Transcript rodden_oslo_federalismx

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 overregulate 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
0.6
0.4
0.2
0
1965
local
regional
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?
0
1
Density
2
3
Kernel density of expenditure and tax decentralization in 40
countries, 1990s
0
.2
.4
Share of total
.6
State-local expenditure/total, GFS
State-local own-source revenue/total, country sources
.8
10
Density
20
30
Histogram, Subnational tax autonomy in OECD
countries (full rate and base autonomy), 1990s
USA
Canada
0
Switzerland
0
.1
.2
State-local autonomous taxation/total revenue
.3
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

 Yi 
Bi 
  ai  bi ln    ei
ln 10 
Bm 

 Ym 
i refers to region
m refers to average of all regions
B  real per capita fiscal balance
Y  real per capita income
-6
-4
-2
0
2
Income elasticity of grants in 9 federations,
1990-2005
ARG
AUS
BRA
CAN
DEU
Country
ESP
EU
IND
USA
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 overrepresented 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.
Brazil, 1990-2001
1.5
.5
1
Density
1.5
1
0
.5
0
1
2
Share of national average
GDP per capita
3
4
0
1
2
Share of national average
GDP per capita
Expenditures per capita
.5
1
1.5
2
2.5
USA, 1990-1997
0
0
Density
Density
2
2
2.5
2.5
Argentina, 1990-2001
0
1
2
Share of national average
GDP per capita
3
Expenditures per capita
4
3
Expenditures per capita
4
2
0
1
1
2
Note: NT
dropped
3
Density
3
4
4
5
5
Canada, 1990-1997
0
2
Share of national average
3
4
0
1
GDP per capita
Expenditures per capita
2
Share of national average
GDP per capita
Expenditures per capita
3
4
5
Germany, 1990
2
Note: city-states
dropped
1
1
0
0
Density
Density
Australia, 1990-2001
0
1
2
Share of national average
GDP per capita
Expenditures per capita
3
4
3
4
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…
.00006
Distribution of Median Income in U.S. Congressional Districts
and U.S. States
0
Density
.00002
.00004
Median/Mean Ratios:
Individuals: .74
Cong. Dist.: .95
States:
.98
20000
40000
60000
Households: Median household income in 1999
U.S. House District Medians
U.S. State Medians
80000
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 creditconstrained 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 selfimposed 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 procyclical, which complicates efforts at stimulus.
• See Aizenman & Pasricha (2011).
Fiscal federalism and
fiscal discipline
Dynamic Bailout Game
EA
Adjust
SNG
SNG
No Bailout
p
Unsustainable
Borrowing
C
No Bailout
G
Debt
Crisis
CG

CG
Bailout
LB
EB
EA
Adjust
1-p
D
Bailout
C
hanc
LA
Adjust
LA
Adjust
e
SNG
No Bailout
No Bailout
SNG
D
Debt
Crisis
Unsustainable
Borrowing
CG
CG
Bailout
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
5
10
15
European Monetary Union and the
Convergence of bond yields
February 7 1992
January 1 1999
Belgium
Italy
Netherlands
Spain
Denmark
Germany
France
Portugal
Sweden
UK
2
4
6
8
10
12
Debt crisis and divergence in 2010
April 2009
May 10 2010
Belgium
Italy
Greece
Portugal
Sweden
Ireland
Germany
France
Netherlands
Spain
UK
Nov 12 2010
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
100
ITA
BEL
FRA HUN
POR
DEU
MAL
AUT
UK
IRE
NET
CYP
50
ESP
POL
FIN
SWE
DEN
LVA
CZR
SLJ
SVK
LTA
KY MA
ROM
AK
CO
AL AZCA CT
BUL
LUX
AR
FL
HI
DE GA
ID
DC
IL IN
RI
NY
PA SC
NV
WA
MI
NE NJNM
TX
OR
VT WI
MO MT
KS
NH
MN
WV
ME
LA MD
MS
SDTN UTVA
OH
NCND
IO
OK
WY
0
EST
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
0
.05
.1
.15
.2
.25
Federal grants as share of state-local
current expenditures
1920
1940
1960
1980
year
Source: BEA
2000
2020
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 quasifederations, 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