Fiscal rules to tame the political budget cycle: Evidence from Italian municipalities

Abstract

The paper provides evidence that fiscal rules can limit the political budget cycle. It uses data on Italian municipalities during the 2000s and shows that: 1) municipalities are subject to political budget cycles in capital spending; 2) the Italian sub-national fiscal rule (Domestic Stability Pact, DSP) introduced in 1999 has been enforced by the central government; 3) municipalities subject to the fiscal rule show more limited political budget cycles than municipalities not subject to the rule. In order to identify the effect, we rely on the fact that the domestic fiscal rule does not apply to municipalities below 5000 inhabitants. We find that the political budget cycle increases real capital spending by about 10–20 percent on average in the years prior to municipal elections and that municipalities subject to the DSP show a pre-electoral increase in capital spending which is only a quarter of the one of municipalities not subject to the rule.

Introduction

This paper presents evidence suggesting that fiscal rules can help moderate the political budget cycle. The term “political budget cycle” generally refers to increases in government spending or in the deficit, or decreases in taxes, in an election year or pre-election year, which are perceived as motivated by the incumbent's desire for re-election. Fiscal rules can limit the political budget cycle because they reduce the politician incentives to be profligate in order to be re-elected, by increasing the cost of pre-electoral profligacy if elected. The focus of the paper is on Italian municipalities during the 2000s when they have been subject to the sub-national fiscal rule (Domestic Stability Pact, DSP) introduced in 1999.

It is well recognized that the political budget cycle has potentially a number of negative effects. The political budget cycle implies that public spending or taxation policies are tweaked to achieve goals that are different from the social welfare (Alesina, 1987, 1988). It also usually leads to excessive spending and deficits. In the context of sub-national entities, it is important to remind that budget deficits at the national levels can originate at sub-national level of governments.

Recently, the growth of deficit and debt to unprecedented levels in many advanced economies has forced many countries to adopt fiscal rules to contain their further growth. While fiscal rules are usually designed to limit deficits and debts directly, this paper argues that they can also have an effect by reducing politicians' incentives to overspend prior to elections. However, assessing the effects of fiscal rules is not always an easy task. For example, identifying the causal effect of fiscal rules on fiscal aggregates is not simple. The obvious endogeneity problem is that national or subnational governments adopting a fiscal rule might be those more fiscally responsible; therefore, the better fiscal outcomes might be due to the voters’ preferences, more than to the introduction of a fiscal rule.

This paper identifies the effect of the rule on the political budget cycle leveraging on the fact that municipalities below 5000 inhabitants have been exempted from the rule. Our difference-in-differences estimates suggest that the political budget cycle increases capital spending by about 11 percent (in real terms) on average in the three years prior to municipal elections and that the sub-national fiscal rule reduces these figures by about 80 percent. These results are confirmed by a regression discontinuity analysis: the electoral cycle effect estimated at the 5000 threshold using polynomial regression is about 18 percent, while municipalities subject to the DSP show an increase in capital spending in pre-electoral years 75 percent lower. We also provide evidence that the fiscal rule has been enforced by the central government, at least over the period 2004–2006 for which we have data on the municipalities that have breached the DSP.

A number of recent papers have used Italian administrative municipal data to address an array of political economy issues. Cioffi et al. (2012) provide evidence of political budget cycle in capital and overall spending, while Alesina and Paradisi (2017) focus on the revenue side by exploiting the introduction of a new real estate tax in 2011. Gagliarducci and Nannicini (2013) study the effect of the wage on the performance of mayors. Alesina et al. (2018) show that younger politicians behave more strategically than older ones. Particularly relevant for our purposes is the paper by Grembi et al. (2016), which shows that the relaxation of the DSP for smaller municipalities in 2001 triggered a significant deficit bias.¹

This paper relates also to three other branches of literature. By assessing how fiscal rules can limit the political budget cycle, our contribution naturally fits in the broad political business cycles literature. See, among many, Rogoff and Sibert (1988), Rogoff (1990), Alesina et al. (1997), Persson and Tabellini (2000), Brender and Drazen (2005, 2008), Shi and Svensson (2006). A number of contributions have assessed empirically the political budget cycle. For a recent one on the political cycle in capital expenditures see Gupta et al. (2015).

Related to our work is also the literature assessing the political budget cycle at the sub-national level. For example, Coelho et al. (2006) and Veiga and Veiga (2007) provide evidence of political cycle at the municipal level in Portugal; Foremny and Riedel (2014) in Germany; Drazen and Eslava (2010) provide evidence on Colombia; Brollo and Nannicini (2012) on Brazil.

Finally, our paper is also connected to the growing literature on national and sub-national fiscal rules (for example, Beetsma and Debrun, 2004, 2007; Debrun et al., 2008). Burret and Feld (2014) nicely summarize the evidence and the literature regarding the role of sub-national fiscal rules in federations, like the US and Switzerland. In this strand of literature, the recent contribution by Grembi et al. (2016) is the first to propose “a quasi-experimental design” to control for omitted and unobservable factors that may affect previous results and to better establish the causal effect of the introduction of the rule.

Our paper contributes to these different literature in several ways. First, it provides evidence on the existence of a political budget cycle on the expenditure side at the local level in Italy and quantifies its effects. Second, it provides new evidence that the central government has enforced the DSP. The fact that the DSP has been enforced by the central government reduces concerns regarding the endogeneity of the rule, although it still leaves open the possibility that omitted and unobservable factors might affect how municipalities have reacted to the imposition of the rule. The regression discontinuity analysis addresses this issue focusing on the behavior of municipalities around the threshold. Finally, and most importantly, it provides novel evidence that the imposition of the rule has reduced the political budget cycle. We believe this is the first paper providing evidence that sub-national fiscal rules can contain the political budget cycle. Importantly, even when the introduction of a fiscal rule proves effective, in the sense that helps contain the deficit, it is very difficult to assess whether it is welfare improving. On the contrary, a rule that mitigates the political budget cycle, at least in this respect, is welfare improving.