1. Fiscal Decentralization and Fiscal Discipline Jonathan Rodden MIT

2. Subnational Deficit as Percent of Revenue: Selected Developing and Transition Countries -0.4 -0.3 -0.2 -0.1 0 198419861988199019921994199619982000 Hungarian local Argentine provinces Indian states Brazilian states Aggregate deficit/revenue

3. 1992 Norwegian local 19861988 Subnational Deficit as Percent of Revenue: Selected OECD Cases -0.2 -0.15 -0.1 -0.05 0 0.1 0.15 1984 19901994 199619982000 Aggregate deficit/revenue U.S. states U.S. local Canadian local GermanLaender Canadian provinces

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

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

7. 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!

8. 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)

9. 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

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

11. 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

12. 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)

13. 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

14. 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?