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Fiscal Federalism in Times of Crisis

Author

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  • Foremny, Dirk
  • von Hagen, Jürgen

Abstract

We study the subnational fiscal adjustment to the Great Recession in a sample of European countries. We find that there are important differences between unitary and federal countries. Subnational governments in federal states reacted to the Great Recession by running larger budget deficits driven by increased spending particularly on social protection and weak revenue performance. In contrast the revenues of subnational governments in unitary states increased during the Great Recession due to larger transfers from central governments. Subnational government deficits increased much less in unitary states as real spending growth fell. In unitary states that fell into a debt crisis after 2009, the central government failed to shield local governments against the adverse macro economic consequences of the Great Recession, forcing them to adjust real spending to falling real revenues. This result suggests that sound public finances at the central level are critical to assure that subnational governments can deliver their allocative functions efficiently in the face of adverse macro economic conditions. In fact, our results call for tighter controls on expenditure growth during goods times and better protection against falling subnational revenues in bad times. We find that the countries that fell into a debt crisis after 2009 are characterized by weaker fiscal discipline at the subnational level already in the decade or so before the Great Recession. This observation suggests that the sustainability of subnational public finances is an important prerequisite for a country to maintain sustainable public finances at the level of general government.

Suggested Citation

  • Foremny, Dirk & von Hagen, Jürgen, 2012. "Fiscal Federalism in Times of Crisis," CEPR Discussion Papers 9154, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:9154
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    Citations

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    Cited by:

    1. Salvador Barrios & Diego Martínez-López, 2017. "Fiscal equalization schemes and subcentral government borrowing," Chapters,in: Central and Local Government Relations in Asia, chapter 4, pages 130-160 Edward Elgar Publishing.
    2. Hansjörg Blöchliger, 2013. "Fiscal Consolidation Across Government Levels - Part 1. How Much, What Policies?," OECD Economics Department Working Papers 1070, OECD Publishing.
    3. Virkola, Tuomo, 2014. "Fiscal Federalism in Four Federal Countries," ETLA Reports 38, The Research Institute of the Finnish Economy.
    4. Sacchi, Agnese & Salotti, Simone, 2014. "The asymmetric nature of fiscal decentralization: theory and practice," MPRA Paper 54506, University Library of Munich, Germany.
    5. repec:kap:pubcho:v:171:y:2017:i:3:d:10.1007_s11127-017-0441-0 is not listed on IDEAS

    More about this item

    Keywords

    European public debt crisis; fiscal federalism; Great Recession; vertical imbalance;

    JEL classification:

    • H12 - Public Economics - - Structure and Scope of Government - - - Crisis Management
    • H71 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Taxation, Subsidies, and Revenue
    • H72 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Budget and Expenditures

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