Working Paper: CEPR ID: DP9154
Authors: Dirk Foremny; Jürgen von Hagen
Abstract: We study the subnational fiscal adjustment to the Great Recession in a sample of European countries. We find that there are important differences between unitary and federal countries. Subnational governments in federal states reacted to the Great Recession by running larger budget deficits driven by increased spending particularly on social protection and weak revenue performance. In contrast the revenues of subnational governments in unitary states increased during the Great Recession due to larger transfers from central governments. Subnational government deficits increased much less in unitary states as real spending growth fell.In unitary states that fell into a debt crisis after 2009, the central government failed to shield local governments against the adverse macro economic consequences of the Great Recession, forcing them to adjust real spending to falling real revenues. This result suggests that sound public finances at the central level are critical to assure that subnational governments can deliver their allocative functions efficiently in the face of adverse macro economic conditions. In fact, our results call for tighter controls on expenditure growth during goods times and better protection against falling subnational revenues in bad times.We find that the countries that fell into a debt crisis after 2009 are characterized by weaker fiscal discipline at the subnational level already in the decade or so before the Great Recession. This observation suggests that the sustainability of subnational public finances is an important prerequisite for a country to maintain sustainable public finances at the level of general government.
Keywords: European public debt crisis; Fiscal federalism; Great recession; Vertical imbalance
JEL Codes: H12; H71; H72
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| type of state structure (federal vs. unitary) (H77) | subnational governments' budget deficits (H69) |
| federal states (H77) | subnational governments increase budget deficits (H69) |
| unitary states (H77) | subnational governments experience increased revenues (H79) |
| central government policies (H59) | subnational fiscal stability (H77) |
| lack of fiscal discipline prior to recession (H69) | subsequent fiscal challenges (H69) |
| subnational governments in unitary states (H70) | smaller deficits (H62) |
| output gap (E23) | budget balances at central level (H60) |
| output gap (E23) | budget balances at subnational level (H60) |