EMU: NEW HISTORICAL DEVELOPMENT

EU fiscal rules have extensive implications:

• Stabilisation

• Allocation and distribution

• Long-term sustainability &intergenerational redistribution

• Relationships between levels of governments

Motivation:

Evaluate implications of EMU fiscal rules for relationships between levels of government

Structure:

• EU fiscal rules• Critical issues for decentralisation• What solutions can be considered?• What solutions have been adopted?• Are current solutions sustainable?

MOTIVATIONAND STRUCTURE

EU FISCAL RULES:A DESCRIPTION

Deficit should not exceed 3% of GDP unless:– Exceptional events– Excess temporary – Excess limited

Close to balance or in surplus

Multilateral surveillance

Excessive deficit procedure (sanctions related to excess)

Fiscal targets:

•Soundness (monetary-financial stability)

- limits to deficit and debt ratios

•Flexibility (stabilisation policy) - medium-term position of ‘close- to-balance or in surplus’

Deficit fluctuates over cycle (automatic stabilisers can operate)

INTERPRETING THE RULES: DISCIPLINE AND FLEXIBILITY

SURPLUS

0

3%

DEFICIT

BAD TIMES GOOD TIMES

LENGTH OF CYCLE

Co-ordination between different government tiers at national level needed independently of EMU

Standard solutions: - central government control - formalised co-operation - rules (e.g., deficit limits) - exceptions allowed (e.g.,

capital outlays) - ex ante validity only

National rules for sub-national governments

EU approach is stricter:

Rules defined as predetermined numerical parameters

Ex-ante and also ex-post compliance required

Flexibility margins defined ex-ante for exceptional factors

No provision for investment

Non-compliance triggers predefined monetary sanctions

A COMPARISON WITH RULES AT NATIONAL LEVEL

Asymmetry of constraints and incentives:

local vs. central governments

EU RULES & LOCAL GOVERNMENTS: THREE CRITICAL AREAS

Public investment:

how can we carry out adequate investment at local level without deficit-finance?

Economic cycle:

how can we avoid the need for pro-cyclical policies?

Compliance with EU rules evaluated with respect to the general government budget (central + local)

ASYMMETRY OF CONSTRAINTS

But in EU rules • no role for sub-national government• central gov. primarily responsible• central gov. carries burden in terms of credibility, sanctions, etc.

Risk: distortions in allocation (sub-national government free-riding)

PUBLIC INVESTMENT (I)

Balanced budget tax-finance for public investment

Risk: reduction of public capital accumulation

Common wisdom: easier to cut investment than current expenditure

Political economy: policy makers with finite horizons (“if we cannot smooth the burden, we cut projects with deferred benefits”) Empirical evidence: fiscal consolidation often implies lower investment

Compression effect potentially stronger for local governments:

• peaks in expenditure• mobility of citizens/taxpayers

PUBLIC INVESTMENT (II)

risk: under-supply of public capital at local level

EU rules reconcile stability and flexibility via reference to structural budget balance

EFFECTS OF THE CYCLE

If this approach cannot be applied to sub-national governments, a risk of:• either pro-cyclical policies at local level• or central government compensating slippages

(distortions in allocation)

• Adapting existing rules

• Replicating the Stability and Growth Pact (SGP)

• A market for deficit permits

SOLUTIONS IN THEORY (I)

• Effects of the cycle:– ex-post nominal limits (pro-cyclical ?)– rainy-day funds (ESA95 ?)– tax-base selection (responsibility ?)

SOLUTIONS IN THEORY (II)

Solution 1:Adapting existing regulations

• Asymmetry of incentives:give equal responsibility to all gov. tiers + sanctions (implementation ?)

• Local investment:allow debt-finance with a ceiling (compensated golden rule) &

rules to allocate outlays (allocation ?)

SOLUTIONS IN THEORY (III)

•Cycle: implementation problems for local governments (CABB?)

Solution 2:National replicas of the SGP

•Asymmetry of incentives: implementation problems for local governments (CABB?)

•Local investment: problem remains (no debt-financing, peaks)

SOLUTIONS IN THEORY (IV)

•Cycle: total amount related to cyclical position (forecasts?)

Solution 3:A market for deficit permits

•Asymmetry of incentives: a predetermined ceiling to overall deficit + market-based allocation to avoid free-riding

•Local investment: total amount related to investments needs (initial allocation of permits?)

SOLUTIONS IN THEORY (V)

Solution 4:An eclectic solution

•Incentive & cycle: replicate SGP for larger government tiers ; proper choice of tax bases + budget rules in nominal terms (ex-post) for smaller government tiers

•Investment: ‘compensated’ golden rule and co-operation

•Sample: Austria, Belgium, Germany, Italy, Spain (countries differ widely in size/institutions)

SOLUTIONS IN PRACTICE (I)

Austria 8.1 83.8 206.0 23.3

Belgium 10.2 30.5 246.0 23.4 Germany 82.1 356.2 2,025.5 22.5

Italy 57.6 301.3 1,165.7 21.8

Spain 39.4 504.8 606.3 17.1

per capita PPP GDP (thousands

of Euros)

Population (millions)

Km2

(thousands)

Nominal GDP (trillions of

Euros)

Austria 2,400 9 14,227 33,398Belgium 600 3 17,203 48,298Germany 15,000 16 14,369 38,671Italy 8,100 20 13,186 28,756Spain 8,100 17 10,566 23,197

Min. regional GDP per

capita(1)

Max. regional GDP per

capita(1)

Number of municipalities

Number of regions

(1) Euros.

•Most countries have adopted new explicit rules/procedures

•No SGP replica (technical problems?)

•Most countries rely on co-operation between tiers of government

SOLUTIONS IN PRACTICE (II)

Domestic rules

Explicit ItalyAustria,

Belgium, Spain

Implicit Germany

Imposed Agreed

•Countries do not use CABB

•Insulation from cyclical effects via non cycle-sensitive tax bases and predetermined transfers (sometimes also for larger regional governments) Limited autonomous revenues

•Different solutions for investments

SOLUTIONS IN PRACTICE (III)

Yes

Explicit flexibility for the cycle

Germany, Italy, Spain

Flexibility for investment

No Yes

NoAustria, Belgium

• Federal State since 1920

• Three government tiers

• Crucial role of co-operation and co-ordination between gov. tiers

• No explicit flexibility for investment and for the cycle

• Explicit Domestic Stability Pact:

- targets- sanctions- ESA 95

AUSTRIA

BELGIUM

•1980s-1990s: ‘federalisation’

•3 economic regions + 3 linguistic communities + provinces + communes

•Federal gov. responsible for most revenues. Regions insulated from cycle

•No predefined rules & no investment allowance

•Consensual approach: Conseil Superieur des Finances sets guidelines and targets

•Successfully combines decentralisation and fiscal consolidation

•Federal State (new Constitution after WW2)

•Three government tiers

•Crucial role of co-operation between government tiers

•Golden rule (not very strictly defined) flexibility for investment

•No explicit flexibility for the cycle

•No explicit Domestic Stability Pact, but an ‘implicit’ rule exists (bailing-out is constitutionally set)

GERMANY

•From centralised to decentralised (advances in 1990s)

•Three government tiers

•Commitment by central government not to bail-out

•Mixture of explicit and implicit rules, largely based on consensus

•Golden rule for local governments flexibility for investment

•No explicit flexibility for the cycle (but borrowing limits can apply only ex-ante)

SPAIN

ITALY

•From centralised to decentralised (advances in 1990s)

•Three government tiers

•Domestic Stability Pact (1999):

- imposed by central government-not comprehensive (excludes investment & health)

-not binding

•Increasing revenue responsibility of regions

•Debt financing only for investment

•2001: change in Constitution move to consensual approach

ITALY: DOMESTIC PACT - 1999

Budget balance (cash terms, exclude financial transactions):

= (R - T) - (S - K - I)

R = total revenue T = central government transfersS = total expenditure K = capital account outlays I = interest payments

Target:

improve trend balance (t-1 deficit (1+0.8 of GDP growth rate)) in proportion to (S - K - I)

Sanctions:

only if Italy sanctioned at EU level

ITALY: DOMESTIC PACT - 2000

Budget balance :

= (R - T - XR - HR) - (S - K - I - XS - HS)

XR = exceptional revenues (asset sales) HR = health revenues XS = exceptional expenditure HS = health spending

Target:

as 1999 but must compensate for 1999 slippages

ITALY: DOMESTIC PACT - 2001/02

2001 Target:

deficit cannot exceed 103 % of 1999 deficit

2002 Target:

deficit cannot exceed 102.5 % of 2000 deficit

2002: additional limit on expenditure growth + sanctions for local govs (reduction of transfers)

ITALY: DOMESTIC PACT - PROBLEMS

• Many changes

• Targets proportional to expenditure or past deficit, not to gap with respect to budget

balance

• Balance EU relevant balance

• Double golden rule?

• No debt target

• Weak sanctions till Italy is sanctioned (credible?)

• Expenditure ceiling compatible with decentralisation?

Asymmetry problem: not solved

Cycle problem: not addressed

Investment problem: odd solution

• Robustness to economic shocks

lengthy negotiations & adjustments

SUSTAINABLE SOLUTIONS? (I)

• Robustness to further decentralisation

larger autonomy requires more revenue power more effects of cycle

• Effects on allocation

local government insulated from cycle distortions

SUSTAINABLE SOLUTIONS? (II)

• A rules+sanction based eclectic framework (regions : ‘domestic-SGP’ others: nominal budget balance & revenue structure

all: compensated golden rule)

may:- shorten reaction time to shocks - be robust to institutional changes- improve allocative efficiency through

increased transparency and control of policy implementation

•Pre-requisite: common accounting standards for all government tiers

• “The extent to which the liberty of experiments in taxation should be conceded to the subordinates bodies must, we believe, be carefully limited.

• For the smaller units the taxes should be absolutely laid down and also the maximum to be raised, but the opportunity of economy should not be denied on the condition that they duly discharge their necessary function.

• The larger circumscriptions are fairly entitled to great latitude. A higher standard of intelligence may be expected from their representatives, and their economic resources are more varied. But even with them the need for supervision cannot be said to be absent.”

Pigou (1927)

IN OTHER WORDS ...

SOME DATA (I)

3

5

7

9

11

13

15

17

19

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

3

5

7

9

11

13

15

17

19

Austria (regions) Austria (sub-regional gov.) Belgium (sub-regional gov.) Germany (sub-regional gov.)

Italy (overall local gov.) Spain (regions) Germany (regions)

Local gov. taxes as a share of general gov. revenues

SOME DATA (II)

Local gov. expenditure as a share of general gov. expenditure

9

12

15

18

21

24

27

30

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

9

12

15

18

21

24

27

30

Austria (regions) Austria (sub-regional gov.) Germany (regions) Germany (sub-regional gov.)

Italy (overall local gov.) Spain (regions) Belgium (sub-regional gov.)

SOME DATA (III)

Local gov. taxes as a share of local gov. overall revenues

10

20

30

40

50

60

70

80

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

10

20

30

40

50

60

70

80

Austria (regions) Austria (sub-regional gov.) Belgium (sub-regional gov.) Germany (regions)

Germany (sub-regional gov.) Italy (overall local gov.) Spain (regions)