Fiscal Adjustment under Centralized Federalism: Empirical Evaluation of the Response to Budgetary Shocks

Abstract

Fiscal federalism implies a challenge of holding fiscal discipline at the local level. Recent analyses of fiscal adjustment have addressed the design of fiscal and political institutions for the US states, and have shown how tax limits and anti-deficit rules strengthen immediate shock adjustment. Here we extend the evidence to the case of centralized financing in Norway. In this system central government takes larger responsibility in smoothing decentralized government revenue, but at the same time the locals are more vulnerable to shocks due to limited room to maneuver. The empirical analysis of responses to budgetary shocks shows that local public investment is the main shock absorber in this system and that investments are procyclical. Local fiscal crisis is avoided, but decentralized government is destabilizing.