EMU: NEW HISTORICAL DEVELOPMENT

1. EMU: NEW HISTORICAL DEVELOPMENT • EU fiscal rules have extensive implications: • Stabilisation • Allocation and distribution • Long-term sustainability & intergenerational redistribution • Relationships between levels ofgovernments

2. MOTIVATIONAND STRUCTURE • Motivation: • Evaluate implications of EMU fiscal rules for relationships between levels of government • Structure: • EU fiscal rules • Critical issues for decentralisation • What solutions can be considered? • What solutions have been adopted? • Are current solutions sustainable?

3. EU FISCAL RULES:A DESCRIPTION •  Deficit should not exceed 3% of GDP unless: • Exceptional events • Excess temporary • Excess limited •  Close to balance or in surplus •  Multilateral surveillance •  Excessive deficit procedure (sanctions related to excess)

4. INTERPRETING THE RULES: DISCIPLINE AND FLEXIBILITY • Fiscal targets: • Soundness (monetary-financial stability) • - limits to deficit and debt ratios • Flexibility (stabilisation policy) • - medium-term position of ‘close- to-balance or in surplus’ •  Deficit fluctuates over cycle (automatic stabilisers can operate) SURPLUS 0 3% DEFICIT BAD TIMES GOOD TIMES LENGTH OF CYCLE

5. National rules for sub-national governments  Co-ordination between different government tiers at national level needed independently of EMU  Standard solutions: - central government control - formalised co-operation - rules (e.g., deficit limits) - exceptions allowed (e.g., capital outlays) - ex ante validity only

6. A COMPARISON WITH RULES AT NATIONAL LEVEL EU approach is stricter:  Rules defined as predetermined numerical parameters  Ex-ante and also ex-post compliance required  Flexibility margins defined ex-ante for exceptional factors  No provision for investment  Non-compliance triggers predefined monetary sanctions

7. EU RULES & LOCAL GOVERNMENTS: THREE CRITICAL AREAS  Asymmetry of constraints and incentives: local vs. central governments  Public investment: how can we carry out adequate investment at local level without deficit-finance?  Economic cycle: how can we avoid the need for pro-cyclical policies?

8. ASYMMETRY OF CONSTRAINTS Compliance with EU rules evaluated with respect to the general government budget (central + local) • But in EU rules • no role for sub-national government • central gov. primarily responsible • central gov. carries burden in terms of credibility, sanctions, etc. Risk: distortions in allocation (sub-national government free-riding)

9. PUBLIC INVESTMENT (I) Balanced budget  tax-finance for public investment Risk: reduction of public capital accumulation Common wisdom: easier to cut investment than current expenditure Political economy: policy makers with finite horizons (“if we cannot smooth the burden, we cut projects with deferred benefits”) Empirical evidence: fiscal consolidation often implies lower investment

10. PUBLIC INVESTMENT (II) • Compression effect potentially stronger for local governments: • peaks in expenditure • mobility of citizens/taxpayers  risk: under-supply of public capital at local level

11. EFFECTS OF THE CYCLE EU rules reconcile stability and flexibility via reference to structural budget balance If this approach cannot be applied to sub-national governments, a risk of: • either pro-cyclical policies at local level • or central government compensating slippages (distortions in allocation)

12. SOLUTIONS IN THEORY (I) • Adapting existing rules • Replicating the Stability and Growth Pact (SGP) • A market for deficit permits

13. SOLUTIONS IN THEORY (II) Solution 1: Adapting existing regulations • Asymmetry of incentives: • give equal responsibility to all gov. tiers + sanctions (implementation ?) • Local investment: • allow debt-finance with a ceiling (compensated golden rule) & rules to allocate outlays (allocation ?) • Effects of the cycle: • ex-post nominal limits (pro-cyclical ?) • rainy-day funds (ESA95 ?) • tax-base selection (responsibility ?)

14. SOLUTIONS IN THEORY (III) Solution 2: National replicas of the SGP • Asymmetry of incentives: implementation problems for local governments (CABB?) • Local investment: problem remains (no debt-financing, peaks) • Cycle: implementation problems for local governments (CABB?)

15. SOLUTIONS IN THEORY (IV) Solution 3: A market for deficit permits • Asymmetry of incentives: • a predetermined ceiling • to overall deficit + market-based allocation to avoid free-riding • Local investment: total amount related to investments needs (initial allocation of permits?) • Cycle: total amount related to cyclical position (forecasts?)

16. SOLUTIONS IN THEORY (V) Solution 4: An eclectic solution • Incentive & cycle: replicate SGP for larger government tiers ; proper choice of tax bases + budget rules in nominal terms (ex-post) for smaller government tiers • Investment: ‘compensated’ golden rule and co-operation

17. SOLUTIONS IN PRACTICE (I) • Sample: Austria, Belgium, Germany, Italy, Spain (countries differ widely in size/institutions)

18. SOLUTIONS IN PRACTICE (II) • Most countries have adopted new explicit rules/procedures • No SGP replica (technical problems?) • Most countries rely on co-operation between tiers of government

19. SOLUTIONS IN PRACTICE (III) • Countries do not use CABB • Insulation from cyclical effects via non cycle-sensitive tax bases and predetermined transfers (sometimes also for larger regional governments) Limited autonomous revenues • Different solutions for investments

20. AUSTRIA • Federal State since 1920 • Three government tiers • Crucial role of co-operation and co-ordination between gov. tiers • No explicit flexibility for investment and for the cycle • Explicit Domestic Stability Pact: • targets • sanctions • ESA 95

21. BELGIUM • 1980s-1990s: ‘federalisation’ • 3 economic regions + 3 linguistic communities + provinces + communes • Federal gov. responsible for most revenues. Regions insulated from cycle • No predefined rules & no investment allowance • Consensual approach:Conseil Superieur des Finances sets guidelines and targets • Successfully combines decentralisation and fiscal consolidation

22. GERMANY • Federal State (new Constitution after WW2) • Three government tiers • Crucial role of co-operation between government tiers • Golden rule (not very strictly defined)  flexibility for investment • No explicit flexibility for the cycle • No explicit Domestic Stability Pact, but an ‘implicit’ rule exists (bailing-out is constitutionally set)

23. SPAIN • From centralised to decentralised (advances in 1990s) • Three government tiers • Commitment by central government not to bail-out • Mixture of explicit and implicit rules, largely based on consensus • Golden rule for local governments  flexibility for investment • No explicit flexibility for the cycle (but borrowing limits can apply only ex-ante)

24. ITALY • From centralised to decentralised (advances in 1990s) • Three government tiers • Domestic Stability Pact (1999): • imposed by central government • not comprehensive (excludes investment & health) • not binding • Increasing revenue responsibility of regions • Debt financing only for investment • 2001: change in Constitution  move to consensual approach

25. ITALY: DOMESTIC PACT - 1999 Budget balance (cash terms, exclude financial transactions): = (R - T) - (S - K - I) R = total revenue T = central government transfers S = total expenditure K = capital account outlays I = interest payments Target: improve trend balance (t-1 deficit  (1+0.8 of GDP growth rate)) in proportion to (S - K - I) Sanctions: only if Italy sanctioned at EU level

26. ITALY: DOMESTIC PACT - 2000 Budget balance : = (R - T - XR - HR) - (S - K - I - XS - HS) XR = exceptional revenues (asset sales) HR = health revenues XS = exceptional expenditure HS = health spending Target: as 1999 but must compensate for 1999 slippages

27. ITALY: DOMESTIC PACT - 2001/02 2001 Target: deficit cannot exceed 103 % of 1999 deficit 2002 Target: deficit cannot exceed 102.5 % of 2000 deficit 2002: additional limit on expenditure growth + sanctions for local govs (reduction of transfers)

28. ITALY: DOMESTIC PACT - PROBLEMS • Many changes • Targets proportional to expenditure or past deficit, not to gap with respect to budget balance • Balance  EU relevant balance • Double golden rule? • No debt target • Weak sanctions till Italy is sanctioned (credible?) • Expenditure ceiling compatible with decentralisation? • Asymmetry problem: not solved • Cycle problem: not addressed • Investment problem: odd solution

29. SUSTAINABLE SOLUTIONS? (I) • Robustness to economic shocks • lengthy negotiations & adjustments • Robustness to further decentralisation • larger autonomy requires more revenue power  more effects of cycle • Effects on allocation • local government insulated from cycle  distortions

30. SUSTAINABLE SOLUTIONS? (II) • A rules+sanction based eclecticframework • (regions : ‘domestic-SGP’ • others: nominal budget balance & • revenue structure • all: compensated golden rule) • may: • shorten reaction time to shocks • be robust to institutional changes • improve allocative efficiency through • increased transparency and control • of policy implementation • Pre-requisite: common accounting standards for all government tiers

31. IN OTHER WORDS ... • “The extent to which the liberty of experiments in taxation should be conceded to the subordinates bodies must, we believe, be carefully limited. • For the smaller units the taxes should be absolutely laid down and also the maximum to be raised, but the opportunity of economy should not be denied on the condition that they duly discharge their necessary function. • The larger circumscriptions are fairly entitled to great latitude. A higher standard of intelligence may be expected from their representatives, and their economic resources are more varied. But even with them the need for supervision cannot be said to be absent.” • Pigou (1927)

32. SOME DATA (I) Local gov. taxes as a share of general gov. revenues

33. SOME DATA (II) Local gov. expenditure as a share of general gov. expenditure

34. SOME DATA (III) Local gov. taxes as a share of local gov. overall revenues