Promoting Subnational Fiscal Discipline:
A Review of Budget Institutions and their Impact on Fiscal Performance
Ernesto Crivelli and Anwar Shah[1]
February, 2009
Abstract: We make a review of subnational fiscal rules adopted in industrial, developing and transition countries and their impact on fiscal management. We describe and analyze co-operative solutions and rules-based control, including balance budget rules, controls on subnational borrowing, and the experiences with procedural rules. Finally, we explicitly review fiscal responsibility legislations at subnational level. An assessment of the impact of fiscal rules on subnational fiscal performance in a number of countries is, then, provided.
JEL Classification Numbers: E61, E62, H7, H81
Keywords: fiscal rules, subnational borrowing
Authors E-Mail Address: ;
1. Introduction
Fiscal rules have attracted significant attention over the last two decades, as several countries have adopted them in an attempt to eliminate large deficits and reduce public sector debts. Kennedy and Robbins (2001) define “fiscal rule” as a statutory or constitutional restriction on fiscal policy that sets a specific limit on a fiscal indicator such as the budgetary balance, debt, or spending.
Fiscal rules (and budgetary institutions in general) have been emphasized in the literature because of their impact on the fiscal results[2]. Fiscal rules refer to numerical fiscal rules but also to procedural and transparency rules. Numerical fiscal rules introduce ceilings (numerical restrictions) on certain fiscal indicators and limitations on contracting debt. These restrictions can differ according to the fiscal performance indicator to which they relate, to the legal hierarchy of the rule that establishes them, or to their coverage (Filc and Scartascini, 2007). Procedural and transparency rules aim to enhance transparency, accountability, and fiscal management. They typically require the government to commit up front to a monitorable fiscal policy strategy, usually for a multi-year period, and to routinely report and publish fiscal outcomes and strategy changes (Ter-Minassian, 2006).
Fiscal rules can be adopted by governments at the national or subnational level. The aim of this paper is to review fiscal rules implemented at subnational level. Subnational fiscal rules may be imposed by a higher level of government, or subnational governments may adopt them themselves, where constitutional arrangements grant them the autonomy to do so. In cases where subnational governments enjoy great autonomy (legal or de facto) the central government can find it difficult to enforce effective budget constraints on them.
A number of reasons make the adoption of fiscal rules at subnational level particularly important and distinguish them from the adoption of fiscal rules at national level. In particular, subnational fiscal rules can help mitigate the “common pool problem” in a federation, which results from the fact that the costs of fiscal indiscipline by one or more subnational governments are likely to spill over to the others. Fiscal rules are also crucial to avoid moral hazard created by the expectation of bailouts. Subnational governments facing soft budget constraints face weak incentives for fiscal responsibility since the costs of indiscipline are transferred to the national budget (Wildasin, 1997, Crivelli and Staal, 2006). In many cases, fiscal rules can help address strong heterogeneity of subnational governments, in cases where the system of intergovernmental transfers is not adequately designed.
Fiscal rules and their adoption at subnational level have evolved over the time. The first wave acknowledges the adoption of fiscal rules in some federal systems, where subnational governments implemented limits on borrowing up to the level of capital spending. This so called “golden rule” on borrowing was adopted by most states in the US since the mid-19th century and several cantons in Switzerland since the 1920s. A second wave, starting with New Zealand’s Fiscal Responsibility Act of 1994, give particular importance to procedural rules, including high accounting and reporting standards, increased transparency, and a medium-term macro-budgetary framework. In recent years, a number of legislations, most prominently Brazil’s Fiscal Responsibility Law of 2000, have attempted to set a framework of budgetary planning, execution and reporting, with strong emphasis on procedural and transparency rules, but also containing numerical ceilings on selected fiscal indicators and sanctions for non-compliance of the rules.
This paper makes a review of subnational fiscal rules adopted in industrial, developing and transition countries and their impact on fiscal management. Section 2 describes the preconditions for reliance on market discipline as an alternative to fiscal rules, and mentions some experiences that mainly rely on this approach to regulate subnational borrowing. Section 3 analyzes the co-operative solutions to subnational fiscal controls, where all levels of government must be involved in formulating the objectives of economic policy and be responsible for their attainment. Section 4 turns the attention to rules-based control. It first describes the experiences with numerical fiscal rules: balance budget rules and controls on subnational borrowing. It then turns to describe the experiences with procedural rules. Section 5 explicitly analyzes and describes the experiences with fiscal responsibility legislations. Section 6 provides an assessment of the impact of fiscal rules on subnational fiscal performance in a number of countries. Section 7 summarizes and concludes.
2. Reliance on market discipline
The greater the discipline that markets can impose on subnational governments (for example, via financing and credit ratings), the lesser the need for budget constraints imposed from the center (Ter-Minassian, 2006). As Lane (1993) points out, however, there are a number of preconditions for effectiveness of market discipline on subnational governments. First, market participants need access to all the information required to evaluate the financial soundness of each government. Second, markets should be free and open, with no regulation on financial intermediaries that could place subnational governments in a privileged-borrower position. Third, there should not be a history or expectation of bailouts by subnational governments. Otherwise, the incentives for discipline faced by local authorities are weakened. Finally, subnational governments need to have an adequate base of own resources. Subnational governments should be able to finance additional spending by rising own revenue, as this increases accountability to local constituencies.
These conditions are difficult to attain and unlikely to apply simultaneously. Subnational governments may rely on “creative accounting” and “window dressing” to difficult the true assessment of the government finances (Balassone et al., 2003). The hard budget constraint condition may lack credibility, especially in those countries where the public sector plays an important role in providing public services and goods (Wildasin, 1997). In addition, the reaction time of decentralized fiscal authorities may be excessively long (Blondal, 1999).
Market discipline is, however, the main form of control is some countries. In Finland, for example, no administrative or legal restrains apply to domestic or foreign borrowing. Moreover, there are no budget balance requirements for subnational governments (state governments). The provincial governments in Canada have no constitutional or legal limits on their borrowing (both domestic and external), and are not subject to central government controls on it. Their debt and debt-servicing capacity are closely monitored by financial markets, in particular by major debt-rating agencies. However, most provinces require balanced budget on annual basis. Moreover, there are strict limits on borrowing by local governments. These include prior approval by the provincial government or restrictions to specific purposes, like capital spending.
Among developing countries, Mexico has establish ex-ante, market based mechanisms in order to prevent excessive sub-national borrowing. The new regulatory framework of year 2000 has four main components (Braun and Tommasi, 2002): (i) the federal government gave up its role in securing debt, (ii) subnational debt is subject to normal credit exposure ceilings, (iii) bank’s capital risk weighting of loans to subnational governments is linked to the international rating of the borrowing government’s creditworthiness, and (iv) the federal government has restricted the use of discretionary transfers (Webb, 2004). Note, however, that central government’s approval is still required for local governments.
3. Co-operative arrangements
With co-operative solutions, all levels of government must be involved in formulating the objectives of economic policy and be responsible for their attainment. In these cases, the incentive problem, namely how to make politicians accountable is addressed through moral suasion and peer pressure. The main advantage of this approach is that it promotes dialogue across levels of governments, while enhancing local policy makers’ awareness about the macroeconomic implications of their budgetary choices (Ter-Minassian, 2006).
In Australia, the historical National Loan Council of 1929 comprises treasurers or heads of government of each state and the Commonwealth treasurer. The Council is in charge of analyzing and approving financing requirements of each state and the Commonwealth as a whole, as well as monitoring the execution of the decisions (Singh and Plekhanov, 2005). Market discipline plays also a major role on final decisions on borrowing targets set by each state.
Some European countries have also adopted co-operative solutions. In Austria, the Domestic Stability Pact of 2001 establishes a national committee, which represents all levels of government, and eight regional committees. These have advisory, coordination, supervision, planning, and implementation responsibilities and are the main information channel among governments. The pact requires all authorities involved to provide proper flows of information concerning their budgetary positions. In Belgium, the High Finance Council (Conseil Superieur des Finances, CSF) sets yearly guidelines for the expenditure growth and the deficit level of each level of government (federal, regions, communities). The regions can levy supplements on national taxes, but they have to consult the federal government and the other regions. In Denmark, bilateral discussions are held with subnational governments, and rules are both set and enforced co-operatively by the association of regional governments. In Spain, a supervisory Council for Fiscal and Financial Policy composed by officials from central government’s Ministry of Finance and subnational governments, monitors implementation and is required to ratify delinquent governments’ action plans.
4. Rules based control
a. Numerical fiscal rules
Numerical rules are a permanent constraint on fiscal policy generally defined in terms of an indicator of overall fiscal performance. They refer to specific quantitative targets. Numerical rules can help contain a deficit or expenditure bias, and address time inconsistency problems. However, they also introduce policy inflexibility and may create incentives to resort to low-quality measures to meet numerical targets. For example, in some countries the application of numerical rules has led to creative accounting practices aimed at circumventing the rules, including reclassification of expenditures, accumulation of arrears, and the use of off-budget public entities to perform government operations (Ter-Minassian, 2006).
Budget balance requirements
At the subnational government level, budget balance requirements can vary across several dimensions. The first relates to the targeted aggregate such as the current budget, the current budget and capital account and the off-budget items. Note that targeting the current budget alone allows sub-central governments to borrow for public investment. The second important dimension refers to the time horizon for budget balance requirements. Although usually annual, in some countries the budget periods have moved to a multi-annual basis. Table 1 presents a summery of the results across countries.
Coverage
Targeting the current budget alone, which allows subnational governments to borrow for public investment, is common in some industrial countries. This is, for example, the case in the German states (Laender), Swizerland, regions in Italy, municipalities in Denmark. In the United States, all but two states have provisions requiring a balanced budget. In general, it targets the current budget, excluding separate accounts such as the capital account and accounts for social insurance and employee retirement. In Canada, fiscal rules cover the operating budget in every jurisdiction. In the province Yukon, deficits are permitted as long as no net debt is accumulated (Kennedy and Robbins, 2001).
In Austria and Spain, off-budget items are included in the objective. In Austria, state governments as a group have to reach a surplus of 0.75 percent of GDP and financially stronger states have agreed to contribute more to the overall target.
In Korea and Turkey, the balance budget requirement for local governments applies to current budget and capital account.
In the Czech Republic and Poland municipal budgets must be balanced, including the current budget and capital account. In Poland, additionally off-budget items are included in the objective. In China, the Budget Law of 1994 requires local governments to have balanced budgets and restricts subnational governments from borrowing in financial markets and issuing bonds.
Time Horizon
Budget balance requirements are frequently set on an annual basis. In some countries, however, the provisions estipulate a multi-annual balanced budget. This is the case, for example, in Australia, Austria, local governments in Canada, Finland, Norway, and Spain. In the Netherlands and Spain, the budget period is three years, with specified annual targets. In Canada, the provinces of New Brunswick and Saskatchewan are required to balance their budgets over a four-year period.
Carry-over
In the Netherlands, if a municipality experiences a deficit, the higher level of government can allow this as long as the budget is in balance over the three year period. If this is not the case, a municipality needs to submit budgets to higher levels of government for approval. In Spain, if a subnational government runs a deficit, it must submit an action plan to resolve the situation within 4 years. In Canada, deficits are permitted in the provinces of Nova Scotia, Quebec and Ontario as long as they are offset in the next fiscal year.
Borrowing constraints
Both federal and unitary countries have relied on rules specified in the constitution or in laws to control subnational government’s borrowing. Instead of relying on market discipline or co-operative arrangements, the constraints analyzed here include clear limits on the level of indebtedness of subnational governments (in absolute terms or limiting borrowing to specific purposes). We also consider cases of direct control of the central government over subnational borrowing (approval, review and authorization or prohibition). Table 2 presents a summery of the results.