ad hoc, and politicized.
• They send the wrong signals to market actors.
• But do they spell the end of market discipline?
Credit Default Swaps for U.S. States
Credit Default Swaps for Selected US States and EU
                    Countries
Can market discipline survive?

• There are good reasons for optimism.
   • Identity of bond-holders
   • Representation of (potentially) insolvent states

• The most important question is not whether bailouts are
  possible, but whether states and creditors are sufficiently
  uncertain.
• States and their creditors are not behaving as if bailouts
  are imminent.
• States are making better progress than the federal
  government
  Bolstering market discipline

• Reduce unfunded mandates

• Avoid policies that make states responsible for
  municipalities

• Embed automatic stabilizers into transfer system

• Keep state and federal obligations as separate as
  possible

• Orderly default procedure
                     Summary

• Fiscal federalism creates serious challenges for macroeconomic
  management, especially in the wake of fiscal crisis

• Subnational governments are font-line service providers, often
  responsible for providing unemployment insurance, health
  services, safety net, not to mention education, police, fire
  protection, infrastructure.

• Own-source revenues are extremely pro-cyclical, and grants are
  not much better. Most subnational governments are highly
  credit-constrained, and cannot easily borrow to smooth shocks.
              Summary (cont.)
•   Subnational governments are thus largely reliant on the central
    government for stabilization (as prescribed in the first-generation
    normative literature).

•   But central governments, and the intergovernmental fiscal
    framework, are often not up to the task.

•   This is an important area for reform

•   Even in unitary systems, there is an ongoing struggle to improve
    incentives associated with partial decentralization

•   But the largest challenges appear to be in federations and quasi-
    federations, where institutions, along with ethnic and regional
    tensions, undermine both hierarchical and market-based forms of
    fiscal discipline.
   Implications for the IMF

• Conditions, targets, monitoring must be sensitive to
  activities and obligations of subnational
  governments

• It is important to assess the basic incentives created
  by the intergovernmental framework. Things are
  often not as they appear on paper, and it is crucial to
  understand the political incentive structure.

• Need for further collaborative research

				
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