Vertical aspects of sub-national deficits: the impact of fiscal rules and tax autonomy in European countries

This article offers an empirical answer to the question of which institutional arrangements can help to keep the accounts of sub-national governments in balance. I take into consideration the autonomy that these governments have in raising their revenues and fiscal rules as formulated in law or constitutions. The former works as an implicit constraint since governments with more autonomy might assume higher responsibility for accumulated deficits. The latter works as a direct explicit constraint on sub-national borrowing, but might be subject to endogeneity through preferences for fiscal responsibility. This potential source of bias is taken into account by using IV techniques for fiscal rules. Results from my original dataset, covering full information for 14 years of all EU15 countries, show that the effectiveness of tools depends critically on the federal background. Fiscal rules work in unitary countries, while higher tax autonomy yields lower deficits in federations.