Based on the economic literature, various policy measures and institutions in the product and labor markets that increase growth and employment are studied. From a cross-country approach, this study finds a significant relationship between Vertical Fiscal Imbalances (VFIs) and fiscal performance in OECD countries. Different measures of vertical imbalance are used. To assess the impact of a vertical gap, a panel equation is estimated that is related to general government primary balance to vertical balance, spending decentralization, covariates, and interaction terms.

Abstract

Based on the economic literature, various policy measures and institutions in the product and labor markets that increase growth and employment are studied. From a cross-country approach, this study finds a significant relationship between Vertical Fiscal Imbalances (VFIs) and fiscal performance in OECD countries. Different measures of vertical imbalance are used. To assess the impact of a vertical gap, a panel equation is estimated that is related to general government primary balance to vertical balance, spending decentralization, covariates, and interaction terms.

III. Decentralizing Spending More Than Revenue: Is It Bad For Fiscal Performance?1

Vertical fiscal imbalances (VFIs) materialize when spending decentralization outpaces revenue decentralization. Based on a cross-country approach, this paper finds a significant and robust negative relationship between VFIs and fiscal performance in OECD countries, especially in the presence of sizeable regional disparities. Italy could benefit from narrowing its VFI but the currently envisaged VFI reduction appears modest and has yet to be turned into an effective increase in sub-national tax autonomy.

A. Introduction

1. Many OECD countries have undertaken fiscal decentralization reforms in recent decades, assigning more expenditure functions and revenue sources to lower levels of governments. The decentralized provision of goods and services is generally intended to better take into account differing local preferences, increase efficiency of public services, and enhance the accountability of sub-national authorities (Oates, 1972).

2. However, the devolution of spending responsibilities has not always gone hand in hand with the devolution of tax revenues, resulting in “vertical fiscal imbalances”. Sub-national authorities have to rely on transfers and, to a lesser extent, on borrowing in order to finance expenditure. This paper uses the concept of “vertical fiscal imbalance” (VFI) to measure the gap between own revenue and spending of sub-national governments.

3. Large vertical imbalances may relax fiscal discipline. Although some level of discrepancy between sub-national own revenues and spending is inevitable and may even be desirable, large gaps present risks. A common view in the normative literature is that a high reliance on intergovernmental transfers or borrowing “softens” the budget constraint of local governments, in particular because the cost of spending is not adequately internalized (Rodden and others, 2003). However, the empirical literature shows conflicting results. Some papers find that intergovernmental transfers improve fiscal performance by strengthening control over sub-national spending (De Mello, 2000).

4. Ensuring a better match of sub-national spending responsibilities with taxing powers is at the core of Italy’s evolving fiscal federalism reform. While the reduction in Italy’s VFI has been among the largest in the OECD countries since 1995, still, about half of sub-national expenditure is financed through transfers. The resulting vertical imbalance remains above the OECD average. The mismatch between local spending and revenues is seen by the Italian authorities as a major cause of the country’s fiscal problems. To this end, reforms are being implemented to phase out most non-equalization intergovernmental transfers and, accordingly, increase sub-national own revenue and shared taxes by 2017. Furthermore, cuts in sub-national transfers are also a key element of the medium-term fiscal consolidation plan adopted by the government in 2010.

5. This paper assesses whether lowering vertical imbalances improves fiscal performance in OECD countries. It presents several elements of novelty. First, it adopts a cross-country approach, in contrast to the prolific case study literature on VFIs. Second, it identifies conditions under which VFIs impact fiscal performance. Third, it analyzes the combined effect of vertical and horizontal imbalances. And lastly, the paper uses an instrumental variable estimation to address the potential endogeneity bias of the VFI in a fiscal performance equation.

6. Our empirical results support the widespread normative view that spending decentralization is not detrimental to fiscal performance when financed through sub-national own revenues and that decreasing vertical imbalances can potentially generate large fiscal gains. A higher reliance on transfers or borrowing reduces the general government balance, other factors being equal. We also find that the negative impact of VFIs is more pronounced when regional disparities are large.

7. The paper is organized as follows. Section B reviews the economic literature on VFI and fiscal performance. Sections C defines and discusses the indicator of VFI applied in Section D to produce stylized facts. Section E uses econometric methods to relate the VFI to fiscal outcomes. Section F discusses aspects of Italy’s fiscal decentralization process and draws implications for Italy from the econometric analysis. Section G concludes.

B. Vertical Fiscal Imbalance and Fiscal Performance

8. A vertical imbalance exists when there is a gap between own spending (total spending minus transfers paid) and own revenues (total revenues minus transfers received) at a given level of government.2 There is no consensus on the specific definition of the vertical imbalance. Most studies use interchangeably the terms “vertical fiscal imbalance”, “vertical fiscal gap” (VFG) or “transfer dependency”. Researchers generally apply the VFI concept to sub-national governments; but gaps can also materialize at the central level. 3 Furthermore, VFI and decentralization are closely related: when new spending responsibilities assigned to sub-national governments are not matched with additional revenue autonomy, their financing needs have to be met by higher transfers from the center (and/or higher borrowing).

9. The normative literature generally emphasizes the risks associated with large vertical imbalances. A common view is that the vertical structure of the public sector may “soften” the budget constraints of sub-national governments, lead them to overspend, and lower their tax effort—mainly because they do not fully internalize the cost of spending and/or anticipate that their financing gap will be covered by additional transfers. The lack of discipline of local governments may spill over to the center if the latter is pressed to bail out sub-national authorities. VFIs may thus lead to excessive and unproductive spending, inefficient revenue mobilization, higher borrowing costs, and lower accountability of local authorities. Conversely allowing sub-national governments to access own revenue through local taxation is seen as essential to promoting fiscal discipline (Oates, 2006; IMF, 2009; Blöchliger and Petzold, 2009).

10. However, closing the vertical gap is not always feasible or even beneficial. As the optimal degree of decentralization is generally larger on the spending than on the revenue side, sub-national authorities have often no choice but to rely on transfers and borrowing to bridge the financing gap. In addition, transfers may be warranted on efficiency and equity grounds with a view to: better controlling sub-national spending, providing insurance to local authorities against external shocks, internalizing inter-jurisdictional spillovers, or pursing redistributive/equalization objectives (Box 1).

Cost-Benefit Analysis of Vertical Imbalances in the Theoretical Literature

Reliance on transfers or borrowing may undermine the fiscal discipline of local governments for the following reasons:

  • Common pool effect. When financed through transfers, sub-national governments do not internalize the full cost of local expenditure and tend to overspend/lower their tax effort.

  • Soft budget constraint. Sub-national governments carry out looser policies when they anticipate transfer-based bailouts by higher-level authorities.

  • Soft financing. Access to borrowing should not contribute to chronic deficits if the market imposes discipline. But in practice, sub-national governments often resort to “soft” financing (by borrowing from public banks or from state-owned enterprises, for instance), which results in another form of soft budget constraint/quasi-bailout (Oates, 2006).

  • Governance and accountability. Discretionary grants are prone to undue sub-national influence or interest. In addition, local authorities are less accountable when they do not have to tax their constituency.

  • Vertical spillovers. Local borrowing and transfer dependency may affect the central government performance by: crowding out available financing and putting upward pressure on interest rates; pushing up risk premia on government bonds; or through the cost of bailouts (IMF, 2009).

  • Grant design. For instance, many grants have a matching dimension, with grant allocation increasing when sub-national governments spend more on the matched service.

However, some degree of vertical imbalance is inevitable. The degree of spending decentralization called for by efficiency considerations tends to exceed the degree of tax autonomy that would be consistent with optimal tax assignment (Ter-Minassian, 1997 a):

  • Tax centralization. Only a few tax bases are best suited for local management—those that are immobile, evenly distributed geographically and that generate stable revenues, whereas nationwide taxes have fewer distortionary effects on flows of mobile resources, and permit a higher degree of progressivity (Joumard and Kongsrud 2003; Ter-Minassian, 1997 b; Norregaard, 1997; and McLure and Martinez-Vasquez, 2000).

  • Spending decentralization. The scope to increase sub-national spending on efficiency grounds is larger. According to Oates’ Decentralization theorem (1972), decentralized provision is at least as efficient as central government provision, efficiency requiring that diversity of preferences be matched with diversity in public good and service provision. In addition, sub-national governments face competitive pressures to attract mobile residents, resulting in more efficient provision of public goods.

  • Capacity constraints. Tax devolution is limited by the lower tax administration capacity of local governments and diseconomies of scale in tax administration (Ter-Minassian, 1997 b). More generally, the quality of bureaucracies is usually lower at the sub-national level.

Vertical imbalances may even be desirable in some cases.

  • Control over local spending. Curtailing transfers may be used by central governments to constrain sub-national spending and, as such, could improve fiscal performance. More generally, stabilization and adjustment policies conducted by the center may be undermined if a large share of taxes and spending is devolved to sub-national governments.

  • Insurance against external shocks. When sub-central governments come under fiscal pressure that has purely external origins, the center should provide assistance through transfers.

  • Redistribution. Equalization grants are needed to transfer resources to poorer regions and correct horizontal imbalances (revenue-raising capacity disparities). In addition, sub-national governments are often given responsibility for implementing national programs meant to be provided equally across regions (although intergovernmental grants are not the most efficient instrument to achieve interpersonal redistribution objectives).

  • Internalize horizontal (inter-jurisdictional) externalities. Matching grants may provide incentives for lower level governments to invest in public goods that have positive spillover effects into other jurisdictions.

  • Internalize vertical (intergovernmental) externalities. Grants may be used to limit the negative implications of under-spending at the local level (on primary and secondary education, for instance) on central government spending (on tertiary education).

11. The empirical literature on vertical imbalances is abundant but mostly draws on case studies. Most papers are country-specific, while cross-country work is scarce and relatively recent, focusing on OECD countries. The literature is particularly rich for Australia, Canada, Germany, and Italy. However, case studies rarely relate VFIs to fiscal performance.

12. Cross-country papers find that large vertical imbalances are generally associated with worse fiscal performance.4 A vast econometric literature on the “flypaper-effect” tests the impact of intergovernmental transfers on local spending (Gamkhar and Shah, 2007). In contrast, fewer papers relate vertical imbalances to fiscal performance. Rodden (2002) provides evidence that higher reliance on intergovernmental transfers worsens the general government overall balance, especially when sub-national governments have high borrowing autonomy. Similarly, Plekhanov and Singh (2007), find that the rules constraining sub-national borrowing improve fiscal performance when transfer dependency is high. In a sample of federations, Rodden and Wibbels (2009), show that transfer dependency is associated with larger fiscal deficits, the negative impact being larger at high levels of decentralization. Jin and Zou (2001) find that transfers increase the size of the government, at the sub-national, national, and general government levels. Fornasari (2000) also demonstrates that sub-national spending funded by transfers is additional to central government spending, not a substitute. Finally, transfer growth may become endogenous, with deficits bringing about more grants, which in turn generate higher deficits, according to De Mello (2007).

13. However, the empirical literature is not consensual. According to De Mello (2000), transfer dependency only deteriorates the fiscal position of the central government in non-OECD countries, while the opposite result is found in OECD countries. His interpretation is that, in the OECD sample, transfer dependency measures the ability of central governments to control sub-national finances rather than indicates common pool problems. This result is consistent with the findings of the comparative literature on successful fiscal consolidations. Based on a sample of OECD countries, Darby and others (2005), show that central governments exert a strong influence on the expenditure of sub-central tiers through their grant allocations; changes in transfers “force the hand” of sub-national governments to adjust expenditure and have a positive impact on the duration of consolidation attempts.

C. Measuring Vertical Fiscal Imbalances

14. Different measures of vertical imbalances are used in the empirical literature. Transfer dependency is the most common indicator with transfers measured either as a share of sub-national spending (Jin and Zou, 2002), or as a share of sub-national total revenues (Rodden, 2002; Baskaran, 2010), or even as a share of central government revenues (Bahl and Wallace, 2007). Some papers measure VFI as the difference between own revenues and own spending rather than the ratio, bringing the concept closer to a fiscal balance (Bird and Tarasov, 2004). Others distinguish between “vertical gap” and “vertical imbalance”.5

15. We define the vertical imbalance as the share of sub-national own spending not financed through own revenues, as Ahmad and Craig (1997), or Shroeder and Smoke (2002). By definition, the counterparts of the VFI are sub-national borrowing and transfers received from other units of general government—both expressed as shares of sub-national own spending (Box 2). In contrast to most of the literature focusing on transfer dependency, our measure of VFI also includes borrowing. There is a strong case for combining transfer and borrowing—two forms of “soft” financing—whereas “own revenues” are more likely to “harden” the budget constraint. Sub-national governments have generally less autonomy over transfers and borrowing, and fewer incentives to use them efficiently (Box 1).6

16. Our vertical imbalance measure presents a number of advantages. First, it extends the concept of “transfer dependency” to sub-national borrowing, which is another “soft” resource (see above). In addition, borrowing is an important contributor to VFI dynamics, as shown in Section D (Fact 2). Second, our indicator measures the mismatch between spending and revenue decentralizations; it widens when countries devolve more spending than revenue. Third, the VFI also varies with changes in the general government overall balance (Box 2). Intuitively, the general government balance term describes the size of the revenue and spending “pies” to be shared among levels of government, whereas the decentralization terms determine the sharing formulae.

17. Owing to data constraints, our VFI measure cannot be easily refined. Its main shortcoming—common to other empirical studies—is that it is an imperfect indicator of the fiscal autonomy of sub-national governments. Several studies (Blöchliger and others, 2006; and Rodden, 2002), show that “own revenues” do not measure accurately the discretion of sub-national governments over their resources in part because tax sharing arrangements are sometimes recorded under taxes. Also, sub-national governments may be given only restricted discretion concerning tax rates/bases. A similar issue arises on the spending side, with much sub-national spending being regulated, mandated or earmarked (Bach, 2009). On the revenue side, this issue cannot be easily addressed as databases do not report separately tax sharing arrangements. This said the magnitude of the problem should not be overplayed: shared taxes are only sizeable in some countries (usually federal ones) and account on average for less than 20 percent of sub-national revenues (Blöchliger and King, 2006). Another problem is that our VFI indicator is based on actual spending and revenues, which may differ from assigned responsibilities owing to cyclical factors, administrative and capacity constraints, or simply the willingness of sub-national governments to use the powers assigned to them.

Vertical Fiscal Imbalance: Definition and Accounting Determinants

We define the VFI as:

VFI=1SNGownrevenueSNGownspending

The vertical imbalance is covered by sub-national borrowing and transfers from the center.

As SNG spending = SNG own revenue + transfer received by SNG + SNG net borrowing and

SNG spending = SNG own spending + transfer paid by SNG, then:

VFI = Transfer dependency + SNG deficit

where:

Transferdependency=NettransferSNGownspending
SNGdeficit=SNGnetborrowingSNGownspending

The vertical imbalance depends on the mismatch between revenue and spending decentralization (and the size of the general government deficit).

VFI=1revenuedecentralizationspendingdecentralization*(1GGdeficit)

where:

Revenuedecentralization=SNGownrevenueGGrevenue
Spendingdecentralization=SNGownspendingGGspending
GGdeficit=GGspendingGGrevenueGGspending

18. This paper focuses on vertical rather than horizontal imbalances. In contrast to “horizontal fiscal imbalances” (HFIs),7 VFIs measure differences in spending and revenue between levels of government, not across sub-national entities. However, VFI and HFI cannot always be clearly separated (Bird and Tarasov, 2004). For instance, vertical balance can be achieved for the richest sub-national government (balancing own expenditure and own revenues) but not for the other sub-national governments when they are regional disparities (HFIs). Another problem relates to vertical equalization: vertical transfers include equalization grants whose purpose is to reduce income disparities across sub-national jurisdictions; this implies that, in general, measures of VFI also capture HFI.

D. Some Stylized Facts on Vertical Imbalances

19. This section presents stylized facts on vertical fiscal imbalances, their evolution overtime, the dispersion across country, and their relation to fiscal performance. We use data from the OECD General Government Accounts database (OECD, 2010) covering the years 1995–2007. We exclude 2008 and 2009, as the financial crisis likely disrupted the intergovernmental relations, creating breaks in the series.

  • Fact 1. The financing of sub-national spending varies greatly across countries, resulting in sizeable differences in vertical imbalances. The VFIs average about 40 percent over the sample between 1995 and 2007. However, VFIs present a large dispersion, varying from 13 percent in Iceland to 83 percent in Mexico. Italy’s vertical imbalance—at 47 percent—is above average, but still moderate compared to the most imbalanced countries (Figure 1, upper chart). From an accounting point of view, this heterogeneity is mostly related to the dispersion of sub-national expenditures across countries rather than to that of transfers and borrowing (Figure 1, lower chart)—the standard deviation being twice higher in the former case. Charbit and Goodspeed (2009), show that differences in the tax-transfer balance reflect country-specific structural factors, including the role of sub-national governments as providers of national public goods and services (health), regional imbalances, differences in externalities, historical circumstances, collective preferences, and institutional features (in particular the constitution).

  • Fact 2. Although vertical imbalances are mostly covered by transfers, sub-national borrowing is essential to understanding the change in vertical imbalances overtime. On average, sub-national spending is almost entirely financed by transfers (Figure 2, upper chart). In the sample, the share of sub-national borrowing has been close to zero over the period, local authorities being usually constrained to borrow either by administrative procedures, explicit rules, financial market discipline, or cooperative arrangements (Plekhanov and Singh, 2007). However, the effect of borrowing should not be overlooked, as its contribution to the change in VFIs over the period is not negligible: between 1995 and 2007, the change in borrowing was of comparable magnitude to the change in transfers8 (Figure 2, lower chart). In other words, sub-national borrowing is low on average but very volatile, which explains its relatively high contribution.9 This result suggests that measuring vertical gaps with “transfer dependency”—as it is done in many empirical papers—can be misleading for some countries.

  • Fact 3. Vertical fiscal imbalances have decreased overtime. Between 1995 and 2007, the VFIs decreased in most countries, with an average change of about -2.5 percent of sub-national own spending. This feature is particularly striking in Italy, where a strong devolution of revenue responsibilities contributed to lower the reliance of sub-national governments on transfers. This result contrasts with the common view that vertical gaps are supposedly increasing in most countries driven by the mismatch of spending and revenue decentralizations. In fact, these two findings are not contradictory. Figure 3 shows average contributions to the annual changes in the VFIs (Box 3). The fact that spending decentralization outpaced revenue decentralization did widen the VFIs on average; however, this was more than offset by the improvement in the general government balance over the period. In other words, sub-national governments received a larger share of general government spending responsibilities without getting an equivalent share of taxes over the period; nonetheless the VFIs narrowed because general government spending increased less than total revenues on average.10

Figure 1.
Figure 1.

Vertical Fiscal Imbalance, Sub-national Own Revenue and Expenditure

(Percent of sub-national own expenditure, unless otherwise indicated; average over 1995–2007)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A003

Sources: OECD; and IMF staff estimates.1/Vertical fiscal imbalance is defined as the share of sub-national own spending (excluding transfers paid) notfinanced through own revenue (excluding transfers received).2/Percent of GDP.
Figure 2.
Figure 2.

Vertical Fiscal Imbalance: Level and Change 1/

(Percent of sub-national own expenditure)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A003

Sources: OECD; and IMF staff estimates.1/ Vertical fiscal imbalance is defined asthe share of sub-national own spending (excluding transfers paid) notfinanced through own revenue (excluding transfers received).2/Percentage points of sub-national own expenditure.
Figure 3.
Figure 3.

Breakdown of the Annual Change in Vertical Fiscal Imbalances

(Average over the period of 1995-2007; percentage points)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A003

Sources: OECD; and IMF staff estimates.1/Negative values = Increase in revenue decentralization;2/Positive values= Increase in expenditure decentralization;3/Negative values = Improvementin general government overall balance.

Contributions to the Change in the Vertical Fiscal Imbalance

According to Box 2:

1VFI=revenuedecentralizationspendingdecentralization*(1GGdeficit)

Taking the logarithm of this expression and then the first difference, and using the approximation ln(1x)x, we compute the contributions of the three variables to the change in the VFI:

dVFI ≈ dln(spend.decentralization)—dln(rev.decentralization) + d(GG deficit)

Changes in the VFI reflect the impact of two factors: the mismatch between spending and revenue decentralizations, and the changes in general government deficits. This accounting decomposition has also an economic interpretation, as the two terms are relatively independent: the growth differential between spending and revenue decentralizations is a structural institutional feature, which can be considered as given when decisions related to the annual overall deficit are made. Intuitively, countries first agree on how to share the spending and revenue pies between levels of government before determining the size of these pies.

  • Fact 4. There is no evidence that revenue decentralization succeeds expenditure decentralization in the short run. The conventional wisdom of “finance-follows-function” suggests that devolution on the spending side would lead that on the revenue side. However, country experience often points to a reverse sequencing because: revenue devolution is easier to implement (more attractive for local governments; less resistance at the center to transfer expenditure functions after the funds have been devolved; easier to design tax-transfer system reforms) while assigning expenditure responsibilities is more politically driven with less well-established assignment rules (Bahl and Martinez-Vazquez, 2006). In our sample, bivariate Granger causality tests (for levels of the degree of decentralization, in logarithm) suggest diverse patterns of relationship between spending and revenue decentralization (Table 1). There seems to be limited support to the “finance-follows-function” rule (lower-left section of Table 1). In most countries, we either find the opposite causality, bi-causality, or no causality. However, Granger tests can only detect short-term sequencing, as lag length is restricted to three years by the data.

  • Fact 5. Large vertical imbalances are associated with worst fiscal performance. Consistent with the literature, the higher the VFI, the lower the fiscal balance of the general government (Figure 4, upper-left). While sub-national budgets are generally close to balance regardless of whether they rely on transfers or own revenues11, fiscal performance at the national level (central plus social security) deteriorates slightly at higher levels of VFI (Figure 4, upper-right). One explanation could be that large VFIs relax the fiscal discipline of sub-national governments, forcing central governments to bail them out. However, this hypothesis is questioned by the negative correlation between sub-national spending and VFI (Figure 4, lower-right)—a somewhat unexpected result that seems to contradict the findings of the “flypaper-effect” literature. We also find a negative correlation between VFI and overall balance when both series are in first difference, suggesting that the speed at which the VFI varies also matters (results are not reported here).

Table 1:

Granger Non-Causality Test Results

article image
Notes:1/ Decentralization variables in logarithms; lags=3.2/ X=>Y: XGranger-causes Y; X≠>Y: X does not Granger-cause Y.3/ Significant at least at 10 percent significance level.
Figure 4.
Figure 4.

Fiscal Performance and Vertical Fiscal Imbalance 1/

(Percent; average over 1995–2007) 2/

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A003

Sources: OECD; and IMF staff estimates.1/ Vertical fiscal imbalance is defined as the share of sub-national own spending (excluding transfers paid) notfinanced through own revenue (excluding transfers received).2/ Fiscal performance variables are in percent of GDP; vertical fiscal imbalance is in percent of sub-national own expenditure.3/National government includes central government and social securityfunds.4/GG = General government; NG= National government; and SNG= Sub-national government.

E. Econometric Evidence

Model Specification

20. To assess the impact of vertical gaps on fiscal performance, we estimate a panel equation relating the general government primary balance to the vertical imbalance, spending decentralization, covariates, and interaction terms. Our purpose is not to model a full-fledged fiscal policy reaction function but to estimate the partial effect of VFI. We apply the following specification to a sample of 27 OECD countries over 1969–2007 (sample period varies across countries, see Appendix 1, Table 1A):

PBit=α×VFIit+β×Decentralizationit+Xit×δ+φi+τt+ɛit(1)

where the indices: i and t denote countries and years, respectively; PBit is the primary balance of the general government as a share of GDP; VFIit is the vertical fiscal imbalance (defined in Section C but we also use “transfer dependency” in the robustness checks); Decentralizationit is spending decentralization (sub-national own expenditure as a share of general government expenditure); Xit denotes control variables; Φi represents country-specific fixed effects; τt time dummies; and εit is a time- and country-specific error term. The dependent variable is the headline (unadjusted) rather than the structural balance in order to capture cyclical effects of VFI (consistent with the literature on transfer pro-cyclicality; Rodden, 2009). The inclusion of the output gap in the equation guarantees that direct effects of the cycle are taken into account. We tested the significance of a large set of covariates including: government debt, the output gap, political variables (including federal/unitary state structure), governance indicators, measures of regional disparities (income and unemployment), borrowing constraints, GDP per capita, trade openness, inflation, and demographic variables as well as multiplicative terms (to assess whether the impact of VFI is conditional on the covariates).12 These variables are described in Table 2A, in Appendix 1.

21. Two relationships are of particular interest. They can be explored within model (1) by using multiple regression analysis in order to interpret the coefficients alpha and beta “other factors being equal”. We expect a negative alpha and a positive beta based on the results of the economic literature and the stylized facts:

  • Effect of changing the sub-national financing mix: The coefficient alpha measures the impact of VFI keeping spending decentralization constant. Thus, alpha assesses the effect of a shift in the structure of sub-national financing—from own revenues to transfer/borrowing—within a given envelope of sub-national spending (as a share of general government spending).

  • Effect of own-revenue financed spending decentralization: The coefficient beta has a more dynamic interpretation. It evaluates the effect of increasing spending decentralization while keeping VFI constant; beta therefore measures the impact of spending decentralization financed through own revenues.13

22. We intentionally did not include the revenue decentralization in the equation. As shown in Box 3, when spending and revenue decentralizations are kept constant, a direct accounting relation relates VFI to the fiscal deficit. A regression including all three variables would capture an artificial correlation between VFIs and fiscal performance, other factors being equal.

A03ufig12

Potential Fiscal Gains from VFI Reduction 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A003

Source: IMF staff estimates.1/ Assumes a reduction in VFI from its 2007 level to the average VFI of the three countries with the smallest VFI (DE, IS, CH). Estimated elasticity of 0.08 is used to derive the impactof VFI reduction on the general governmentprimarybalance.

Main Results

23. As expected, vertical imbalances negatively affect fiscal performance, while spending decentralization financed from own revenues has a positive effect (Table 2). Beta is positive and strongly significant in all equations. The impact of the VFI is negative (in the equations with interaction terms, the effect of VFI should be assessed by summing alpha and the coefficients of interactive terms for different values of the covariates). Depending on the specification, the estimated elasticity of the VFI ranges from 0.08 to 0.18, suggesting that a one percent increase in the VFI deteriorates the general government primary balance by 0.1–0.2 percentage points of GDP. Including regional income disparities (HFI) in the equation reduces this elasticity to 0.08 (Table 2, columns 6–7), suggesting that other specifications may suffer from omitted variable bias.14 We also find a lower estimate in the instrumental variable specifications discussed below.15 Based on these estimates, the text figure reports the fiscal gain that countries can expect from reducing their current VFI to that of the least imbalanced countries of the sample.

Table 2.

Vertical Fiscal Imbalance and Fiscal Performance

(Dependent variable: General government primary balance, percent of GDP)

article image
Source: IMF staff estimates.Notes: Annual data over 1969-2007 (sample period varies, see Appendix 1); fixed-effects estimation; t-statistics in parentheses; ***(**, *) = significant at the 1 (5, 10) percent level; T1997-T2000 time fixed effects. See Appendix 1 for the definitions and sources of variables.

Changes in the magnitude and sign of estimated coefficients do not reflect instability of relations; total effect should also take into account interaction terms.

One country fixed effect is excluded from equations.

Combined effect of VFI = (i) VFI coefficient if no interaction term; (ii) VFI coefficient + interaction term coeffiecient(s) at average value of the interacted covariate(s) when significant.

24. The estimated coefficients of other covariates are consistent with priors. The debt coefficient is positive, suggesting that fiscal policy incorporates debt sustainability constraints. The output gap (deviation of the actual from potential GDP) has a positive effect, suggesting that fiscal policy is on average countercyclical in the sample. Governance (rule of law) improves fiscal performance, while a presence of large regional income disparities deteriorates fiscal performance. Finally, more trade openness is associated with better fiscal outcomes, reflecting the disciplinary effect of a larger market exposure.

25. We find some limited evidence that the effect of vertical imbalances is conditional, in particular on the size of horizontal imbalances. Our estimations show that the effect of VFI is more negative in times of legislative elections (Table 2, column 5), or when sub-national borrowing autonomy is large, consistent with Rodden (2002) (Table 2, column 5), or when regional disparities are sizeable (Table 3, columns 7–8). The latter result is interesting, as it suggests that VFIs and HFIs interact with each other and that their combination could be particularly detrimental to fiscal performance, likely because HFIs aggravate soft budget constraints and bailout anticipations. This result also implies that decreasing VFI has a larger impact on fiscal performance in countries, like Italy, with high HFIs. However, we could not find a general specification including more than two interaction terms, either because they significantly reduce the sample size (for instance, HFIs), or because of potential collineratity problems (between covariates, or between VFI and the interaction terms). We also have some reservations about including the interaction term of spending decentralization and VFI, as it is done in many empirical papers. By construction, this variable is the share of the VFI in general government expenditure, which is highly correlated with the VFI and artificially reduces the statistical significance of the latter variable (Table 2, column 4).

Table 3.

Vertical Fiscal Imbalance and Fiscal Performance: Selected Robustness Checks

(Dependent variable: General government primary balance, percent of GDP)

article image
Source: IMF staff estimates.Notes: Annual data over 1969-2007 (sample period varies, see Appendix 1); fixed-effects estimation; t-statistics in parentheses; ***(**, *) = significant at the 1 (5, 10) percent level; T1997-T2000 time fixed effects. See Appendix 1 for the definitions and sources of variables.

Changes in the magnitude and sign of estimated coefficients do not reflect instability of relations; total effect should also take into account interaction terms.

One country fixed effect is excluded from equations.

Combined effect of VFI = (i) VFI coefficient if no interaction term; (ii) VFI coefficient + interaction term coefficient(s) at average value of the interacted covariate(s) when significant.

Robustness Analysis

26. Sensitivity tests confirm the robustness of the results.16 First, to control for the stability of the relation and the existence of possible outliers, we estimate the equation over sub-samples or exclude one country at a time. Results remain broadly unchanged. Second, removing time dummies does not significantly affect the estimates. Country-specific fixed effects, on the contrary, should not be excluded, as indicated by Hausman tests. Third, we examine whether the response of the overall balance to the VFI is asymmetric—a result emphasized by the empirical literature on transfers and spending (Gamkhar and Shah, 2007). To do so, we estimate the equation on two sub-samples depending on whether the VFI increased or decreased overtime; results were not significantly different, suggesting that the response is broadly symmetric. Third, to check that the empirical correlation between decentralization and VFI does not alter the results, we exclude the former from the equation and note that the VFI coefficient does not change materially. Finally, we re-estimate our equation with two alternative measures of the VFI (Table 3): the vertical gap as a share of general government (rather than sub-national) spending (columns 1–3) and transfer dependency, defined as the share of net transfers received by sub-national government in sub-national own expenditure (columns 4–6). Our estimates are generally not altered. The signs of the VFI and spending decentralization coefficients remain the same, and the estimated elasticity of transfer dependency is very close to that of the VFI.

27. We use instrumental variables to correct for the potential endogeneity of the vertical imbalance variable (Table 3, columns 7–8). VFI may be endogenous with regards to the fiscal balance for several reasons: First, the general government balance and the VFI are related through an accounting relation (Box 2). Second, some unobserved omitted variable such as governance could explain both variables (although this bias is likely to be corrected by the fixed effect estimation). Third, the design of some transfers—matching grants, in particular—entails that spending and transfers are simultaneously determined (Gamkhar and Shah, 2007). Fourth, when transfers are used to bail-out sub-national governments that overspent, a reverse causality goes from fiscal performance to transfers. In order to correct for the potential endogeneity bias, we look for instrumental variables, which should be time-variant (the first stage is a fixed-effects estimation), correlated with the VFI but indirectly related to fiscal performance. Five variables ended up being exogenous, economically relevant and statistically significant in the first stage:17

  • The share of sub-national health spending in national health spending reflects the role of sub-national governments in the delivery of public goods and services—a determining factor of the tax-grant balance across countries, according to Charbit and Goodspeed (2009). The distribution of competencies between levels of government is unlikely to have a direct effect on fiscal performance, but it impacts the financing mix of sub-national governments: when large social spending responsibilities are transferred to sub-national governments, more transfers from the center are generally needed given that the scope to raise revenues from local taxation is often limited.

  • The fiscal autonomy indicator of Hooghe and others (2010) measures the extent to which the legal framework gives regional governments a free hand to tax its population. This factor reduces the need for transfers without being directly related to the overall fiscal balance.

  • The population size also affects the reliance on transfers, as large countries generally have to decentralize spending without being able to give equivalent tax responsibilities to sub-national authorities.

  • The old-age dependency ratio increases the reliance on transfers, when sub-national governments are responsible for a large share of social spending.18

  • The lag of the VFI is also used as an instrument, as fiscal performance may impact current but not past VFI.

The two-stage least-squares model reports an estimated coefficient of alpha close to the lower bound of the fixed-effect specifications (0.07–0.13), consistent with the econometric theory.19

28. Lastly, we run the equation separately on general government spending and revenue to determine whether the negative impact of vertical imbalances is channeled through higher spending or a lower tax effort. Results are reported in Table 4, where we include also some more traditional determinants of government size (columns 3 and 6). We find that the vertical gap increases primary expenditure and decreases revenue but the second effect is slightly stronger. The latter observation is somewhat surprising given that the literature tends to emphasize the spending side (with the “flypaper effect”, for instance). The conditional effects of VFI are significant only in the expenditure equation.

Table 4.

Vertical Fiscal Imbalance, Government Expenditure, and Government Revenue

(Dependent variables are in percent of GDP)

article image
Source: IMF staff estimates.Notes: Annual data over 1969–2007 (sample period varies, see Appendix 1); fixed-effects estimation; t-statistics in parentheses; ***(**, *) = significant at the 1 (5, 10) percent level; T1997-T2001 time fixed effects. See Appendix 1 for the definitions and sources of variables.

Changes in the magnitude and sign of estimated coefficients do not reflect instability of relations; total effect should also take into account interaction terms.

One country fixed effect is excluded from equations.

Combined effect of VFI = (i) VFI coefficient if no interaction term; (ii) VFI coefficient + interaction term coefficient(s) at average value of the interacted covariate(s) when significant.

F. Fiscal Federalism Reform in Italy: Straightening the “Crooked Tree” of Italy’s Public Finances20

Background

31. The paths of fiscal decentralization and fiscal adjustment cross again at the current juncture of Italy’s economic history. On the one hand, the long-lasting process to deepen fiscal decentralization is gaining impetus in the context of the implementation of the 2009 fiscal federalism framework law. On the other hand, as in most advanced and particularly euro-area economies, strengthening the fiscal position and lowering public debt have become a focus of Italy’s economic policy in the aftermath of the recent global financial and sovereign debt crises. Both central and sub-national governments are expected to contribute to the consolidation effort—about one-third of the authorities’ 1.5 percent of GDP fiscal adjustment over 2011–2012 is to come from cuts in transfers to sub-national governments.

32. Italy’s vertical fiscal imbalance remains high, despite a large reduction since the early 1990s. Expenditure and revenue shares assigned to sub-national governments increased since mid-1990s, though the trend reversed somewhat more recently (Figure 5). In 2005–2009, expenditure (half of the former, on health), while sub-national revenue was less than one-fifth of the general government revenue (Figure 6). Decentralization reforms succeeded to reduce Italy’s VFI from over 60 percent in 1995 to about 40 percent in 2007—one of the largest reductions among the OECD countries (see Section D); still it remained above the OECD average and increased in 2008-2009. The effective taxing power of sub-national governments also remained low (Blöchliger and Rabesona, 2009).21

Figure 5.
Figure 5.

Italy: Fiscal Decentralization and Vertical Imbalance, 1980–2009

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A003

Sources: OECD; and IMF staff calculations.1/ Share of sub-national expenditure (excluding transfers paid) in general government expenditure.2/ Share of sub-national own revenue (excluding transfers received)in general government revenue.3/ Vertical fiscal imbalance is defined as the share of sub-national own expenditure financed with sources other than own revenue (i.e., transfers and borrowing).
Figure 6.
Figure 6.

Italy: General Government Expenditure and Revenue by Sub-Sectors, 2005–2009

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A003

Sources: ISTAT (Conti economici delle Amministrazioni pubbliche);and IMF staff calculations.Note: For all sub-sectors, expenditureand revenue are net of transfers to other public entities. Interest expenditure is included.

33. The impact of past decentralization reforms on fiscal performance is difficult to assess. The devolution of health and other expenditure in the 1970s in the context of a highly centralized tax system was detrimental to fiscal discipline (Ambrosanio and others, 2010), making Italy’s case an epitome of the type of problems that a mismatch between spending decentralization and fiscal autonomy could create (Darby and others, 2003). Subsequent major revenue decentralization reforms took place during the ERM crisis (1992) and in the run-up to the euro adoption (1997–1998), making it complicated to disentangle the decentralization impact. Figure 7 documents fiscal developments around the 1992, and the 1997–1998 decentralization reforms. In particular, in the years following the introduction of the IRAP (regional tax on company value added) and the personal income tax surcharge for sub-national governments—which resulted in the large VFI reduction in late 1990s—tax burden and general government expenditure declined, but the overall sub-national government balance worsened, and the fiscal effort (structural primary balance) weakened.22

Figure 7.
Figure 7.

Italy: Fiscal Developments around Selected Major Decentralization Events

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2011, 176; 10.5089/9781462301201.002.A003

Sources: WEO; OECD; ISTAT; and IMF staff estimates.Major fiscal decentralization events referred to in the main text and charts:1978: Decentralization of health expenditure (not shown as complete fiscal series are not available for pre-1980 period).1992: Health contributions and automobile taxes are attributed to regions; ICI (property tax) is attributed to municipalities.1997: IRAP (a new tax on productive activities)is introduced and assigned to regions.1998:A surcharge on personal income tax, IRPEF, is introduced (0.5 percentage points) for regions and municipalities.

Recent reforms: from “derived” to own-source financing

34. Addressing the mismatch between sub-national spending responsibilities and taxing powers is a main focus of the ongoing fiscal federalism reform. The authorities see the VFI as a key distortion in Italy’s public finances that has resulted in such problems as: poor quality and inefficiency of public expenditure, especially in the South; proliferation of extra-budgetary activities at the sub-national level; and an increase in VAT sharing which has become a negotiated transfer to cover ex-post health expenditure overruns. To this end, the new decentralized financing model, to be in effect by 2017, envisages nearly complete revenue autonomy for sub-national governments, complemented primarily with shared taxes and equalization transfers.

35. The recent decrees on municipal and regional federalism aim at increasing sub-national tax autonomy. The main principle is to replace central transfers with own taxes (“fiscalizzazione”) while providing also incentives to sub-national governments to enhance their revenue effort (Box 4). The envisaged increase in tax autonomy appears to be modest, at least in the immediate future. Until 2014, municipalities will receive transfers from an experimental equalization fund which will be financed with the taxes to be attributed to municipalities. Primary residence—a key tax base for municipalities—will remain exempted. For regions, the reform increases only marginally tax autonomy, maintaining a strict control of the center.

Municipal and Regional Financing Reform: Some Highlights

  • Municipal financing reform (in effect since April 7, 2011) envisages a substitution of about €11 billion central transfers with own-source revenues and tax-sharing arrangements, including VAT and a flat tax on rental income. The tax system will be simplified, and after 2014, the existing taxes (excluding on primary residence) will be combined in two taxes—municipal own tax (IMU) and secondary municipal tax. To provide further incentives to local governments to engage in the fight against tax evasion, they will receive a larger share of revenue recovered from tax evasion (from the existing 33 percent to 50 percent).

  • Regional financing reform (approved on March 31, 2011) widens the scope for the regions to increase the personal income tax (IRPEF) surcharge (up to 1.4/2.0/3.0 percent from 2013/2014/2015 against the current base rate of 0.9 percent) and envisages more flexibility in their use of tax deductions. Regions’ discretion to lower IRAP is extended (as long as IRPEF surtax is not increased by more than 0.5 percent), and the vehicle tax is attributed to the regions. VAT sharing arrangement will be based on a territorial principle after 2013. Estimates of the amount of transfers that would be replaced with higher IRPEF surtax are not yet available; these are expected to be coordinated with transfer reductions envisaged in the government’s July 2010 fiscal adjustment package (for regions, €4.5 billion in 2011). Also, the national IRPEF rate will be reduced commensurately to ensure that the overall tax levy remains unchanged. An equalization fund will be established in 2013.

Some implications from the cross-country empirical analysis

36. The results from our econometric analysis (Section E) suggest that Italy could benefit from reducing further its vertical imbalance. In particular, a reduction in Italy’s VFI to the levels of the least imbalanced countries—namely, halving the VFI from its 2009 level of 50 percent of sub-national own expenditure (equivalent to about €60 billion of additional own revenue, keeping sub-national expenditure unchanged)—would improve the general government primary balance by about 2–3 percentage points of GDP.23 Such a large VFI reduction is not unprecedented in Italy, and the potential fiscal gain could be important. However, the authorities envisage a more modest VFI reduction (less than €20 billion substitution of transfers for own taxes),24 suggesting a possibly smaller fiscal impact. Our results also suggest that the positive effect of VFI reduction on the primary balance is channeled through both lower expenditure and higher revenue. While the authorities expect the reform to yield efficiency gains and expenditure savings, the positive revenue effect would appear in conflict with one of the objectives of the reform, namely not to increase the tax burden.

37. Large horizontal imbalances are associated with worse fiscal outcomes, and their presence makes the need for a VFI reduction more pressing and beneficial. Our results suggest that HFIs have a negative effect on fiscal performance. Reducing Italy’s large regional economic disparities with structural reforms would thus produce direct fiscal gains. In addition, when HFIs are large, our conditional analysis shows that the positive effect of reducing vertical imbalances is stronger, probably because large regional disparities aggravate the problems generated by vertical imbalances (for instance, overspending related to bailout anticipations).

38. Fiscal federalism reform, despite its recent progress, is still incomplete in its design and details. While the purpose of this section is not to look at all aspects of the reform (such as determination of expenditure needs, health sector governance, equalization schemes, fiscal discipline, sanctions/rewards, accounting standards), looking forward, some considerations should be highlighted:

  • Regional disparities and interregional redistribution: Given that about 80 percent of sub-national expenditure is defined as essential/fundamental, and fiscal capacity should be equalized to meet these expenditure needs, the horizontal equalization fund will be large. Thus, sizeable interregional redistribution will remain, making the question of the design of equalization mechanisms of utmost importance. In this regard, reforms to base equalization mechanisms on more objective/formula-based criteria are welcome and should be rigorously pursued.

  • Tax autonomy and fiscal discipline: The abolition of the primary residence property tax (in 2008) not only limited the local resources but importantly affected the quality of revenue devolution. Going forward, if local governments continue to rely on taxes and tax-sharing arrangements that are less visible to taxpayers/local voters, this may weaken the disciplining effect of fiscal federalism and VFI reduction.

  • Federalism at variable speed: Regional differences could be taken into account when designing the new decentralized financing model. Maintaining larger VFI in the regions where the link between fiscal/economic outcomes and voter accountability is particularly weak and/or administrative capacity is low could be necessary to enforce effective central control.

  • Long transition and implementation risks: The reform process, which is planned to be completed by 2017, has not been smooth, and out of 8 implementing decrees which should have been adopted by end-May 2011, seven were approved as of mid-June.25 Political factors and technical difficulties (especially, availability of comparable data and harmonization of accounting standards) have been and will continue to be significant.

  • Coordination with concurrent fiscal adjustment efforts: The 2009 delegation law explicitly states that implementation of fiscal federalism reform should not deteriorate public finances (and not increase the tax burden). For the immediate future, the challenge for the authorities will be to deliver the planned fiscal consolidation (and sustain it beyond the medium term) while numerous transitional arrangements are being introduced in the context of the fiscal federalism reform.

G. Conclusion

39. This paper provides new evidence on the impact of vertical fiscal imbalances on fiscal performance, focusing on OECD countries. Our econometric results confirm the widespread view that spending decentralization financed through own revenues is beneficial and that increasing the share of transfers and borrowing in sub-national spending deteriorates the general government balance. Our findings also suggest that the combination of vertical and horizontal imbalances is particularly damaging to the fiscal stance and that reducing the VFI may lower primary expenditure but increase the tax burden.

40. The reduction in vertical fiscal imbalances should be accompanied by more revenue autonomy of sub-national governments. Revenue autonomy is critical to improving fiscal discipline. That is why reducing VFIs is not just an accounting exercise. For instance, substituting grants for tax sharing may lower the VFI, if tax-sharing is recorded as sub-national tax, without markedly affecting revenue autonomy and improving fiscal performance.

41. Italy could benefit from reducing further its vertical fiscal imbalance. Despite a major past reductions in VFI, there is still a sizeable scope for Italy to reduce it further to the levels of the least imbalanced countries. Indeed, such a reduction would imply halving Italy’s VFI from its 2009 level of 50 percent of sub-national own expenditure. This would translate, using our econometric estimates, to an improvement of about 2–3 percentage points of GDP in the general government primary balance. However, the current reform plans aim at a more modest VFI reduction, with the implications for the effective increase in sub-national tax autonomy still uncertain.

42. In practice reducing vertical imbalances may be difficult to achieve. Our results naturally raise three questions:

  • How to boost sub-national revenues, given that local authorities face specific challenges, including tax competition, tax base mobility, higher administrative costs, and horizontal disparities in revenue-raising capacity? The literature is generally skeptical about the revenue-raising capacity of lower levels of government. Some papers question nonetheless the dogma that sub-national authorities should only rely on benefit taxation and that the largest tax bases cannot be transferred to them (Bird, 1999). Furthermore, not only the magnitude but also the quality of revenue decentralization is important; local taxes should be carefully selected, based on feasibility and efficiency considerations such as the “benefit principle” (tax paid and public services received should be linked).

  • If sub-national own revenues cannot be increased above a certain level, can the transfer system be reformed to become less distortionary? A large empirical literature suggests that grant and tax sharing design can actually be improved (Bergvall and others, 2006; Blöchliger and Charby, 2008; Blöchliger and Petzold, 2009). Well-designed grants are generally based on objective criteria that cannot be manipulated by sub-national governments. An another cause of inefficiency seems to be the use of the same grant for various purposes, for instance, subsidization grants that simultaneously attempt to equalize, or financing grants that simultaneously attempt to subsidize.

  • Are there other ways to enforce fiscal discipline than raising sub-national tax responsibilities, rationing transfers, or controlling local borrowing? Additional hard budget constraint mechanisms have come under closer scrutiny, in particular: financial market and land market discipline, fiscal rules, and adequate political institutions (Ter-Minassian 1997a, 1997b; Rodden and others, 2003).

Appendix 1. Data Sources and Definitions

Table. 1A.:

List of Countries and Data Availability

(Dependent variable: General government primary balance, percent of GDP)

article image
Notes: Sample period for OECD (2010a) data; sub-national (state, where applicable, and/or local) fiscal data are not available for Australia (all years); Austria (1988-1994); France (1978-1994); Japan (all years); New Zealand (all years); United States (all years); and Poland (1995-2004); non-oil fiscal and GDP data for Norway (source: IMF).
Table 2A.

List of Variables, Definitions, and Sources

article image

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1

Prepared by Luc Eyraud (FAD) and Lusine Lusinyan (EUR). The authors are grateful to Izabela Karpowicz, the participants of the seminar held at the Bank of Italy, the Ministry of Economy and Finance staff, and the members of the Technical Commission for Implementation of Fiscal Federalism (COPAFF) for helpful discussions and comments.

2

In the paper, the term “transfer” always refers to intergovernmental (not interpersonal) transfers. “Own revenues” include both tax and non tax revenues, measured as the difference between total revenues and intergovernmental transfers received by a given level of government.

3

Both gaps are often related as the sub-national “vertical deficit” is generally covered by intergovernmental transfers and is likely to be associated with a central government “vertical surplus”.

4

Most of the empirical literature uses “transfer dependency” as a measure of the vertical imbalance, the former being defined as the ratio of transfers received by sub-national governments to their total revenues (or spending).

5

According to Boadway (2002), and Lazar and others (2004), the existence of a vertical gap does not necessarily imply that there is an imbalance. A VFI appears when the actual VFG differs from the optimal gap between levels of government. In their view, the VFI concept is a normative concept founded in theory in contrast to the VFG. Our paper does not make this distinction.

6

According to Oates (2006), “Soft budget constraints manifest themselves both in terms of transfer dependency and a poorly functioning banking system that is subject to manipulation by public officials for funding deficits.” Rodden and others (2003), also claim that “If soft budget constraints exist and the sub-national governments can appeal to the central government for additional resources through channels such as intergovernmental fiscal transfers, state-owned enterprises, and banking, they are likely to overspend, undertax, or overborrow”.

7

HFIs materialize when they are differences between the revenue capacities of individual sub-national governments.

8

In Figure 2, the change in VFI, transfer and borrowing is computed between 1995-1997 and 2005-2007, (instead of 1995 and 2007), to ensure that our results are not too sensitive to the choice of the initial and final dates.

9

Among financing sources of sub-national governments, borrowing has the highest volatility relative to transfers (medium volatility) and taxes (lowest volatility).

10

This suggests that the gap between revenue and spending decentralization, as often used in the literature, is not a good indicator of the VFI.

11

This result should not be interpreted as reflecting the good performance of sub-national governments, which are usually borrowing-constrained and may receive bailout transfers from the center.

12

The impact of fiscal rules other than borrowing constraints could not be tested due to data availability constraints for the OECD sample.

13

More precisely, this second interpretation would require that the vertical gap be measured as a share of general government spending. In that case, keeping the vertical imbalance constant while increasing spending decentralization would imply that the share of sub-national own revenues in sub-national own spending increases. In the robustness analysis, we propose an alternative equation based on this alternative definition of vertical imbalances, and beta is still found positive.

14

When the regional disparities’ variable is omitted, the negative effect of the VFI is overestimated, consistent with the prediction of the econometric theory (in a simple model, the bias on alpha is expected to be negative when the effect of HFIs on fiscal performance is negative, and HFIs are positively correlated with VFIs).

15

On the other hand, the measurement error (of revenue autonomy by the VFI, see Section III) could result in an underestimation of the coefficient. Indeed, the estimate is biased downward if the measurement error of the explanatory variable is neither correlated with VFI nor with revenue autonomy (“attenuation bias”).

16

Not all robustness checks are reported in the paper.

17

The results of the first stage regressions are available from the authors upon request.

18

This instrument may be weak for countries where health and social assistance are provided by the national government.

19

In the case of reverse causality, the bias on alpha is expected to be negative, given that alpha is negative and the effect of fiscal performance on VFI is also likely to be negative.

20

This section does not aim to provide a full account of past or ongoing decentralization reforms in Italy; rather, it highlights some selected aspects of Italy’s long-lasting decentralization process and some recent reform initiatives. A vast literature covers in detail Italy’s fiscal decentralization, its shortcoming, and challenges (e.g., Bordignon, 2000; Arachi and Zanardi, 2004; Giarda, 2004; Bibbee, 2007). The government’s June 2010 report on fiscal federalism compares Italy’s public finances with a “crooked tree” (albero storto) in light of the anomalies that emerged over time in the decentralized fiscal framework.

21

For example, the sub-national governments’ power to change the rates of devolved taxes and surtaxes has been restricted in recent years.

22

Giarda (2004) argues that a decrease in the fiscal unbalance ratio hides the fact that marginal budgetary decisions have not been affected at all by the increase in tax revenues as all sub-national governments remained recipients of equalization grants.

23

The assumptions are: a range of 0.08-0.13 for the VFI elasticity and a VFI reduction by 25 percentage points.

24

According to the preliminary estimates reported in the government’s Relazione sul Federalismo Fiscale (June 30, 2010) and subsequent municipal financing decisions, central government transfers that could potentially be replaced with own taxes are estimated at about €18.6 billion (about €5.6 billion for regions (including the cuts envisaged in the 2010 fiscal adjustment package), €11.2 billion for municipalities (of Ordinary Statute Regions; for 2011), and €1.8 billion for provinces).

25

These include the decrees on sub-national property (federalism demaniale), Rome (Roma capitale), standard needs of municipalities/city/provinces (fabbisogni standard), municipal federalism (federalismo municipale), regional federalism and health sector (federalismo regionale), infrastructural equalization/regional cohesion (perequazione infrastrutturale e coesione territoriale), and harmonizing of accounting/budget systems (armonizzazione dei sistemi contabili delle regioni e degli enti locali).