XREAP2007-14
In this case, every tier of government sets its surplus in response to its stock of public debt. The
condition that
ρi > 0 i =1,..., N (5)
implies that every tier of government runs a sustainable fiscal policy. Fiscal policy will be sustainable
if (2) holds: if each government controls its public debt, fiscal policy will be sustainable on aggregate.
Consequently, there will be no problem of soft budget constraints. This is a very strong restriction as
the fiscal system imposes a hard budget constraint on each tier individually. Actually, a weaker
condition can be sufficient for the absence of a soft budget constraint. It is sufficient that the federal
government runs a sustainable policy, and that on average the reaction of all regional governments is
sustainable, to have a hard budget constraint. In the latter case, there may still be offsetting transfers
between regions that makes regional budget constraints soft. But there is a hard constraint on fiscal
relations between the first and second tier of government. We test this condition with a fiscal rule (1)
for the federal government, and the condition that regions run sustainable policies in a panel version of
the same fiscal rule.
By splitting up the contribution of the reaction of the general government into the response of both
federal and regional governments, we can attribute the burden of consolidation to a particular tier of
government. Moreover, we shed some light on how the burden of fiscal adjustments is spread across
various tiers of government to maintain fiscal sustainability at the aggregate level.
The setting of fiscal policy is determined by many other factors of course. A simple regression of the
surplus on debt might suffer from an omitted variable bias (Bohn, 1998). Ideally, the specification of a
fiscal rule would derive from some theory of public spending and taxation. The Barro tax smoothing
model is one such model; but there are several alternative theories available for fiscal policy.
According to the Fiscal Theory of the Price Level, the surplus should react to debt only. More
elaborate DSGE models of fiscal policy argue that the government should target the output gap and
inflation (Benigno and Woodford, 2003). Still other theories argue that the interaction with monetary
policy is important, and hence the policy stance of the central bank should be accounted for (Dixit and
Lambertini, 2003). There are other ‘political’ models of fiscal policy as well, which argue that the
fiscal stance is determined by political factors, such as majority-minority government, political colour,
etc. Political business cycle theories argue that the government tries to influence economic conditions
(Drazen, 1999). Several of these theories point to the importance of cyclical conditions in the
determination of the surplus. Hence, the inclusion of the GDP growth rate in the fiscal rule could