TURNING A BLIND EYE TO POLICY PRESCRIPTIONS: EXPLORING THE SOURCES OF PROCYCLICAL FISCAL BEHAVIOR AT THE SUBNATIONAL LEVEL.

Author:Meloni, Osvaldo

(34) Let Pharaoh proceed to appoint overseers over the land to take a fifth of the harvest of Egypt during the seven years of abundance. (35) They should collect all the food of these good years that are coming and store up the grain under the authority of Pharaoh, to be kept in the cities for food. (36) This food should be held in reserve for the country, to be used during the seven years of famine that will come upon Egypt, so that the country may not be ruined by the famine.

Genesis 41:34-36

  1. INTRODUCTION

    Policy recommendations to smooth out the business cycle are among the most popular in economics. Carrying out a countercyclical fiscal policy is an old prescription that can be traced back to the Holy Bible although it gained fame and recognition from the scientific community with the publication of The General Theory of Employment, Interest and Money by John Maynard Keynes in 1936. Recommending increases in public spending and decreases in tax rates during recessions and the opposite in booms has become essential in macroeconomists' toolkit and quasi-mandatory in any macroeconomic textbook. Nonetheless, these prescriptions are usually ignored by developing countries' governments. Moreover, a large body of empirical works reports procyclical rather countercyclical fiscal behavior for developing countries (Bruckner & Gradstein, 2014; Catao & Sutton, 2002; Gavin & Perotti, 1997; Kaminski, Reinhart, & Vegh, 2004; Talvi & Vegh, 2005).

    Several theories have been put forth to explain this apparent suboptimal behavior of emerging economies. (1) The most prevalent is the borrowing constraint hypothesis that derives from the observation that credit markets narrow sizably for developing countries during recessions and expand considerably in booms, compelling governments to act procyclically. Another theory suggests that debt accumulation, resulting from procyclical fiscal behavior, is a strategic move of incumbents in their last term to constraint the actions of future opposition governments (Cukierman, Edwards & Tabellini, 1992). Alesina, Campante & Tabellini (2008) consider procyclical spending to be a result of rational voters' demand to avoid leaving excessive rents to corrupt governments in an environment characterized by information asymmetries.

    Alternatively, Lane &Tornell (1996) conjecture that in the presence of common pool resources the "voracity" of politicians exacerbates expenditures during booms. Economic expansions generate additional funds for which pressure groups compete to appropriate them.

    Recently, Frankel & Schreger (2013, 2016) have come out with a new hypothesis that may explain procyclical fiscal policy. Using data from several countries, mostly from the Euro area, the authors documented that government forecasts used for fiscal planning are systematically more optimistic than private sector forecasts, which helps explain excessive deficits in practice.

    Proposed theories look well suited to explain cross-country fiscal performance, but except for the voracity hypothesis they are not very useful in explaining variation across subnational districts. Notice that districts in a given country face similar liquidity constraints during recessions. Likewise, the intertemporal strategic game suggested by Cukierman, Edwards & Tabellini (1992) calls for strong parties that subordinate politicians to their long-term strategy, which is hardly the case in most of the emerging economies. On the other hand, Alesina, Campante & Tabellini (2008) assume that voters observe the state of the economy but not the rents appropriated by corrupt governments, a strong assumption for subnational constituencies that have lower costs of information about local politicians than national authorities. (2) Frankel & Schreger (2013) argument also seems inadequate for subnational districts of developing countries that receive large transfers from the federal government based on short-run political agreements that either cannot be anticipated--even a few months in advance and therefore cannot be included in the budget --or simply were left out of the budget.

    Undoubtedly, studying the cyclicality of subnational districts calls for additional hypotheses that take into account the relationship between the central government and the subnational jurisdictions.

    Why is it important to study procyclicality at the subnational level? In federally organized countries, provinces account for a large fraction of total revenues and expenditures, so procyclical behavior of subnational governments could exacerbate the procyclicality of fiscal policy at the federal level while constraining its ability to save resources for countercyclical discretionary spending during economic downturns.

    This paper analyses the fiscal behavior of subnational districts in Argentina over the business cycle. Argentina is a federal republic with some peculiarities that make it an interesting case to study: provincial governments undertake a large share of total spending in Argentina, yet they collect only a small fraction of taxes, implying huge transfers from the federal level to subnational jurisdictions which might be a source of procyclicality. Moreover, transfers are funneled to provinces through two channels: an automatic mechanism called the Federal Tax-Sharing Agreement (FTSA) and a discretionary channel, which usually involves political liaisons.

    I address two questions. Firstly, is the fiscal policy of Argentine districts procyclical? If so, what are the variables that best explain procyclicality? The answers come from the estimation of an error correction model from a panel that spans 23 years (from 1985 to 2007) and all 24 districts. Working with a relatively large panel is a contribution respect to previous studies that have worked either with time series and cross sectional but no panel data (Sturzenegger & Werneck, 2006) or with panel data having a considerably lower number of observations (289) with the exclusion of the City of Buenos Aires from the sample (Rodden & Wibbels, 2010). To preview my results, I find strong evidence of procyclicality in all categories of public expenditures except for personnel. I show that this behavior is mostly driven by the political alignment between the president and governors, the influence of federal intervention of provinces undergoing political and economic turmoil and two sources of voracity effects: discretionary transfers from the federal government and the oil, gas and mining grants received by producer states. This channel was ignored in the literature. In contrast with the earlier research on Argentine subnational districts, I also explore the role of the main national parties on procyclicality.

    The rest of the paper is organized as follows. The next section reviews both the theoretical and the empirical literature on procyclical fiscal policies. Section 3 discusses some key features of Argentine federalism, and section 4 describes the empirical investigation and presents the results obtained from the dynamic panel data estimation. Finally, section 5 concludes.

  2. LITERATURE REVIEW

    Since ancient times, societies have demanded that governments smooth in-tertemporal consumption and avoid macroeconomic instability. Nonetheless, it was just after the Great Depression that formal discussions, in technical terms, gave birth to policy prescriptions rooted in economic theory. The standard Keynesian countercyclical policy recommends tax cuts, expenditure increases, and deficits during recessions, and tax increases, expenditure cuts and surplus during economic booms. On the other hand, the tax-smoothing theory of budget deficits (Barro, 1979) claims that budget deficits and surpluses should be used to "smooth" the distortionary cost of taxation, which implies that a temporary increase in expenditures in bad times should be financed by issuing debt in order to spread the increase in taxes over a longer time horizon and to minimize the welfare costs of high tax rates. Thus, for different reasons, both theories propose countercyclical policies. (3)

    The empirical evidence from cross-country studies suggests that most of the developed countries practice some kind of countercyclical policies to smooth consumption while developing countries seem to ignore them (Gavin et al., 1996; Gavin & Perotti, 1997; Talvi & Vegh, 2005). Why do emerging economies turn a blind eye to policy prescriptions? For Alesina, Campante & Tabellini (2008), procyclicality is driven by voters who seek to reduce political rents. In a context of asymmetric information, voters observe the state of the economy but not the rents appropriated by corrupt governments. Hence, after observing a boom, voters demand more public goods or lower taxes, and this induces a procyclical bias in fiscal policy. For Cukierman, Edwards & Tabellini (1992), procyclicality is the result of a political game in which the incumbents run up debt levels in order to constrain the spending policies of future opposition governments. This strategic move would presumably facilitate their return to office next period. Therefore, countries accumulate debt during boom periods, generating a procyclical fiscal policy. Obviously, indebtedness requires full access to credit markets, which seems reasonable for developed countries but not for developing ones--and even less plausible for subnational districts. Furthermore, this intertemporal strategic game needs strong political parties with a long-term planning horizon, which is hardly the case of Argentine parties in most of the districts (Jones, Sanguinetti & Tommasi, 2000; Jones, Saiegh, Spiller & Tommasi, 2002; Jones & Hwang, 2005)

    The most common explanation of procyclicality is the credit constraint theory formalized in Gavin, Hausmann, Perotti & Talvi (1996). According to this theory, during recessions, emerging economies lose access to credit markets or get scarce funds at a very high rate, precluding any...

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