FISCAL CONSOLIDATION AND DECENTRALISATION: A TALE OF TWO TIERS



1: Introduction

Governments’ attempts to improve the sustainability of their fiscal balances have been at the
forefront of fiscal policy discussion for more than a decade. In some countries the
consolidation effort has resulted in sizeable surpluses for the first time in a generation. Debt to
GDP ratios have been stabilised and begun to fall. Elsewhere, some previous bastions of fiscal
prudence are now struggling to maintain or regain sound fiscal positions. Lower interest rates
have reduced debt servicing costs for the majority, but adherence to fiscal rules and the fiscal
implications of ageing populations will ensure that the need to strengthen fiscal positions will
remain a key issue in the years to come.

An established literature has examined fiscal consolidation attempts and concluded that the
composition of the consolidation effort is a crucial determinant of the ultimate effect on debt.
Throughout this literature (see for example, Alesina and Perotti [1995] Alesina et al. [1998],
McDermott and Wescott [1996] and Von Hagen et al. [2001]) the focus has been on general
government data1. This has one clear advantage in that large and consistent data sets are
readily available, but in our view, this advantage is outweighed by a key weakness. This
approach implicitly assumes that governments behave as if a single authority exercises
complete control over the size and composition of fiscal balances. Indeed, political economy
models of fiscal consolidations, including Alesina and Drazen [1991], Roubini and Sachs
[1989], assume a single tier of government. In view of the substantial role played by sub-
central governments in the conduct of fiscal policy, we believe that it is worth extending this
literature to look at the distinct contributions made by sub-central and central government and
examine how these tiers of government interact during consolidation attempts.

The size and responsibilities of sub-central tiers of government differ markedly across
countries2. In many countries with a federal structure e.g. the USA, Austria, Germany and
Canada, sub-central legislatures have considerable political power and sizeable spending and
financing responsibilities relative to the central/federal tier. In Canada, for example, data from
IMF Government Financial Statistics indicate that over 50% of total government expenditure
and revenue is assigned to the sub-central tiers.

In unitary countries it is often assumed that fewer fiscal responsibilities are devolved to lower
tiers of government, although it does not necessary follow that their role in fiscal policy is
insignificant. Many unitary countries have devolved considerable fiscal responsibilities. For
example, IMF figures indicate that in 1998, sub-central government expenditure was 44% of

1 General government is defined by the OECD as “all departments, offices, organisations and other bodies which
are agencies or instruments of the
central, state or local public authorities” OECD [2002].



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