Traditional theory of fiscal federalism assigns the role of macro-economic stabilisation to the federal government. In addition to this long-standing theory, there is the empirical observation that federal governments in developing countries typically have cheaper and more stable access to capital markets. The basic over-riding question is whether stabilising transfers from the federal budget can really help deal with the boom-bust cycles so prevalent in the developing countries of Latin America.
Drawing on the recent experience of four large countries with federal governments in Latin America (Argentina, Brazil, Colombia, and Mexico), this World Bank paper examines how intergovernmental transfers affect the division of the burden of stabilisation across all levels of government. Imposing stabilising rules on federal transfers that protect subnational governments from fluctuations in the business cycle can serve two purposes: (1) During boom periods, stabilising rules prevent subnational government’s tendency to increase inflexible expenditures and (2) during downturns, stabilising rules place the burden of borrowing at the federal level – the level most appropriate for macro stabilisation and often the level with superior access to credit. Argentina and Colombia have stabilising rules for federal transfers: The other two countries have alternative arrangements (or no arrangements) but their fiscal/economic results do not appear to have been adversely affected by the absence of stabilising rules.
Despite the logic of stabilising rules, the recent experience of these four countries reveals that these rules can contribute to fiscal and political tensions, particularly in the face of high GDP volatility. Other conclusions from the paper are that:
- Protection against falling revenues in the downturn constitutes a contingent liability for the central government
- There is a danger that the federal government would overuse the floors on subnational transfers in circumstances when the federal government has little else to offer in intergovernmental bargains
- The larger the share of transfers of total public sector revenues, the more the subnational governments need to share in the risk of a fall in total public sector revenues
Certain conditions should be in place before establishing a stabilisation rule to federal-to-subnational fiscal transfers. Further policy implications include:
- Subnational governments must be credit constrained, rationed out of the market or confront a substantially higher cost of borrowing
- The federal government must possess stable access to credit and quality debt management
- There must be no severe structural fiscal imbalance, either within any one level of government or across levels of government
- Subnational governments should have some margin to enable them to increase their own revenue
- Subnational governments have to keep spending flexible, especially their deferrable investment programme, and keep it below the level of 99 per cent of income going to wages and debt service
- Subnational governments have to build reserve funds and have a secure credit line, available in times of fiscal distress.
