XREAP2007-14
2. Sustainability of fiscal policy across government tiers
The continued high deficits in most industrialised countries in the seventies and eighties caused
concern about the sustainability of public debt. This raised interest in ways to constrain the ‘deficit
bias’ that seems inherent to the political decision process. Fiscal rules have taken the form of an
improved design of the budget process or a numerical target on deficit or debt ratios. Part of the debt
problem may be due to shifting political power. In the last two decades, increasing economic
integration has been associated with political disintegration of existing countries, and the creation of
more supra-national structures (Alesina et al., 2000).
Devolution of fiscal policies further complicates the problem of controlling government finances. The
main reason is the incompatibility of the constitutionally determined division of spending tasks, and
the sharing of (tax) revenues across different government levels. On the spending side, regional
governments often have very precisely constitutionally stipulated tasks on which it is difficult to
renege. On the revenue side, governments share tax revenues and sometimes co-decide on tax bases
and rates. If economic or political linkages across a country’s regions are strong, little flexibility is
allowed in differentiating regional budgets. Less than complete fiscal autonomy accordingly gives
incentives to lower tier governments to spend on local public goods with revenues that draw from the
common pool of resources of the entire federation. Regional budgets are usually complemented with
(vertical) transfers from the central government or (horizontal) transfers from other regions. Regional
governments may thus indulge in unsustainable policies and have little reason to adjust the budget to
satisfy their intertemporal balance. The federal fiscal system faces a problem of soft budget
constraints.
Federal fiscal systems are therefore complemented with control systems on public finances at lower
tiers. Fiscal arrangements between the first tier and lower levels of government have been set up in a
variety of ways. In some federations, the central and regional government cooperate in councils (e.g.
Austria, Belgium, and Germany). In others, there are explicit numerical limits on the regional
borrowing capacity (e.g. EU).2 A combination of institutional, political and economic factors accounts
for the large differences we observe in the set up of fiscal federations. Some recent theoretical studies
have made some progress in examining the interaction between regional and federal policies.
However, these models cannot grasp all aspects of fiscal federalism (Inman, 2003).
2 In some newly created federal structures, the central government searches for agreements with lower tier
governments to contribute to stabilisation of the ‘historical’ central debt burden (e.g. Belgium).