1 Federalism and Economic Performance: Evidence for Swiss Cantons Presentation at the BMF-ZEW-Conference on Fiscal Policy Challenges in Europe, Berlin, March 23, 2007 Prof. Dr. Lars P. Feld University of Heidelberg, University of St. Gallen (SIAW-HSG), ZEW Mannheim, Crema Basel and CESifo Munich Berlin

2 In a Nutshell Difference to the Literature –Literature is on fiscal decentralization and economic growth –Here: Instruments of fiscal federalism and economic performance. –‚Instruments‘ are tax competition, grants, fragmentation. Message –Tax competition is not harmful to regional performance. –No clear-cut results on grants. –Fragmentation is not harmful to economic performance. Berlin

3 Federalism and Economic Performance Outline of the Presentation Introduction Theoretical Background Empirical Studies Swiss Federalism Results on Federalism and Economic Performance in Switzerland Conclusion Berlin

4 Introduction Political Discussion around the World –Commission on Fiscal Federalism in Germany Is German federalism harmful for economic development? Joint Decision Trap –Similar discussions in Austria and Switzerland. Academic Discussion –What is the impact of vertical separation or division of powers on economic development of countries? –Federations vs. unitary states. –Cooperative vs. competitive federalism. Berlin

5 Introduction Advantages and Disadvantages of Federalism –Broad discussion in the literature. –Theory of fiscal federalism and plenty of interjurisdictional externalities. –Political economy arguments. –Specific problems in developing countries. Corruption. Contradictory Hypotheses –Necessity to conduct empirical research. Empirical study on Switzerland is particularly helpful. Berlin

6 Theoretical Background Berlin

7 Theoretical Background Regional Development and Convergence –Competitive federalism Efficiency gains and political innovation vs. Brain drain –Fiscal equalization/ grants Income increase and attraction of new industries Disincentives for structural change and bail-out problems National Economic Growth –Competitive federalism: Efficiency reserves vs. decline of help to change economis structures –Fiscal equalization/ grants Negative incentives vs. development aid. Berlin

8 Empirical Studies Cross Country Studies –Still ambiguous results on fiscal decentralization and economic growth. –Specific problems of LDCs. –Autonomy vs. share of decentralized spending. China –First glance: Ambiguous results. –Second evaluative view: Fiscal decentralization has a positive impact on economic growth of Chinese provinces. Berlin

9 Empirical Studies USA –Xie, Zou and Davoodi (1999): National level: U.S. are in a decentralization equilibrium, because decentralization has no significant impact on national economic growth. –Akai and Sakata (2002) State level: Decentralization in the U.S. states has a positive impact on their development. Local Autonomy measured by the share of own from total revenue does not have a significant impact. –Stansel (2005) Higher fragmentation is associated with significantly higher growth in (log) real per capita money income at the municipal level. Berlin

10 Empirical Studies Germany –Behnisch, Büttner and Stegarescu (1999): National level: Increasing federal share of total spending has a positive impact on total productivity growth. –Berthold, Drews and Thode (2001) State level: Horizontal fiscal equalization and vertical supplementary grants have a negative impact on regional development of the German states. Panel of 16 states from 1991 to 1998: Methodological Problems. –Berthold, Drews and Thode (2007) Panel of 16 states from 1991 to 1998: Still Methodological Problems due to Invalid Instruments. General Problems of the Studies –Too strong concentration on decentralization measures. –Autonomy and instruments of federalism. Berlin

11 Swiss Federalism Berlin

12 Swiss Federalism II Berlin CH: Population 7'261'200 Foreigners 1'457'800 Area: 41‘293 km 2 26 Cantons (AI 14'900 Inhabitants) 2903 Communes

13 Swiss Federalism III Berlin

14 Results on Federalism and Economic Performance in Switzerland Econometric Approach –Exogenous Growth Model –Production function of Mankiw, Romer and Weil (1992) –Organisation of federalism as technological progress. Berlin

15 Results on Federalism and Economic Performance in Switzerland Variables –Q it : Real GDP; –L it : Number of Employees –H it : Share of People with High School Degree or Cantonal Education Spending per Capita –K it : Private Investment –V it : Vector of Controls –  0 to  4 : Parameters –  it : Error Term. Berlin

16 Results on Federalism and Economic Performance in Switzerland Federalism Variables –Share of Decentralization: Share of local spending (tax revenue) from total local and cantonal spending (tax revenue) –Grants per capita Lump sum grants Matching grants –Urbanisation as a proxy for agglomeration economies Berlin

17 Results on Federalism and Economic Performance in Switzerland Federalism Variables –Fragmentation of a canton in communities as a proxy for economies of scale in consumption. –Tax competition Difference between an canton‘s tax rate and the average tax burden of other cantons (weithed by the inverse of distance) in the highest income tax bracket (1 million SFr). –Language dummy –Dummy Basel-City. Berlin

18 Results on Federalism and Economic Performance in Switzerland Panel of 26 Cantons from 1980 to 1998 OLS and TSLS with time dummies Instruments: –Cantonal Dummies –Lagged grants and federal index of mountainous areas –Proxies for interest group influence Robust standard errors (Clustering-Method). Berlin

19 Results on Federalism and Economic Performance in Switzerland Berlin

20 Results on Federalism and Economic Performance in Switzerland

21 Conclusion Impact of Swiss fiscal federalism on cantonal economic performance –Production function approach –Panel of cantons from –Grants, in particular matching grants, is negatively correlated with GDP per employee. –Tax competition is not harmful. –Economies of scale do not have a significant impact. Robustness Checks –Fixed effects regressions. –Growth regressions. –Interaction of population with tax competition proxy. –Political Controls. Berlin