Fiscal Sustainability Across Government Tiers

XREAP2007-14

Perotti, 2003; Ballabriga and Martinez-Mongay, 2005). Given that any additional transfers for
implicitly bailing out regional governments are financed by at least one other tier of government, the
aggregate deficit and debt position provides an indicator of overall sustainability of the federal fiscal
system. Contrasting overall sustainability with a disaggregate analysis for the different tiers of
government then indicates problems of fiscal imbalance implicit in the federal fiscal system.

We thus test a fiscal rule both for the federal government and for regional tiers. We compare two
decentralised countries with similar fiscal institutions. Both US states and German Lander are subject
to budget rules, but are able to issue debt autonomously. The federal system in both countries is
characterised by a similar degree of vertical fiscal imbalance. But while in the US, the majority of
transfers are provided by vertical transfers from the central budget, Lander are predominantly financed
by (horizontal) intergovernmental transfers that are complemented with specific transfers from the
central level.¹ We argue that this different set up of the fiscal system is responsible for different
responses to public debt. The federal government cannot induce lower tiers to react in a stabilising
way to debt when large part of the revenues are shared across lower tiers of government. Regions that
are financed by horizontal transfers do not internalise the spillover on aggregate debt. Results indeed
indicate that 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 federal
government debt.

The paper is structured as follows. In section 2, we develop the test for the sustainability of public
finances across different tiers of government. In section 3, we present the fiscal rule as a means for
testing sustainability. In section 4, we discuss the empirical results and argue that the financing
structure of the fiscal system has implications for the consolidation efforts of different tiers of
government. Concluding remarks follow in section 5.

¹ In addition, tax autonomy of German Lander is much more constrained than in US states.

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