Fiscal Decentralization and the Challenge of Hard Budget Constraints

Fiscal Decentralization and the Challenge of Hard Budget Constraints This Page Intentionally Left Blank Fiscal Decentralization and the Challenge of Hard Budget Constraints edited by Jonathan Rodden, Gunnar S. Eskeland, and Jennie Litvack The MIT Press Cambridge, Massachusetts London, England © 2003 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any elec- tronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. This book was set in Palatino by SNP Best-set Typesetter Ltd., Hong Kong. Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data Fiscal decentralization and the challenge of hard budget constraints / edited by Jonathan Rodden, Gunnar S. Eskeland, and Jennie Litvack. p. cm. Includes bibliographical references and index. ISBN 0-262-18229-7 (hc. : alk. paper) 1. Fiscal policy. 2. Intergovernmental fiscal relations. I. Rodden, Jonathan. II. Eskeland, Gunnar S. III. Litvack, Jennie I. (Jennie Ilene), 1963– HJ192.5 .F567 2003 336.3—dc21 2002029553 10987654321 Contents Preface vii Contributors ix I Introduction 1 1 Introduction and Overview 3 Jonathan Rodden, Gunnar S. Eskeland, and Jennie Litvack II Decentralized OECD Countries 33 2 Transfers and Bailouts: Enforcing Local Fiscal Discipline with Lessons from U.S. Federalism 35 Robert P. Inman 3 Constraining Subnational Fiscal Behavior in Canada: Different Approaches, Similar Results? 85 Richard M. Bird and Almos Tassonyi 4 Vertical Imbalance and Fiscal Behavior in a Welfare State: Norway 133 Jørn Rattsø 5 Soft Budget Constraints and German Federalism 161 Jonathan Rodden vi Contents III Developing Countries with Histories of Federalism and Fiscal Decentralization 187 6 Argentina: Hardening the Provincial Budget Constraint 189 Stephen B. Webb 7 Federalism and Bailouts in Brazil 213 Jonathan Rodden 8 The Challenge of Fiscal Discipline in the Indian States 249 William J. McCarten IV Newly Decentralizing Countries in Transition 287 9 Soft Budget Constraints and Local Government in China 289 Jing Jin and Heng-fu Zou 10 Creating Incentives for Fiscal Discipline in the New South Africa 325 Junaid Ahmad 11 Systemic Soft Budget Constraints in Ukraine 353 Sean O’Connell and Deborah Wetzel 12 Strengthening Hard Budget Constraints in Hungary 393 Deborah Wetzel and Anita Papp V Conclusion 429 13 Lessons and Conclusions 431 Jonathan Rodden and Gunnar S. Eskeland Index 467 Preface This book is the product of a multicountry research project at the World Bank aimed at understanding the institutional settings in which decentralization may lead to large fiscal deficits and macroeconomic insta- bility. The project was undertaken by the Decentralization Thematic Group, which found a significant gap in knowledge regarding the macroeconomic risks associated with decentralization. Not until there is a better understanding of how and why decentralization poses risks to macroeconomic stability can governments begin to design policies and institutions to safeguard against those risks. The study develops an analytical framework for considering the issues related to soft budget constraints for state and local governments, including the institutions, history, and policies that drive expectations for bailouts among subnational governments. Four mechanisms for disciplining subnational governments—fiscal, financial, political, and land markets—are developed and applied to each of the eleven country case studies (Argentina, Brazil, Canada, China, Germany, Hungary, India, Norway, South Africa, Ukraine, and the United States). While recent econometric studies and scattered case studies allude to the complexity of hard budget constraints, this is the first in-depth look at a wide range of institutions that individually and collectively affect subnational discipline. Including developed and developing countries in the same study is important since the latter provide a his- torical perspective unavailable in many newly decentralizing developing countries. The policy implications of the study are very strong, playing directly into the long-standing debate (in which the World Bank, International Monetary Fund, and many academics have participated) between market and hierarchical mechanisms in the support of fiscal discipline under decentralization. The study concludes that this will often be a viii Preface false dichotomy. In practice, most countries, and virtually all developing countries, will require both in order to maintain fiscal discipline and derive some efficiency gains. The cases provide ample examples of different combinations of mechanisms that have resulted in varying degrees of success. Expectations about extraordinary fiscal support from the central government are formed not only by whether there is a history of bailouts, but also by cues embedded in a variety of fiscal, political, and financial institutions. These institutions range from the basic architecture of government, like the separation of powers and the fiscal strength of the central government, to specific rules governing municipal bankruptcies and the distribution of intergovernmental transfers. Rather than portraying bailout episodes merely as regrettable failures, several of the cases suggest that if unavoidable bailouts are properly structured, they present opportunities to reform the underly- ing institutions that create bad incentives. The editors conclude that successful market discipline is not likely to appear instantly in newly decentralizing countries, but can emerge from a gradual evolutionary experience that starts with carefully crafted rules and oversight. We are grateful to the World Bank, especially Shanta Devarajan and Cheryl Gray for their insights and support throughout the project. Robert Inman deserves special thanks for helping to give the study its direction and form. We appreciated helpful comments on the introduction and conclusion chapters from Amaresh Bagchi, Nirvikar Singh, Jürgen von Hagen, and the authors of the case studies. For useful comments on the entire manuscript, we thank four anonymous referees. We also thank John Covell for his help in bringing the volume to fruition at MIT Press. Finally, we are thankful to Humaira Qureshi for logisti- cal support and Diana Rheault for editorial assistance. Contributors Junaid Ahmad, Lead Economist, Infrastructure and Urban Development Department, South Asia Region, World Bank Richard M. Bird, Professor Emeritus and Director of International Tax Program, Rotman School of Management, University of Toronto, Canada Gunnar S. Eskeland, Senior Economist, Development Research Group, World Bank Robert Inman, Miller-Sherrerd Professor of Finance and Economics, Wharton School, University of Pennsylvania, Philadelphia Jing Jin, SAIS, Johns Hopkins University, Washington, D.C. Jennie Litvack, Senior Economist, Poverty Reduction and Economic Management Network, Public Sector Management Division, World Bank William J. McCarten, Senior Economist, South Asia, Poverty Reduction and Economic Management Network, World Bank Sean O’Connell, Securities Analyst, Columbus Circle Investors Anita Papp, Economist, Poverty Reduction and Economic Management Network, World Bank (Sadly, Ms. Papp passed away in September of 2000.) Jørn Rattsø, Professor, Department of Economics, Norwegian University of Science and Technology, Trondheim, Norway Jonathan Rodden, Assistant Professor of Political Science, Massachusetts Institute of Technology, Cambridge Almos Tassonyi, Senior Economist, Property Taxation Policy Branch, Ontario Ministry of Finance, Canada x Contributors Steven B. Webb, Senior Economist, Latin America and Caribbean Region, Economic Policy Sector Deborah Wetzel, Lead Economist, Europe and Central Asia, Poverty Reduction and Economic Management Network, World Bank Zou Heng-fu, Senior Economist, Development Economics and Chief Economist, World Bank, and Professor of Economics, Peking and Wuhan Universities, China I Introduction This Page Intentionally Left Blank Introduction and 1 Overview Jonathan Rodden, Gunnar S. Eskeland, and Jennie Litvack 1.1 The Context of Decentralization The basic structure of government is undergoing a major transforma- tion in countries around the world. In the past decade, demands for greater democracy and frustrations with the inability of central governments to deliver local services have provided politicians with incentives to decentralize power and resources to lower levels of government. Although many industrialized countries have had a long history with decentralized governance, developing countries—federal and unitary alike—have only recently begun to follow suit. Challenges facing industrialized countries are often magnified in developing countries, where the institutions necessary for successful decentralization are weaker. This wave of decentralization is often driven by politics, yet its reper- cussions can be felt heavily in the economic sphere. And just as global experience with decentralization has accelerated, so too has research examining its economic impact on efficiency, equity, and macroeconomic stability. This has engendered a debate about the costs and benefits of decentralization.1 On the one hand, economists have long posited that moving decision making to the lowest level possible—as long as externalities and economies of scale are tolerable—will lead to decisions that reflect local needs and preferences better and thus improve

Load more