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
 Bm   Ym 
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

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 SLJ
SVK

LTA
KY MA RI
NY
ROM PA SC
AK CO FL IL IN MI NV WA
AL AZCA CT KS MO MT NE NJNM
NH OR TX VT WI
HI MN WV
BUL LUX AR ME
LA MD MS OH SDTN UTVA
DE GA 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