Fiscal Decentralization and Fiscal Discipline Jonathan Rodden MIT

Subnational Deficit as Percent of Revenue: Selected Developing and Transition Countries Hungarian local Argentine provinces Indian states Brazilian states Aggregate deficit/revenue

1992 Norwegian local Subnational Deficit as Percent of Revenue: Selected OECD Cases Aggregate deficit/revenue U.S. states U.S. local Canadian local GermanLaender Canadian provinces

Overview Fiscal discipline as a commitment problem Types of discipline –Markets –Hierarchy Lessons from case studies and econometric research Implications

Can the center commit? History and expectations The constitution The size and structure of jurisdictions Political/electoral incentive structure Fiscal obligations and incentives

Commitment facilitates market discipline U.S. states since 1840s, Canadian provinces since 1950s –Borrowing of state and local governments is disciplined by self-interested voters and creditors with minimal central oversight. –Markets view states as “sovereigns” (e.g. Fitch, S&P). –Requirements: Strong accountability mechanisms, heavy dependence on broad-based local taxes, a “disengaged” central government. This level of commitment is quite rare!

What happens when pure market discipline is impossible? Hierarchical Discipline works well when the center has the constitutional and political authority to tightly regulate local borrowing. –Tools: “Golden rules,” numerical restrictions, central approval, prohibitions, etc. –Examples: Norway, Hungary, local governments in Canada –Less successful in large federations with powerful provinces (e.g. India)

When do subnational governments run unsustainable deficits? When the central government cannot commit but also cannot limit subnational borrowing The problem has been most severe in large federations where provinces: –have politically powerful representatives –depend heavily on intergovernmental transfers –have autonomous access to deficit finance bonds, borrowing from local banks state-owned banks and public enterprises non-payment of local employees contingent liabilities

Additional problems Highly discretionary transfers History of politicized bailouts Poor or unclear assignment of responsibilities Asymmetric jurisdiction size, “too big to fail” problem

World Bank Case Studies Norway Canada local Hungary local Argentina provinces Brazil states U.S. local India states Germany states ChinaCanada provinces UkraineU.S. states WeakStrong Market mechanisms Strong Hierarchical mechanisms Weak

Cross-country and within-country econometric studies Transfer-dependence  larger public sector, larger subnational and overall deficits, higher inflation, especially when SNGs have independent access to credit markets “Partisan harmony”  lower overall deficits and inflation –However, conflicting results regarding partisanship and fiscal discipline within countries (Italy, Argentina, Brazil, Germany, India)

How can fiscal discipline be improved? In most countries, first-best pure market discipline scenario is not possible Best strategy is to improve central monitoring and oversight while planting seeds for market discipline –Reduce central government’s discretion, delegate to independent agencies when possible –Clarify distribution of responsibilities –Privatize state-owned banks and enterprises –Improve intergovernmental transfer systems –Increase provincial own-source revenue mobilization, strengthen tax-benefit link –Improve accounting and basic administration –Clean up contingent liabilities

Discussion points for Italian decentralization Can the center commit? Can expectations be changed? –History of bailouts public health care Is market discipline possible? In some jurisdictions, not others? How can/should the center regulate subnational access to credit markets? Can the “golden rule” work? How can the the intergovernmental transfer system be improved? Further decentralization of taxation?