Fiscal Federalism Jonathan Rodden Stanford

slide1. Fiscal Federalism Jonathan Rodden
Stanford University
August 8, 2011<br>
slide2. 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<br>
slide3. 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?<br>
slide4. Intellectual history From “First Generation” to “Second Generation” fiscal federalism<br>
slide5. 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.”<br>
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 government<br>
slide7. 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.<br>
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.<br>
slide9. Broad consensus circa 1990: Based on theory literature, virtual consensus about potential benefits of decentralization, especially in developing countries in late 1980s<br>
slide10. 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<br>
slide11. 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<br>
slide12. What do we know? Trends and stylized facts<br>
slide13. local regional<br>
slide14. Source: GFS<br>
slide15. Correlates of expenditure decentralization Panizza 1999, Garrett and Rodden 2005:
Country size
GDP per capita
Democracy
Federal constitution
Ethno-linguistic heterogeneity?<br>
slide16. But what about the revenue side?<br>
slide17. Kernel density of expenditure and tax decentralization in 40 countries, 1990s<br>
slide18. Switzer-land USA Canada Histogram, Subnational tax autonomy in OECD countries (full rate and base autonomy), 1990s Source: OECD<br>
slide19. 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<br>
slide20. The division of expenditure responsibilities<br>
slide21. Source: Henderson (2000)<br>
slide22. Source: Henderson (2000)<br>
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 transfers<br>
slide24. 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).<br>
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<br>
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 environments<br>
slide27. Who gets what? Empirical studies of intergovernmental transfers<br>
slide28. 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?<br>
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 redistribution<br>
slide30. 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<br>
slide31. 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<br>
slide32. 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?<br>
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.”<br>
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)<br>
slide35. Income elasticity of fiscal flows<br>
slide36. Income elasticity of grants in 9 federations, 1990-2005<br>
slide37. Average income and transfers (1990-2005)<br>
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?<br>
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 bargaining<br>
slide40. Legislative representation and transfers (1990-2005)<br>
slide41. Average income and transfers (1990-2005) Size of marker reflects relative per-capita representation<br>
slide42. 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.<br>
slide44. Note: NT dropped Note: city-states dropped<br>
slide45. 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…<br>
slide46. Distribution of Median Income in U.S. Congressional Districts and U.S. States Median/Mean Ratios:
Individuals: .74
Cong. Dist.: .95
States: .98<br>
slide47. 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<br>
slide48. 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<br>
slide49. 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.<br>
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 research<br>
slide51. Looking ahead Macroeconomic management in a world of:
Partial decentralization
Incomplete contracts
Politicized transfers<br>
slide52. Coffee Break<br>
slide53. 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?<br>
slide54. Fiscal federalism and the business cycle<br>
slide55. 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?<br>
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, India<br>
slide57. 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<br>
slide58. 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<br>
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).<br>
slide62. Fiscal federalism and fiscal discipline<br>
slide64. 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.<br>
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.<br>
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 autonomy<br>
slide67. 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)<br>
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 today<br>
slide69. 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<br>
slide70. European Monetary Union and the Convergence of bond yields<br>
slide71. Debt crisis and divergence in 2010<br>
slide72. The way forward in Europe A moment for centralization?
Can market discipline function again?
Toward an orderly default procedure
European bankruptcy?<br>
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.<br>
slide74. Debt/GDP ratios for European countries and U.S. states<br>
slide75. 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?<br>
slide76. 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<br>
slide77. But much has changed Beginning with the New Deal, creeping centralization.
States are increasingly used as agents of the federal government<br>
slide78. Federal grants as share of state-local current expenditures<br>
slide79. 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?<br>
slide80. Credit Default Swaps for U.S. States<br>
slide81. Credit Default Swaps for Selected US States and EU Countries<br>
slide82. 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<br>
slide83. 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<br>
slide84. 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.<br>
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.<br>
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<br>