Abstract
A growing literature emphasizes that the output effect of fiscal consolidation hinges on its composition, as the choice of increasing revenues vs cutting expenditure is not neutral. Existing studies, however, underscore the role of local governments in a federal setting. Indeed, transfer cuts at the central level might translate into higher local taxes, changing the effective composition of the fiscal adjustment. We evaluate this transmission mechanism in Italy, where municipalities below the threshold of 5,000 inhabitants were exempted from (large) transfer cuts in 2012. This allows us to implement a difference-in-discontinuities design in order to estimate the causal impact of transfer cuts on the composition of fiscal adjustment, also because tight fiscal rules impose a balanced budget on Italian municipalities. We find a pass-through mechanism by which local governments react to the contraction of intergovernmental grants by mainly increasing taxes rather than reducing spending. From a political economy perspective, this revenue based fiscal consolidation is driven by local governments with low electoral competition and low party fragmentation.
Highlights
Recent works in both macroeconomics and political economics show that the output effect of fiscal consolidation depends on its composition, as the choice of increasing revenues vs cutting expenditure is not neutral from both an economic and a political perspective.1 In particular, the evidence summarized by Alesina et al (2019) shows that expenditure based fiscal consolidations, on average, have a smaller contractionary effect than tax based fiscal consolidations
As transfer cuts at the central level might translate into higher local taxes, changing the effective composition of the national fiscal adjustment, any macro evaluation of fiscal consolidations should take this transmission mechanism into account
In order to identify the causal impact of the 2012 transfer cuts, imposed to municipalities above 5000 inhabitants but not to those below, we need to control for a series of potential confounding factors, which prevent the use of a simple regression discontinuity design
Summary
Recent works in both macroeconomics and political economics show that the output effect of fiscal consolidation depends on its composition, as the choice of increasing revenues vs cutting expenditure is not neutral from both an economic and a political perspective (see Berndt et al 2012; Alesina and Ardagna 2013, Alesina et al 2017, 2019). In particular, the evidence summarized by Alesina et al (2019) shows that expenditure based fiscal consolidations, on average, have a smaller contractionary effect than tax based fiscal consolidations. Local governments might use their tax autonomy to compensate for the reduction in transfers, just reshaping revenues’ composition to avoid spending cuts.2 We isolate this mechanism in Italy, where we can causally evaluate the fiscal policy reaction of local governments to a large fiscal consolidation effort imposed at the central level. Central governments can affect local fiscal policy behavior in two ways: by changing the amount of grants or by imposing non-monetary restrictions such as tax and expenditure limitations In this respect, Skidmore (1999) looks at local tax limitations imposed in US states between 1976 and 1990, and finds that they produced a reduction in constrained revenue sources but a parallel increase in unconstrained ones.
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