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Spain: Selected Issues

Author(s):
International Monetary Fund. European Dept.
Published Date:
January 2017
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Fiscal Non-Compliance among Spanish Regions1

A. Background and Framework

1. Weak compliance among regional governments has hampered Spain’s fiscal consolidation efforts. Spain’s regional governments have been subject to annual nominal budget balance targets over the last two decades under different rule-based fiscal frameworks. However, fiscal compliance was weak, varied markedly across regions (Figure 1), and has been identified as one of the main risks to the fiscal consolidation process going forward (AIReF, 2016). Non-compliance increased following Europe’s sovereign debt crisis, accounting for the bulk of the general government target deviation set in Spain’s Stability Program. For this note, fiscal non-compliance is defined as the inability to remain within the limits set under these targets (Lledó, 2015). The note gauges how frequently regions missed the target, by how much, and what factors contributed to non-compliance based on a conceptual framework developed in Delgado-Téllez and others (forthcoming, Box 1).

Figure 1.Spain: Regions’ Non-Compliance with Fiscal Deficit Targets

(2013-15)

Sources: Ministry of Finance, and Delgado-Téllez and others (forthcoming).

Note: Non-compliance events are defined as cases of negative deviations between budget balance outturns and budget balance targets for a given region and year. Non-compliance frequencies are defined as the percentage of non-compliance cases to the total number of cases within a specific group (e.g. region, year). Non-compliance margins defined as differences between fiscal targets and outcomes, with positive margins indicating compliance and negative margins, non-compliance. Non-compliance margins are reverted in the bottom right chart to facilitate readability – i.e. positive (negative) bars indicated the size of the non-compliance (compliance) margin. CAN=Canary Islands, GAL=Galicia, MAD=Madrid, AST=Asturias, CL= Castilla and Leon; EXT=Extremadura, AND= Andalusia, ARA= Aragon, BASC =Basque Country, NAV=Navarra, RIO=Rioja; CLM=Castilla La Mancha, BAL = Balearic Island, CANT=Cantabria, MUR=Murcia, CAT=Catalonia, and VAL = Valencia.

B. What Explains Involuntary Non-Compliance by the Regions?

2. Common-shocks and adjustment needs seem to have contributed to involuntary fiscal non-compliance among Spain’s regions. Non-compliance frequencies have clearly moved in tandem with nominal GDP growth forecast errors (Figure 2) and so did compliance margins, as supported by positive and statistically significant estimates under various estimated models (Table 1). On the other hand, idiosyncratic shocks did not show a systematic impact. Fiscal non-compliance has displayed some inertial patterns in the form of positive auto-correlated margins, possibly reflecting budget rigidities owing to incremental budget processes or multi-year expenditure commitments. Fiscal non-compliance also increased with the required adjustment effort—proxied by differences between the fiscal deficit target in year t and t-1. Adjustment efforts have been quite heterogeneous across regions given that fiscal deficit targets, despite the existence of different starting fiscal positions, have been set uniformly across regions in most years. As expected, adjustment efforts are found to have a negative and statistically significant impact on fiscal compliance margins in most specifications in Table 1.

Figure 2.Spain: Involuntary Fiscal Non-Compliance and Shocks

Sources: Ministry of Finance, and Delgado and others (forthcoming).

Note: Common shocks are proxied by observed deviations between nominal (national) GDP growth outturns and forecasts set in annual budget laws (growth forecast errors). Idiosyncratic shocks do not seem to play a role in determining fiscal non-compliance (measured by differences between regions’ real GDP growth, CPI and house price inflation and corresponding national average).

Table 1.Spain: First-Difference GMM Estimates of Fiscal Compliance Margins
(1)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13)
Lagged compliance margin0.74*1.09**0.76*0.83*0.760.70***0.370.91**2.42***0.31*0.73*0.490.24
Growth forecast errors0.09*0.040.090.10*0.10*0.12***0.040.090.060.050.090.12***0.04
Region-National growth differential−2.09*−2.67*−2.16*−2.13−2.00−0.73−0.60−2.32*−1.82*−0.36−2.17*−1.190.24
Region-National inflation differential−0.36−2.08−0.39−1.10−1.28−1.27−2.41**−1.23−1.68−2.83*0.86−1.29−1.19
Fiscal Target Adjustment−0.80**−1.13**−0.81**−0.94**−0.85*−0.35−0.82***−1.02**−0.99***−0.51***−0.68*−0.52−0.49
Execution minus budgetary transfers (in regional GDP)−0.48
Region weight in national population3.86
Region weight in national GDP7.12
Region weight in national percapita GDP0.36
Tax autonomy0.03
Social spending share in regional government spending−0.33**
Investment share in total regional spending−0.24***
Vertical fiscal imbalances−0.15***−0.13**
Fiscal Rule Index0.050.020.01
Fiscal Rule Index X Lagged compliance margin−0.06**
Region Ratings
Lagged Annual Change Region Ratings−0.09
Lagged Annual Change in Implicit interest rates1.03***
Ratio of security to loans0.000.19
National election dummy−0.60***
Regional election dummy−0.36*−0.50*
Party congruence dummy−0.180.40−0.41***
Pro-autonomy party share−0.030.02
Regions’ seats in national parliament−0.31−0.86
Number of observations176160176176176160160160160145176176144
Number of regions16161616161616161615161616
Number of instruments16151616161515151515171714
Hansen0.600.800.440.870.660.280.370.820.650.140.680.150.05
ml0.120.110.130.150.230.020.090.100.060.140.120.200.00
m20.390.610.430.490.420.480.610.660.770.160.280.220.67
Note: Dependent variable is the difference between regions’ fiscal deficit outturns and fiscal deficit targets. The larger this difference is, the larger is the fiscal compliance margin. *, **, and *** indicate statistical significance at the 10%, 5%, and 1% levels, respectively. Instrument set in all models includes the second and third lag of the explanatory variables. Hansen is the p-value of the test of the over-identifying restrictions (see Hansen, 1982), which is asymptotically distributed chi square under the null hypothesis that these moment conditions are valid. A p-value equal or higher than 0.05 indicates that the instrument set is valid, which is confirmed under all models, m1 and m2 are the p-values of serial correlation tests of order 1 and 2, respectively, using residuals in first differences. The null hypothesis under both m1 and m2 tests is that there is no correlation between variables in the instrument set and the residuals. Observed p-values higher than 0.05 under the m2 test for all models indicates that there is no correlation with the instrument set defined in second lags.
Note: Dependent variable is the difference between regions’ fiscal deficit outturns and fiscal deficit targets. The larger this difference is, the larger is the fiscal compliance margin. *, **, and *** indicate statistical significance at the 10%, 5%, and 1% levels, respectively. Instrument set in all models includes the second and third lag of the explanatory variables. Hansen is the p-value of the test of the over-identifying restrictions (see Hansen, 1982), which is asymptotically distributed chi square under the null hypothesis that these moment conditions are valid. A p-value equal or higher than 0.05 indicates that the instrument set is valid, which is confirmed under all models, m1 and m2 are the p-values of serial correlation tests of order 1 and 2, respectively, using residuals in first differences. The null hypothesis under both m1 and m2 tests is that there is no correlation between variables in the instrument set and the residuals. Observed p-values higher than 0.05 under the m2 test for all models indicates that there is no correlation with the instrument set defined in second lags.

Box 1.Potential Factors Explaining Non-Compliance: A Framework

Fiscal non-compliance can be voluntary or involuntary. Fiscal non-compliance is voluntary when the non-compliant government has the capacity, but not the incentives to comply with a fiscal target. Fiscal non-compliance is involuntary when the converse holds (Figure). A government has the (fiscal) capacity to meet the target if it has sufficient resources or instruments to keep the budgetary outcomes within the target. A government has the incentives to meet the target when the costs of non-complying with the target outweigh the non-compliance benefits. Fiscal non-compliance equilibria could be the result of a sequential process, whereby the central government (CG) moves first and sets an ex-ante feasible fiscal target for the regional government (RG). RG then decides whether to comply or not with the fiscal target and CG to enforce it or not. In the final stage, the process is hit by a shock affecting RG’s fiscal capacity to meet the fiscal target (i.e., the ex-post feasibility of the target).

Fiscal Non-Compliance Typology
CapacityIncentives
VoluntaryYesNo
InvoluntaryNoYes

Voluntary fiscal non-compliance occurs when the RG is not willing to comply with the budget balance target even when the target is ex-post feasible. This may be driven by bailout and overspending incentives. Bailouts incentives will, on turn, depend on factors expected to increase the central government’s non-bailout costs such as regions’ (i) economic size (“too big or too small to fail”, Wildasin, 1997, Inman, 2003); (ii) political influence (“too connected to fail”; Porto and Sanguinetti, 2001; Grossman, 1994; Bolton and Roland, 1997); and (iii) lack of fiscal autonomy (“too dependent to fail”; Von Hagen and Eichengreen, 1996). Overspending incentives, on the other hand, may increase as a result of weak fiscal rules and insufficient market discipline (Ter-Minassian, 2015).

Involuntary fiscal non-compliance occurs when the RG is willing and ex-ante capable to comply, but does not have the capacity to do so, as ex-post the target is no longer feasible. This pattern becomes more likely in times of fiscal stress, defined as periods with large negative fiscal shocks. Fiscal stress times are also periods when CGs are subject to strong (domestic or supranational) pressure to ensure fiscal consolidation targets at the general government level are met. In decentralized economies, this implies ambitious but feasible fiscal consolidation targets at the RG level, as consolidation efforts are often shared across governments levels and sub-sectors. Implementing such consolidation plans have been shown to be less likely the larger they are (Beetsma and others, 2009). In the case of RGs, this may be the result of ambitious but feasible center-imposed fiscal targets turned unfeasible once a negative fiscal shock materializes.

Alternative hypotheses for voluntary and involuntary compliance have been tested for Spain by looking at the frequencies and margins of non-compliance events. The empirical analysis covers Spain’s autonomous regions during the period 2002–151 using a dynamic panel regression. Estimates are derived using Arellano-Bond first-difference General Method of Moments estimator in order to allow for possible inertial patterns in non-compliance as well as the endogeneity of dependent variables.

1 The econometric analysis excludes the Basque Country, where lower government levels rather than regional governments are responsible for the provision of public services, but not for the compliance with fiscal targets.

C. What Factors Have Impacted Voluntary Non-Compliance by the Regions?

3. Region’s size, fiscal autonomy, and politics influence voluntary fiscal non-compliance. The impact of regions’ size is not clear-cut though: non-compliance frequencies tend to be higher among larger regions, while margins do not deliver conclusive results (Figure 3, Table 1, models 3 to 5). Fiscal non-compliance frequencies tend to be larger among regions with more limited autonomy to raise their own revenues. Fiscal non-compliance frequencies increase and compliance margins decrease among regions showing less autonomy to cut their own spending, and, larger vertical fiscal imbalances (Figure 4, Table 1, models 6 and 7).2 Fiscal non-compliance frequencies, however, are not necessarily larger among regions in the top expenditure and VFI quartiles (i.e. regions with greater social mandates and less own resources to fund them). As conjectured, fiscal non-compliance frequencies seem to increase during national and regional election years, among regions politically aligned with the center, with strong pro-autonomy preferences, and large parliamentary representations (Figure 5). That said, apart from election years, region’s political alignment, pro-autonomy inclinations, and parliamentary representation did not appear to affect fiscal compliance margins in a statistically significant and systematic way (Table 1, models 11–13).

Figure 3.Spain: Regions’ Size and Non-Compliance with Fiscal Deficit Targets

(Frequency of non-compliance cases over 2003–15 by quartiles)

Sources: Ministry of Finance, National Institute of Statistics.

Note: Regions’ size is measured according to the weight of a region’s population, GDP, and GDP per capita in their corresponding national figures.

Figure 4.Spain: Regions’ Fiscal Autonomy and Non-Compliance with Fiscal Deficit Targets 1/

(Frequency of non-compliance cases over 2003–14 by quartiles)

Sources: Ministry of Finance, and Delgado and others (forthcoming).

Note: Tax autonomy is defined as the ratio between RGs own revenue to total tax revenues. Expenditure autonomy is measured by regions’ share of general government spending on essential services. The larger the share, the larger are expenditure responsibilities and the smaller are expenditure.

Figure 5.Spain: Politics and Regions’ Non-Compliance with Fiscal Deficit Targets

Frequency of Non-Compliant Cases over 2003-15, by Category Frequency of Non-Compliant Cases over 2003-15, by Quartiles

Source: Delgado-Téllez and others (forthcoming).

Note: Party congruence assigned Yes (No) if regional government led by same (different) party or government coalition leading central government. Pro-autonomy refers to the percent of members of regional parliaments from regional/pro-autonomy parties. Regional seats in national parliament refers to the number of seats in the lower house allocated to each region.

4. Stronger fiscal rules have not necessarily helped improve fiscal compliance, while the impact of financial markets has been ambiguous. Subnational fiscal rules in Spain have been significantly strengthened in the aftermath of the Euro Area sovereign debt crisis with the adoption of formal monitoring and enforcement procedures (Figure 6). However, such procedures have not been fully implemented, undermining fiscal compliance (Lledó, 2015). Regression results seem to reinforce this point. Stronger fiscal rules do not show any direct impact on fiscal compliance margins directly. Instead, they seem to have an indirect impact on compliance margins by helping reduce inertial patterns (Table 1, models 8 and 9). Financial markets seem to affect fiscal non-compliance through two different channels. On the one hand, fiscal non-compliance becomes less prevalent among regions that are more reliant on market-issued securities than on often softer bank loans, as regions internalized the impact of fiscal non-compliance on credit ratings and market-financing costs (Figure 7). On the other hand, fiscal non-compliance frequencies were larger among regions with lower (poorer) credit ratings and facing higher implicit interest rates, which seems to provide some support to the idea that financial markets weakened fiscal compliance by raising the financing costs of regions that were not perceived as creditworthy.3 Regression analysis of fiscal compliance corroborate the disciplinary effect of financial markets by showing fiscal non-compliance to decline among regions facing larger financing costs (Table 1, model 10).

Figure 6.Spain: Fiscal Non-Compliance and Fiscal Rules

Sources: Ministry of Finance and European Commission.

Note: Standardized fiscal rule index is computed by the European Commission. It is the weighted average of the fiscal rule strength index over all rules in force at any given years. Weights are given by the coverage of general government finances for a given rule.

Figure 7.Spain: Financial Markets and Regions’ Non-Compliance with Fiscal Targets

(Frequency of non-compliance cases over 2003–15 by quartiles)

Sources: Ministry of Finance and Delgado-Téllez and others (forthcoming)

Note: Region ratings based on a numerical scale from 0 to 21 derived from Fitch, Standard and Poor, and Moody region ratings. The lower the ratings, the poorer the creditworthiness. Security to loans ratio defined as ratio of regions’ public debt in government securities to banking loans. Implicit interest rates estimated as region’s interest payments in percent of end-of-year region public debt stock.

D. Policy Issues for Discussion

5. A list of issues warranting further policy discussion and analysis includes (i) the need to improve macro-fiscal forecasting at the central and subnational level to minimize unanticipated common shocks; (ii) an assessment on whether and, if so, how reforms on regions financing system and spending mandates, including minimum spending standards, may increase fiscal autonomy and reduce vertical fiscal imbalances; (iii) adoption of differentiated regional fiscal targets to improve the feasibility of fiscal adjustment plans, without undermining incentives to implement such plans in the first place; and (iv) rules-based automatic enforcement mechanisms to ensure fiscal compliance during election years and, especially in good times.

References

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    BeetsmaR.M.Giuliodori and P.Wierts2009Planning to Cheat: EU Fiscal Policy in Real TimeEconomic Policy Issue 60 pp. 753804.

    BoltonP. and G.Roland1997The Breakup of NationsQuarterly Journal of Economics Vol. 11 No. 4 pp. 105789.

    Delgado-TéllezM.V. D.Lledó and J. J.Perez forthcoming “On the Determinants of Fiscal Non-Compliance: An Empirical Analysis of Spain’s Regions.”

    GrossmanP.1994A Political Economy of Intergovernmental GrantsPublic Choice Vol. 78 No. 34 pp. 295303.

    InmanR.2003Transfers and Bailouts: Enforcing Local Fiscal Discipline with Lessons from U. S. Federalism“ in Fiscal Decentralization and the Challenge of Hard Budget ConstraintsRoddenJ.G.Eskelund and J.Litvack (eds) pp. 3583 (Cambridge, MA: MIT Press).

    LledóV. D.2015Coordinating Fiscal Consolidation in Spain: Progress, Challenges, and Prospects“ in Spain—Selected Issues IMF Country Report No. 15/233 (Washington: IMF).

    PortoA. and P.Sanguinetti2001Political Determinants of Intergovernmental Grants: Evidence from Argentina.” Economics and Politics Vol. 13 No. 3 pp. 23756.

    Ter-MinassianT.2015Promoting Responsible and Sustainable Fiscal Decentralization“ in AhmadE. and Brosio Geds.Handbook of Multi-Level Finance (Cheltenham: Edward Elgar Publishing).

    Von HagenJ. and B.Eichengreen1996Federalism, Fiscal Restraints, and European Monetary UnionAmerican Economic Review Vol. 2 pp. 13438.

    WildasinD.1997Externalities and Bailouts: Hard and Soft Budget Constraints in Intergovernmental Fiscal RelationsPolicy Research Working Paper 1843 (Washington: World Bank Group).

Prepared by Victor Lledó based on Delgado-Téllez, Lledó, and Perez (forthcoming).

Vertical fiscal imbalances are defined as [1-Own Revenue/Own Spending]. Own revenue (spending) corresponds to region’s total revenue (spending) minus transfers received by the central government and other public entities (transfer paid to the central government and other public entities).

Although one cannot rule out the possibility of reverse causality with fiscal non-compliance leading to poorer credit ratings.

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