Spain: Recent Economic Developments and Selected Issues

This Recent Economic Developments and Selected Issues paper highlights that after several years of relatively buoyant growth, Spain’s economy went into recession in late 1992 and through 1993, but recovered rapidly in 1994 and early 1995. Toward the end of 1995, there was a renewed slowdown, though less marked than in other European countries, followed by a gradual acceleration during 1996. Over the three-year period 1994–96, GDP growth averaged 2.4 percent a year. The employment growth picked up relatively strongly in 1995 and 1996.

Abstract

This Recent Economic Developments and Selected Issues paper highlights that after several years of relatively buoyant growth, Spain’s economy went into recession in late 1992 and through 1993, but recovered rapidly in 1994 and early 1995. Toward the end of 1995, there was a renewed slowdown, though less marked than in other European countries, followed by a gradual acceleration during 1996. Over the three-year period 1994–96, GDP growth averaged 2.4 percent a year. The employment growth picked up relatively strongly in 1995 and 1996.

III. Fiscal Decentralization in Spain11

A. Introduction

52. At the time of General Franco’s death in 1975, Spain was extremely centralized: the share of the central government in total government expenditure was about 90 percent, with the local governments providing the remaining 10 percent of total expenditure.12 The regions were established under the 1978 Constitution. Since then, Spain has experienced one of the most rapid increases in fiscal decentralization among industrial countries. By the early 1990s, the share of central government expenditure in total government expenditure had fallen to 70 percent—close to the average for industrial countries—and the regional governments had become responsible for almost 20 percent of total government expenditure, while the local governments’ share had remained almost unchanged at a little over 10 percent (Table III.1).

Table III.1.

Share of Central Government Expenditure in Total Government Expenditure in Selected Countries 1/

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Source: Government Finance Statistics Yearbook, International Monetary Fund; and staff estimates.

Total expenditure and lending minus repayments; consolidated central government (including social security) as a ratio of consolidated central government plus state, region or province governments, plus local governments.

Countries that report state/regional/provincial data separately to the GFS.

Countries that do not report state/regional/provincial data separately to the GFS.

53. Over the past two decades, fiscal decentralization mostly took the form of additional spending powers for the regional governments, with their revenue-raising responsibilities lagging behind. The regions gradually gained control over the provision of education, health, and social services, while most of their revenues continued to consist of transfers from the central government and the social security administration. This low degree of “fiscal co-responsibility” by the regions results in an inherent tendency for them to overspend, because while they have a mandate to provide government services, they do not play a commensurate role in raising revenue and can therefore avoid the political costs associated with tax collection (Monasterio et al., 1995, and Pastor, 1993). Not surprisingly, this has at times led to problems, notably in the early 1990s, when relatively large regional deficits emerged against the background of a rapidly increasing share of regional expenditure in total public spending: in 1991, the regional government deficit rose to 1½ percent of GDP and the deficit as a proportion of expenditure amounted to almost twice as much in the regions as it did in the central government (Table III.2).

Table III.2.

Spain: Deficit and Debt by Level of Government 1/

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Source: Bank of Spain, Cuentas Financieras and Bolelin Estadistico.

On a national accounts basis, before discovery of 1995 overruns.

Including the State and the central government agencies.

54. The issue of fiscal decentralization gained renewed prominence in Spain in 1996 because it constituted a critical part of the agreement whereby the minority government gained the support of the regional parties in Parliament, and because of the establishment of a new five-year regional financing plan, which includes measures intended to increase the regions’ fiscal co-responsibility. The main innovation is that, beginning in 1997, the regional governments will be able to set the rates and deductions on ceded taxes13 and, more important, on 15 percent (30 percent from 1998) of their own region’s personal income tax base. As a result, the regions have gained additional control over their fiscal policies.

55. The importance of fiscal discipline in the regions is highlighted by Spain’s commitment to comply with the fiscal requirements for its participation in the European Monetary Union (EMU) from January 1999. In recent years, the debts and deficits of subnational authorities have been contained through a number of mechanisms, the most important of which has been a multi-year agreement (adopted in March 1992 and revised in June 1994) setting out a framework for fiscal adjustment as part of the overall Maastricht Convergence Program of the Spanish government. Its implementation has been coordinated through the Consejo de Política Fiscal y Financiera (CPFF), which consists of the Minister of Economy and Finance, the Minister of Public Administration, and the representatives of the various regions. The CPFF sets the debt and deficit targets for each level of government (central, regional, and local) and subsequently for individual subnational authorities, including for each region, within the Convergence Program framework. Since 1994, the regional governments as a whole have broadly respected the agreements undertaken within the CPFF. Nevertheless, to avoid potential ‘free rider” problems,14 the CPFF is discussing potential ways of reinforcing its coordination and monitoring activities, including through the establishment of a domestic “Stability Pact” among the regions (somewhat similar to the Stability Pact among EMU countries) which might include sanctions for noncompliance.

56. This chapter describes the process of fiscal decentralization in Spain and the current system by which the regions are financed, and highlights the need for improved coordination and monitoring to ensure fiscal discipline, particularly in light of the obligations related to participation in the European currency union.

B. Decentralization and Adjustment

The Spanish regions

57. Under the 1978 Constitution, 17 regions (listed in Table III.3) were established, with varying degrees of autonomy related to historical factors and the status that each region chose to adopt at the time the Constitution was signed. There are 15 common regime regions (Comunidades Autónomas de Régimen Común) and 2 special regime regions (Comunidades Autónomas de Régimen Foral). The former, which operate under the regular financing arrangements described in Section C, are split into two groups: (a) Article 151 regions (Andalucía, the Canary Islands, Catalonia, Galicia, and Valencia), which chose to acquire more quickly the control over expenditure on education (around 40 percent of their total expenditure) and health (30 percent), in addition to “ordinary expenditures” (competencias comunes), which include social services, arts and culture, and infrastructure such as roads and sewage (the remaining 30 percent); and (b) Article 143 regions (Aragón, Asturias, Baleares, Cantabria, Castilla-La Mancha, Castilla-León, Extremadura, Madrid, Murcia, and La Rioja), which chose a slower path toward assuming greater control over spending: until recently they only controlled ordinary expenditures, but over the last few years they have gradually taken over the mandate to provide education.15

Table III.3.

Spanish Regions

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Sources. Boletin Estadistico, Bank of Spain; and Instituto National de Estadistica.

58. The two regions under special regimes (the Basque Country and Navarra) are the most independent, for historical reasons. They are regulated by charters that grant them direct control over a large number of taxes (impuestos concertados), and pay to the central government an amount (cupo) that is intended to cover the cost of services provided by the central government. Traditionally, the charter regions have had powers not only over the collection of a number of taxes that are regulated and collected by the State in common regime regions, but also over setting their rates and conditions. They are currently the only regions with the mandate to collect VAT, “special taxes” (impuestos especiales), i.e., excise taxes on tobacco, alcoholic beverages and gasoline, and corporate income taxes, and with some degree of control over corporate income tax rates.

Decentralization of expenditure responsibilities to the regions

59. The process of decentralization of expenditure responsibilities to the regions has taken place in the context of an increase in the overall size of the public sector. Current expenditure (on a national accounts basis, excluding transfers within the general government) by the regions rose from 1 percent of GDP in 1982 to 4½ percent in 1995; over the same period, expenditure by the social security system also increased significantly, from 15 percent of GDP to 19 percent of GDP, while local government expenditure and central government expenditure rose only by slightly more than ½ percent of GDP each, resulting in an increase in current expenditure by the general government from 32½ percent of GDP in 1982 to over 41 percent in 1995 (Table III.4). Similarly, the number of public employees in the regions rose to more than 630,000 in 1996, while total employment in the public administration increased from slightly more than a million in the late 1970s to 1,970,000 in 1995. While much of the rapid growth in employment by the regions took place in the early and mid-1980s, this pattern persisted in recent years, with public employment rising approximately by 180,000 between 1988 and 1996 in the regions, by 130,000 in the local governments, by 50,000 in the central government (including social security, armed forces, security forces, justice, and universities) (Table III.5). While the growth of public spending as a share of GDP cannot be specifically attributed to the increased role of the regions,16 it is interesting to note that the devolution of spending powers to the regional governments was not accompanied by a corresponding reduction in central government current expenditure.17

Table III.4.

Spain: Revenue and Expenditure by Level of Government 1/

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Source: Bank of Spain, Cuentas Financieras.

On a national accounts basis, before discovery of 1995 overruns.

Excluding transfers within the general government.

Including the State and the central government agencies.

Table III.5.

Spain: Employees in the Public Administration, by Level of Government

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Source: Ministry of Economy and Finance, Boletin estadistico del Registro Central de Personal.

Including social security.

Armed forces, security forces, justice, and universities.

60. In general, increases in the size of the public sector do not necessarily result in a commensurate improvement in the efficiency of public services (Tanzi and Schuknecht, 1995). At the same time, simply observing that the expansion of the role of the regions has coincided with further growth of the overall public sector does not in itself prove duplication of services. Nevertheless, OECD (1993) points out that regional government employment per inhabitant is higher in the regions with low per capita incomes and high unemployment, suggesting that perhaps some regional governments increased the number of their employees as a way of making jobs available in a context of high unemployment.

The role of the regions in fiscal adjustment

61. As already noted, the process of decentralization of expenditures to the regions seems at times to have put a strain on the general government’s finances, notably in the late 1980s and at the beginning of the 1990s, when the deficit of the regional governments reached relatively high levels (peaking at 1½ percent of GDP in 1991), against the background of a sharply increasing share of regional expenditure in total public spending and relatively high investment spending by the regions.18 Since that time, regions have displayed a greater degree of fiscal responsibility, particularly since 1994. The targets of the original 1992 Convergence Program were missed by the regional governments (as well as by other levels of government). The 1994 revised fiscal consolidation agreement envisaged a reduction of the general government deficit by 3.7 percent of GDP between 1994 and 1997, of which 0.7 percentage points was to come from the territorial governments (Table III.6). Thus far, the regions and the local governments appear to have broadly complied with the revised Convergence Program, and have made a notable contribution to the overall adjustment effort.

Table III.6.

Deficit and Public Debt, 1993-97

(In percent of GDP)

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Source: Actualizatión del programa de convergencia, Ministerio de Economía y Hacienda, 1994.

62. The importance of the role of the regional governments in Spain’s efforts to meet the EMU requirements is also apparent when observing recent trends in the debt of the regions. The debt of the regional governments as a share of GDP increased from about 2 percent of GDP in 1990 to near 6 percent in 1995, while the local authorities’ debt remained stable as a share of GDP, and the central government’s debt increased from almost 40 percent of GDP to 55 percent over the same period (Table III.2). From 1997, the regions will acquire considerable powers over the setting of tax rates, with potentially significant implications for the general government deficit. The next sections describe the regional financing system and recent changes in that domain.

C. Sources of Finance for the Subnational Authorities

The basic blocks of the system

63. A large part of the regions’ resources comes from their share in central government revenues (participation in State receipts) (Table III.7), but the regions also collect directly the so-called “ceded taxes” (mainly on property), whose rates and conditions were set by the central government until this year, as well as quantitatively unimportant own taxes, fees, and fines, over which they have almost full control. In addition, they can borrow directly from the markets subject to certain conditions (see below). The regions also receive capital transfers from the central government (including through the Interterritorial Compensation Fund) and the EU, and transfers from the social security system for health and social services. Overall resources available to the regions in 1994 amounted to about 10 percent of GDP (of which almost 1 percentage point consisted of borrowing), having gradually increased from 6 percent of GDP in 1986. The composition of these resources has remained broadly unchanged in recent years, though the regions have used borrowing somewhat more extensively in the 1990s, and the importance of the EU funds in total capital transfers has gradually increased. This section describes in further detail the resources available to the regions, distinguishing between conditional resources, which can only be spent on specific items (typically health or public infrastructure) and unconditional ones.

Table III.7.

Spain: Sources of Finance for the Regions, 1986-94

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Source: Ministerio de Economia y Hacienda, Informe sobre la Financiacion de las Comunidades Autonomas and Desarrollo del Proceso Autonomico en el Periodo 1986-1989.

Excluding Participation of the local authorities in State revenue, which is merely channeled through the regions.

Convenios de Inversion and Contratos-Programa.

Includes transitory compensation in 1990-91.

Transfers to the Comunidades Autonomas Uniprovinciales and for Coste Efectivo.

Conditional resources
  • Transfers for investment, including through the Interterritorial Compensatory Fund (which makes capital transfers to the regions for the financing of infrastructure projects to regions whose per capita incomes are below the national average, and EU funds (such as the European Regional Development Fund).

  • Transfers from the social security system to the regions for the financing of health (INSALUD—Instituto National de la Salud)19 and social programs (INSERSO—Instituto Nacional de Servicios Sociales).

Unconditional resources
  • Participation in State receipts (Participación en los ingresos del Estado—PIE), which is a given share of overall tax revenue collected by the central government.20 For each region, this share is determined at the beginning of every five-year period,21 on the basis of “distributive” variables (population, area, geographical dispersion and—for the islands—distance from the mainland) and “redistributive” variables (per capita income and “fiscal effort”),22 with a view to ensuring that all regions are able to provide their citizens with minimum standards of services.

  • Ceded taxes (tributos cedidos) and taxes for transferred responsibilities (tasas afectas a los servicios traspasados), whose rates were traditionally set by the central government but whose collection is undertaken by the regions. These include taxes on inheritances and donations, wealth, property transactions, legal acts, and gambling. From this year, ceded taxes also include a portion of personal income taxes, and the regions contribute to setting their rates and deductions (see below).

  • Regional governments’ property income, and own taxes, fees and fines, set and collected by the regions themselves (only 1 percent of total sources of finance in 1994).

  • The special regime regions collect a wide range of taxes (tributos concertados), including, in addition to those collected by the common regime regions, the value-added tax, and personal and corporate income taxes.

Borrowing
  • Borrowing by the regions is subject to various legal constraints: (a) the regions must obtain the Central Administration’s approval for all bond issues, and all liabilities in foreign currency, although bonds issued by the regional governments are not guaranteed by the central government; (b) short-term borrowing (with maturities of less than a year) can only be incurred to cover temporary liquidity needs; (c) long-term debt (with maturities of more than one year) can only be issued to finance investment expenditures; and (d) debt service cannot be higher than 25 percent of a region’s current revenues, but this limit has been exceeded at times with no apparent penalties (Monasterio et. al., 1995).

Changes in the PIE: participation in personal income tax revenue

64. Beginning in 1994, the PIE was changed so that it would consist of two components. The first part amounted to 15 percent of personal income tax (Impuesto sobre la Renta de las Personas Fisicas—IRPF) revenue collected in the region. The second part continued to be a share of overall State tax revenue; its initial amount (for 1994) was determined in such a way that total resources for each region were the same as they would have been under the previous system.23 The main consequence of this innovation was to increase the share of a region’s resources that would depend on its own economic performance, though its primary motivation was to prepare the ground for additional co-responsibility in the domain of personal income taxes, which was introduced with the agreement for 1997-2001.

The agreement for regional financing in 1997-2001

65. Until this year, fiscal co-responsibility was confined to the collection of ceded taxes (and, quantitatively much less important, to the setting and collection of own taxes and fees). The recent agreement24 for 1997-2001 constitutes a major innovation, in that for the first time it allows the regions, within limits, to set the rates and deductions over ceded taxes and a portion of the personal income tax base. In 1997, under the new agreement, an additional 15 percent of the IRPF has been ceded to the regions, on which they have powers to vary the rates within a ±1/5 range of the rate set by the central government for the national IRPF. This new “regional personal income tax” is effectively a ceded tax. From now on, tax declarations by Spanish citizens for the IRPF will distinguish between a central government IRPF and a regional government IRPF. To illustrate how the new system operates, it may be useful to consider the case of Ptas 100 that under the previous system would have been subject to a personal income tax rate of—for instance—40 percent (Table III.8).

Table III.8.

Decentralization of Income Taxes—A Numerical Example

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(a) National personal income tax.(b) Participation of the region in personal income tax revenue collected in the region.(c) Regional personal income tax, the exact tax rate to be determined by the individual region within a ±1/5 range of the national rate, as indicated.

66. For 1997, the PIE has three components: (i) the new regional personal income tax, amounting to 15±3 percent of IRPF revenue that would have been collected in the region under the previous system; (ii) the 15 percent of regional IRPF revenue already available in 1994-96, which is transferred to the regions but over which they have no rights to vary the rates; and (iii) the remainder, which was set in such a way that the total resources to each region in 1997 are the same as they would have been under the previous system, and which from now on will simply be a proportion of overall revenue. For the richer regions, IRPF revenue collected on its own residents’ incomes can amount to more than half of total resources from PIE and taxes, but this proportion will be somewhat smaller for regions with lower per capita incomes.

67. From 1998 (or, more precisely, from the time when the regions assume full responsibilities over education), the regions will be able to set the rates also on block (ii). In other words, while in 1997 the regions have the right to set the rates on 15 percent of the personal income tax base and will simply receive another 15 percent of the personal income tax revenue collected in the region, from 1998 they will gain the right to set the rates on the full 30 percent of the personal income tax base that has been ceded to them. From 1998, the PIE will therefore consist of two components: the first will be the regional personal income tax amounting to 30±6 percent of the regional IRPF revenue that would have been collected under the 1993 system; and the remainder will continue to evolve in line with overall state tax revenue.

The system of guarantees

68. In order to protect the regions against possible revenue shortfalls arising from regional shocks, the new system for 1997-2001 includes a set of guarantees that—loosely speaking—compensate the region if its income growth falls below the national average. (Of course, revenue shortfalls arising from a region’s decision to cut tax rates will not be covered.) There are three guarantees, which operate sequentially, as follows.

(1) If Spain’s nominal GDP grows more slowly than IRPF collection at the national level, and a region’s IRPF collection grows more slowly than Spain’s nominal GDP, the central government will make transfers to the region to cover any difference. If Spain’s nominal GDP grows faster than IRPF collection at the national level, but the rate of growth of a given region’s IRPF collection falls below 90 percent of the rate of growth of IRPF collection for all regions, then the central government will make transfers to the region to compensate it for the difference (up to 90 percent of the average growth of IRPF collection for all regions).

(2) If the growth of a region’s total resources (including those from IRPF, PIE, ceded taxes, and other taxes, and those obtained under the first guarantee) falls below 90 percent of the growth of total resources of all regions, then the central government will make transfers to compensate it for the difference (up to 90 percent of the average growth of total resources for all regions).

Transfers arising from guarantees (1) and (2) will be made each year by the central government to the regions affected by a slowdown, with the regions paying back the transfers in subsequent years to the extent that their revenues grow faster than average.

(3) After 1998, there will be a third guarantee: should the level of per capita resources obtained by a given region fall below 90 percent of the national average, there will be transfers from the central government to compensate the region for the difference (up to 90 percent of the national level).25

Transfers arising from this last guarantee will be made at the end of the five-year period.

69. The first two guarantees represent an attempt to protect a region in case its economic performance falls below the national average, whether as a result of short-run fluctuations deriving from region-specific shocks, or as a result of a lower-than-average long-run growth rate. The third guarantee seems to be more closely related to the principles of solidarity among the regions and sufficiency of the resources for the services to be provided, but can also be interpreted as a further safeguard against persistently slow growth in a given region.

70. In sum, the current strategy for decentralization of revenue responsibilities is (a) to let the regions set the rates of ceded taxes and a portion of personal income tax; and (b) to increase the share of a region’s finances that depends on its own personal income tax collection.26 Because the regions are being given more “co-responsibility”, additional coordination and monitoring will be needed in order to achieve fiscal adjustment at the general government level. As a result of the regions’ higher dependence on their own economic performance, there will be more variation in their individual resources, though mitigated to a significant extent by the system of guarantees. The next section focuses on the issue of coordination and monitoring, while Section E addresses the question of the potential variability of resources.

D. Coordination and Monitoring Issues

71. The strategy of decentralizing revenue-raising powers to the regions is predicated on the grounds that it will make them more responsible in their decisions over expenditure. Under the new system, should a region wish to spend more, it would be able to increase taxation on its own residents, bearing the associated political costs.27 The central government will continue to plan and coordinate macroeconomic policy, including through the CPFF’s debt and deficit targets, while the regions would be able within limits to choose the expenditure levels and the tax burden consistent with those targets: regions wishing to provide more services could tax their residents more heavily, and vice versa. However, the viability of this framework rests on the assumption that the regions are faced with a hard budget constraint, i.e., that they are unable to obtain bail-outs from the central government and that they comply with the debt and deficit agreements established in the CPFF.

72. A number of arrangements can help ensure that the regions do not pose a threat to the overall process of fiscal adjustment. As already noted, existing legislation imposes constraints on borrowing, and the CPFF plays a major role in coordinating and monitoring the regions’ policies.

Limits on borrowing and market discipline

73. The legal constraints on borrowing by Spain’s regional and local governments while fairly comprehensive when compared with those of other countries (Ter-Minassian, 1996), on their own do not guarantee success in the process of fiscal adjustment.28 Looking at the various subnational authorities in Spain, there is no obvious relationship between the degree of control over borrowing policies and debt/GDP ratios.29 Also, it remains unclear whether the legal limits on borrowing by the regions are truly binding, and whether in practice there are penalties in case a region does not comply with them. On a number of occasions, the central government denied permission to issue new bonds or borrow in foreign currency to regions that had exceeded the legal 25 percent ratio between debt service and current revenues, or the deficit and debt limits set by the CPFF to comply with the Convergence Program. Nevertheless, it is not clear whether the affected regions had difficulty in continuing to borrow in domestic currency from the banking system.30

74. Some moderating influence on borrowing by the regions may also come from the discipline imposed upon them by financial markets, which may be effective if capital markets are open, information on the borrower’s liabilities is readily available, no bail-out is anticipated, and the borrower responds to market signals (Lane, 1993). These conditions seem to be met: Spain’s capital markets are open; the Bank of Spain regularly publishes information on the debt of the various regional governments, though data on their expenditures, receipts, and deficits is not as timely; the central government does not guarantee bonds issued by the regions; and the regions’ borrowing policies seem to respond to changes in market conditions. However, market discipline on its own is unlikely to be sufficient to induce sound fiscal behavior, and intensified coordination and monitoring at the level of the CPFF is likely to remain a crucial element in ensuring that the general government deficit remains within the agreed limits.31

Convergence agreements and the CPFF

75. In addition to the legal limits, borrowing policies at the subnational level are subordinated to the overall economic policy objectives of the government under the Maastricht Convergence Program, with the coordination taking place within the CPFF. Consistent with that framework, the CPFF sets four-year programs for the debts and deficits of each region, which are signed and monitored on a bilateral basis between the central government and the individual region. For approval of any bond issue, the regions have to present to the central government an annual borrowing plan in line with the agreed program. Compliance with the targets is required at the end of the year. The fact that the spirit of the exercise is to contain the end-of-the-year deficit is helpful, as recent contributions have suggested that end-of-the-year targets are more effective disciplining devices than beginning-of-the-year constraints.32 However, there are (at this point) no penalties for missing the targets.

76. Information on recent and prospective developments in the finances of the various subnational governments during the course of the year is relatively scarce and it would seem desirable to increase its transparency and dissemination.33 One indicator on the fiscal performance of the regions, the stock of debt of the territorial authorities (including the debt for each region), is published monthly by the Bank of Spain and is available on a timely basis, but is still insufficient for thorough monitoring, for two reasons. First, information on the agreed debt targets for each region is not available to the public. Second, in practice the change in the stock of debt is only an approximation of the deficit. The regions are currently required to submit preliminary deficit and debt outturns to the CPFF twice a year, but a table with the outturn for all individual regions, compared with the targets under the Convergence Plan, has never been published. The CPFF is currently discussing the possibility of increasing the frequency (possibly to quarterly) with which the regions provide debt and deficit data to the central government to monitor compliance with the agreed targets, an obviously welcome step. Timely provision of similar statistical information to the general public may also be useful, as it would enable public opinion to be mobilized to ensure that the regional governments comply with the agreements.

77. Moral suasion in the context of the convergence program agreements appears to be a somewhat more binding source of fiscal restraint than the legal borrowing limits, but the evidence on the effectiveness of the debt and deficit reduction agreements also remains somewhat mixed. On the one hand, after the introduction of the Convergence Program regional government debt growth declined, and in 1995, with one exception, all regions apparently maintained their debts within the agreed ceilings (Grupo Analistas, 1996). On the other hand, Monasterio (1996) shows that in recent years there has been considerable variation in the experiences of the 17 regions, with several regions increasing their debt sharply even after the introduction of the Convergence Program (and some even exceeding the limit on the debt service to current revenues ratio, apparently with no penalties).

A “Stability Pact” among the regions?

78. In the context of the CPFF, the Spanish authorities are discussing the possibility of undertaking a domestic “Stability Pact” among the regions, in order to ensure compliance with the fiscal requirements implied by participation in EMU. This would help strengthen the existing coordination of policies among the various branches of government and among the regions. Increased incentives for compliance with the agreements, perhaps through the introduction of penalties for deviations, would also play a useful role. One aspect to be considered in such a pact is whether sufficient allowance is made for the possibility of adverse shocks to output, in order to avoid rendering the regions’ fiscal policies excessively procyclical. The next section describes the variability of incomes in the Spanish regions and concludes that the new system of guarantees will probably provide adequate protection in case of lower-than-average income growth.

E. The Variability of Regional Incomes

79. With the transfer of an increased share of the personal income tax to the regional governments, a larger proportion of a region’s finances has come to depend directly upon that region’s economic performance. As a result, a region’s resources will be subject to higher variation, both because of short-run fluctuations from year to year in income growth compared with those of the country as a whole, and because a given region may have a lower (or higher) income growth rate than the national average over a period of several years. As already noted, a system of guarantees has been set up to serve a risk-pooling role among the regions and help avoid an undesirable increase in the procyclicality of their fiscal policies.

Shocks and the need for guarantees

80. The need for the introduction of a mechanism to protect the regions from variation in their resources becomes very apparent when (i) the variability of deficits in the Spanish regions is compared with that in the EU countries, where cyclical effects were considered sufficiently large to warrant the inclusion of an “escape clause” in the Stability Pact among EMU participants;34 and (ii) the variability of resources in the Spanish regions under the previous system is compared with that of the new system.

Spanish regions and EU countries

81. While the elasticity of expenditures with respect to income is probably somewhat lower in the Spanish regions than in the EU countries, mostly because the regions are not responsible for the provision of unemployment benefits, the elasticity of revenues with respect to income will be considerable in the regions, as in several cases more than one half of their resources now consists of personal income taxes collected from residents.

82. The variability of output in the Spanish regions is relatively high. Over 1981-94, the standard deviation of the real income growth rate of the typical Spanish region35 amounted to 4.0, twice as large as that for the typical EU country (Table III.9).36 Similarly, the standard deviation of the difference between regional and overall Spanish growth amounts to 3.1 for the typical Spanish region, while the standard deviation of the difference between national and overall EU growth amounts to 1.5 for the typical EU country (Table III.10).37 Based upon both of these criteria, the variability of real output growth in the Spanish regions is considerably higher than that in the EU countries, implying a greater need for protection in the former than in the latter. These findings suggest that the introduction of a mechanism to protect the regions from output shocks was warranted.

Table III.9.

European Union Countries and Spanish Regions: Real Output Growth, 1981-1994

(in percent)

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Sources: World Economic Outlook database, IMF; and Contabilidad Regional de Espana, Institute National de Estadistica.

Real GDP growth.

Nominal growth rates of value added minus national gross value added deflator inflation.

Table III.10.

European Union Countries and Spanish Regions: Real Output Growth, Deviations from EU and Spanish Average, 1981-94

(In percent)

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Sources: World Economic Outlook database, IMF; and Contabilidad Regional de Espana, Institute National de Estadistica.

Deviation of real GDP growth rate from the EU average.

Deviation of real growth rate of value added (computed as nominal growth rate of value added minus national gross value added deflator inflation) from the Spanish average.