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the financing gap, regions are less inclined to adjust their fiscal policies. As a consequence, the
response to regional (and aggregate) debt is weakened. According to Laubach (2006), specifically
earmarked or matching grants have increased the power of the US central government over spending
decisions of states. Similarly, a gradual tendency to co-finance regional tasks of Lander has increased
the bargaining position of the government in Berlin (Seitz, 1999).
5. Conclusions
The ongoing process of fiscal decentralisation world-wide urges some insight in the process of fiscal
adjustment in federal states (Ter-Minassian, 1997; Wildasin, 1997). The aim of this paper is to analyse
how fiscal adjustment comes about when both central and sub-national governments are involved in
consolidation. We test fiscal sustainability for central and regional governments with fiscal rules. We
extend the usual approach in the literature to analyse fiscal sustainability to consider debt
consolidation problems between different tiers of government.
We analyse fiscal behaviour of different government tiers in the US and Germany. Institutional
settings and the fiscal structure are rather similar in both countries. Spending capacity and the degree
of vertical imbalance are rather similar in the US and Germany. However, horizontal transfers are
more important for regional budgets in Germany. Lander also have less political power over their tax
bases. Results indicate rather different behaviour of fiscal policy in both countries. In the US, both the
federal and state governments keep debt under control. In Germany instead, lower tier governments do
not consolidate at all. All of the fiscal adjustment occurs via central government debt. The central
government cannot induce lower tiers to react in a stabilising way to debt: the application of fiscal
rules is lax. Lander do not internalise the spillover on aggregate debt.
This paper is a first step in the empirical analysis of fiscal relations between different government
tiers. We have abstracted from many relevant issues. First, the specification of the fiscal rule is simple.
Adjustments on the spending or on the revenue side have rather different implications. There is much
evidence on the ‘flypaper’ effect of additional central government transfers to lower tiers. The
consolidation effort may vary in response to own revenues, vertical grants or horizontal transfers. This
would shed more light on the nature of the interaction between different government levels. More
detailed data are necessary for this. Second, the empirical analysis ignores any spillover effect of fiscal
policy across regions. Several authors have shown the importance of tax competition and spending
reductions for local government (Brückner, 2003). Similar evidence at the federal and regional level is
much more limited (Redoano, 2007). Finally, fiscal transfer systems are mostly designed to address a
problem of redistribution across regions. Transfers are permanent and may not always lift the region
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