Fiscal Federalism - PowerPoint Presentation

Slide1

Fiscal Federalism

Jonathan Rodden

Stanford University

August 8, 2011Slide2

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 grantsSlide3

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?Slide4

Intellectual history

From “First Generation” to “Second Generation” fiscal federalismSlide5

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.” Slide6

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 governmentSlide7

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.Slide8

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.Slide9

Broad consensus circa 1990:

Based on theory literature, virtual consensus about potential benefits of decentralization, especially in developing countries in late 1980sSlide10

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 bailoutsSlide11

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 distributionSlide12

What do we know?

Trends and stylized factsSlide13

local

regionalSlide14

Source: GFSSlide15

Correlates of expenditure decentralization

Panizza 1999, Garrett and Rodden 2005:

Country size

GDP per capita

Democracy

Federal constitution

Ethno-linguistic heterogeneity?Slide16

But what about the revenue side?Slide17

Kernel density of expenditure and tax decentralization in 40 countries, 1990sSlide18

Switzer-land

USA

Canada

Histogram, Subnational tax autonomy in OECD countries (full rate and base autonomy), 1990s

Source: OECDSlide19

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 powersSlide20

The division of expenditure responsibilitiesSlide21

Source: Henderson (2000)Slide22

Source: Henderson (2000)Slide23

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 transfersSlide24

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).

Slide25

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 Slide26

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 environmentsSlide27

Who gets what?

Empirical studies of intergovernmental transfersSlide28

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? Slide29

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 redistributionSlide30

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 shocksSlide31

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 alignmentSlide32

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?Slide33

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.”Slide34

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)Slide35

Income elasticity of fiscal flowsSlide36

Income elasticity of grants in 9 federations, 1990-2005Slide37

Average income and transfers (1990-2005)Slide38

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?Slide39

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 bargainingSlide40

Legislative representation and transfers (1990-2005)Slide41

Average income and transfers (1990-2005)

Size of marker reflects relative per-capita representationSlide42

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.Slide43
Slide44

Note: NT dropped

Note: city-states droppedSlide45

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…Slide46

Distribution of Median Income in U.S. Congressional Districts and U.S. States

Median/Mean Ratios:

Individuals: .74

Cong. Dist.: .95

States: .98Slide47

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 meanSlide48

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 ruleSlide49

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.Slide50

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 researchSlide51

Looking ahead

Macroeconomic management in a world of:

Partial decentralization

Incomplete contracts

Politicized transfersSlide52

Coffee BreakSlide53

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?Slide54

Fiscal federalism and the business cycleSlide55

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? Slide56

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, IndiaSlide57

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 skepticismSlide58

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 problemSlide59
Slide60
Slide61

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).Slide62

Fiscal federalism and fiscal disciplineSlide63
Slide64

U

sng

(EB) = 1 >U

sng

(LB)> U

sng

(EA)> U

sng

(LA)>U

sng

(D) = 0.

U

cgr

(EA) = 1 > U

cgr

(LA)> U

cgr

(D)> U

cgr

(EB)> U

cgr

(LB) = 0.

U

cgi

(EA) = 1 > U

cgi

(LA)> U

cgi

(EB)> U

cgi

(LB)> U

cgi

(D) = 0. Slide65

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.Slide66

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 autonomySlide67

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)Slide68

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 todaySlide69

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 defaultsSlide70

European Monetary Union and the Convergence of bond yieldsSlide71

Debt crisis and divergence in 2010Slide72

The way forward in Europe

A moment for centralization?

Can market discipline function again?

Toward an orderly default procedure

European bankruptcy? Slide73

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.Slide74

Debt/GDP ratios for European countries and U.S. statesSlide75

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? Slide76

Market discipline in U.S. federalism

Begins with aftermath of 1840s debt crisis

Throughout 20

th

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 Slide77

But much has changed

Beginning with the New Deal, creeping centralization.

States are increasingly used as agents of the federal governmentSlide78

Federal grants as share of state-local current expendituresSlide79

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?Slide80

Credit Default Swaps for U.S. StatesSlide81

Credit Default Swaps for Selected US States and EU CountriesSlide82

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 governmentSlide83

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 procedureSlide84

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.

Slide85

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.Slide86

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