Inefficiencies in the Financing of Finnish County Governments - Lessons from the Literature on Fiscal Federalism

The Finnish regional government reform currently under consideration will create a new tier of regional county governments, which will be responsible mainly for the provision of health and social care services. On the revenue side, counties will be financed mostly through grants from the central government and out-of-pocket payments (i.e. client fees). The funding model of the counties raises a number of questions from the point of view of the fiscal federalism literature. One important question in particular is: what kind of incentives will centrally-allocated funding create for the regional governments? One concern raised is that this type of financing structure will create a soft budget constraint for the counties. In other words, the county governments will expect that the central government will provide them with additional resources if they surpass their allocated budget. This paper discusses the potential for soft budget constraints (SBC) in the newly-created Finnish counties, by reviewing contributions from the fiscal federalism literature. Besides providing the overview of the relevant literature, we highlight the determinants of SBC problem most relevant for the Finnish regional government reform and possible solutions. One important conclusion from our discussion is that decentralizing spending alone can lead to softer budget constraints and overspending for the regional governments, due to the vertical fiscal imbalances that it creates. In other words, the spending responsibilities of the county governments might be too large for their revenue-generating possibilities. One channel through which the proposed funding system softens the budget constraint is the possibility for local governments to “blame†the central government for the deficits or fiscal troubles. According to the literature, this problem is particularly relevant for the health care services, since it touches a politically sensitive issue. Another interesting conclusion from our discussion is that it might simply be impossible for the central government to commit to a no-bailout policy. In the case of health and social care provision in Finland, the central government might even explicitly commit to increasing resources ex ante if services are at risk. In this case, the literature suggests having pre-determined mechanisms around the bailouts. Possibilities include mandated austerity measures as conditions for the bailout, or direct central oversight. These measures seem to improve local public finances. Our findings from the fiscal federalism literature also suggest that the reform should proceed with additional tax autonomy at the county level, since that would limit the soft budget constraints and improve the fiscal performance of counties.