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Fiscal Federalism, Fiscal Consolidations and Cuts in Central Government Grants: Evidence from an Event Study

  • Julia Darby

    ()

  • Muscatelli Anton

    ()

  • Graeme Roy

    ()

This paper contributes to a developing literature that examines financial interactions between different levels of government. More specifically, we investigate the use of grants, shared tax revenues, and their impact on fiscal outcomes, including decentralized service provision. Most existing empirical evidence has focused on individual country studies, and has predominantly been US based. However, it is difficult to generalize the conclusions obtained for the US to countries where the position and remit of lower tiers of government has recently been evolving or is less clear constitutionally. We use a panel dataset covering 15 OECD countries to investigate how central and sub-central expenditures, taxation, and intergovernmental grants change in response to central governments' attempts to correct their fiscal positions. We adopt an event study methodology to examine the timing of expenditure, taxation and intergovernmental grant shifts around the periods of fiscal consolidation. In addition to highlighting issues regarding the interaction between central and sub-central tiers of government, our analysis also sheds light into the extent to which sub-central tiers of government participate in fiscal consolidations, and hence to macroeconomic adjustment. Our key results can be summarized as follows. First, successful fiscal consolidations are generally driven by similar, and sustained, falls in expenditure at both central and sub-central tiers. Moreover, our evidence counters that identified by Gramlich (1987) for the USA, in that when central governments cut intergovernmental grants sub-central tiers do not take redress through offsetting increases in other forms of revenues. Second, unsuccessful consolidations tend to be characterized by increased central government taxation, with no fall back in grants and no tendency for sub-central taxation to change. It does appear that there is strong correlation between success in consolidating central fiscal deficits and similar actions from lower tiers of government. Third, we find that where consolidations are successful sub-central tiers of government are typically forced to cut back on capital expenditure. This suggests that in this regard the burden of adjustment falls onto lower tiers of government and central governments worry less about the long-term (i.e. public investment) consequences of consolidation if these decisions are taken at local level. We also find that when faced with cuts in intergovernmental grants, sub-central governments tend to maintain expenditures on wages at the expense of capital expenditure, reflecting a definite compositional switch towards public consumption. This might be interpreted as a variant of the effect identified by Gramlich (1987): sub-central governments seeking to defend current services rather than spending on infrastructure or raising taxation. This may reflect the greater constraints on sub-central tiers’ tax raising powers in many of the OECD countries in our sample, relative to those in the USA. Finally, our results shed some light, at least indirectly, on the ‘Fly-paper Effect’, by showing that it operates in reverse. Successful consolidations are characterized by cut-backs in grants that are more than offset by cut-backs in sub-central expenditures. In contrast, periods of unsuccessful consolidation are characterized by increases in central taxation, no change in grants, and small, temporary reductions in sub-central expenditure.

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Paper provided by European Regional Science Association in its series ERSA conference papers with number ersa04p366.

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Date of creation: Aug 2004
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Handle: RePEc:wiw:wiwrsa:ersa04p366
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  1. Giavazzi, Francesco & Jappelli, Tullio & Pagano, Marco, 2000. "Searching for non-linear effects of fiscal policy: Evidence from industrial and developing countries," European Economic Review, Elsevier, vol. 44(7), pages 1259-1289, June.
  2. James R. Hines & Richard H. Thaler, 1995. "The Flypaper Effect," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 217-226, Fall.
  3. Alberto Alesina & Roberto Perotti, 1996. "Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects," NBER Working Papers 5730, National Bureau of Economic Research, Inc.
  4. Michael Keen, 1998. "Vertical Tax Externalities in the Theory of Fiscal Federalism," IMF Staff Papers, Palgrave Macmillan, vol. 45(3), pages 454-485, September.
  5. Julia Darby & V. Anton Muscatelli & Graeme Roy, 2004. "Fiscal Consolidation And Decentralisation: A Tale Of Two Tiers," Working Papers 2004_2, Business School - Economics, University of Glasgow.
  6. Wallace E. Oates, 1999. "An Essay on Fiscal Federalism," Journal of Economic Literature, American Economic Association, vol. 37(3), pages 1120-1149, September.
  7. Rodden, Jonathan, 2003. "Reviving Leviathan: Fiscal Federalism and the Growth of Government," International Organization, Cambridge University Press, vol. 57(04), pages 695-729, September.
  8. Edward M. Gramlich, 1990. "Fiscal Indicators," OECD Economics Department Working Papers 80, OECD Publishing.
  9. Marianne Bertrand & Esther Duflo & Sendhil Mullainathan, 2002. "How Much Should We Trust Differences-in-Differences Estimates?," NBER Working Papers 8841, National Bureau of Economic Research, Inc.
  10. Aaron Tornell & Frank Westermann, 2002. "Boom-Bust Cycles in Middle Income Countries: Facts and Explanation," NBER Working Papers 9219, National Bureau of Economic Research, Inc.
  11. Isabelle Joumard & Per Mathis Kongsrud, 2003. "Fiscal Relations across Government Levels," OECD Economic Studies, OECD Publishing, vol. 2003(1), pages 155-229.
  12. A. Craig MacKinlay, 1997. "Event Studies in Economics and Finance," Journal of Economic Literature, American Economic Association, vol. 35(1), pages 13-39, March.
  13. Alberto Alesina & Roberto Perotti, 1995. "Fiscal Expansions and Fiscal Adjustments in OECD Countries," NBER Working Papers 5214, National Bureau of Economic Research, Inc.
  14. Alesina, Alberto Francesco & Perotti, Roberto & Tavares, Jose, 1998. "The Political Economy of Fiscal Adjustments," Scholarly Articles 12553724, Harvard University Department of Economics.
  15. C. John McDermott & Robert F. Wescott, 1996. "An Empirical Analysis of Fiscal Adjustments," IMF Staff Papers, Palgrave Macmillan, vol. 43(4), pages 725-753, December.
  16. Massimo Bordignon, 2000. "Problems of Soft Budget Constraints in Intergovernmental Relationships: The Case of Italy," Research Department Publications 3099, Inter-American Development Bank, Research Department.
  17. Jürgen von Hagen & Andrew Hughes Hallett & Rolf Strauch, 2001. "Budgetary Consolidation in EMU," European Economy - Economic Papers 148, Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission.
  18. Ebel, Robert D. & Yilmaz, Serdar, 2002. "On the measurement and impact of fiscal decentralization," Policy Research Working Paper Series 2809, The World Bank.
  19. Alberto Alesina & Roberto Perotti & José Tavares, 1998. "The Political Economy of Fiscal Adjustments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(1), pages 197-266.
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