XREAP2007-14
1. Introduction
Increasing economic integration is shifting political sovereignty to both supra-national organisations
and regional governments, not only in Europe but world-wide. The ongoing process of shifting
political powers urges some insight in the consequences of fiscal decentralisation on public budgets
(Ter-Minassian, 1997; Wildasin, 1997). Devolution of public finances creates problems of fiscal
imbalance at lower tiers of government. Whereas there usually is a constitutionally determined
division of spending tasks, revenues are shared among different government levels. In addition to
(vertical) transfers from the central government, (horizontal) transfers between regional governments
complement regional budgets. Incomplete fiscal autonomy reduces incentives for lower tier
governments to pursue fiscal discipline. Devolving fiscal power is therefore likely to create fiscal
imbalances. Regional governments can run up debt, and try to shift the burden on the central
government (or other regional governments). Federal fiscal systems are therefore complemented with
control systems on the sustainability of public finances at lower tiers. These fiscal rules are not always
effective constraints. Tax sharing agreements and joint spending schemes often provide implicit
additional financing of regional budgets. In extreme cases, this may even entail explicit bail out.
The variety of fiscal arrangements in different countries makes it hard to examine the interaction
between regional and federal policies. Some recent studies have made some progress at the theoretical
level (Inman, 2003). These models are often much stylised, and do not grasp all institutional and
economic aspects of fiscal federalism. Empirical studies that look into the sustainability of different
federal fiscal systems are fraught with two major identification problems. First, intergovernmental
transfers do not only allocate, but also redistribute tax resources between rich and poor regions. No
fiscal system is neutral in this regard. Second, expectations of bail outs are what matter for the
sustainability of any federal fiscal system (Bordignon, 2006). These expectations are hard to identify
in the budget data we observe. On the one hand, bail outs are not necessarily the consequence of
prolonged unsustainable fiscal policies. On the other hand, the absence of bail out does not necessarily
imply that the fiscal system is solvent either. Basically, the federal and regional governments may
anticipate fiscal problems with additional transfers. Consequently, we need not observe sustainability
problems in the data. Focussing on bail outs overlooks these strategic interactions between different
tiers of government.
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 sustainability with a fiscal rule in which
the budget surplus responds to debt developments (Bohn, 1998). This test has become rather popular
for assessing fiscal sustainability. Most studies have considered general government data (Gali and