Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Reconstruction multipliers Riccardo Trezzi and Francesco Porcelli 2014-79 NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers. Reconstruction multipliersI a b, Francesco Porcelli ,RiccardoTrezzi ⇤ aBusiness School, University of Exeter, UK. bBoard of Governors, Federal Reserve System, USA. Abstract A law issued to allocate reconstruction grants following the 2009 "Aquilano" earthquake has resulted in a large and unanticipated discontinuity across municipalities with comparable damages. Using diff-in-diff analysis we estimate the "local spending" and the "local tax" multipliers - according to the composition of the stimulus - controlling for the negative supply shock generated by the event. The stimulus prevented a fall in economic activity and the multiplicative effects of tax cuts are estimated much higher than those of spending. Our results underline the importance of countercyclical fiscal interventions and suggest the most effective composition of such a stimulus. Keywords: Natural disasters, Fiscal multipliers, Mercalli scale. JEL: classification C36, E62, H70. IWe are extremely grateful to Giancarlo Corsetti for useful comments and invaluable support. We are also grateful to the participants of the conferences and workshops at the University of Cambridge, University of Pavia, University of Exeter, University of Rome Tor Vergata, University of Barcelona (Autonoma), New Economic School, Board of Governors of the Federal Reserve Bank, University of Ferrara, KOF Swiss Economic Institute, 2014 IAEE conference (Queen Mary University of London), 2014 CFM macroeconomics workshop (at NIESR), and the 2014 IIPF annual congress in Lugano for helpful comments. Finally, we are grateful to the Italian National Institute of Geophysics and Volcanology and to the Civil Protection Department for providing the requested data and information. We thank the University of Cambridge, the University of Exeter and the ESRC for financial support. All errors and omissions remain ours. This paper previously circulated with the title ’Shake me the money!’. This version: October 2014. Disclaimer: the views expressed in this paper are those of the authors and do not necessarily reflect those of the Board of Governors of the Federal Reserve System. ⇤E-mail address: [email protected]. 1. Introduction The effectiveness of fiscal policy - typically summarized by a number "the multiplier" - has been an important driver of policy and academic debates in recent years. Although several contributions have provided estimates of "the multiplier" using different identification strategies, the literature is far from consensus. While virtually all earlier contributions have focused on aggregate effects, recent papers have shifted the attention to the local dimension. As Acconcia et al. [1]pointout,theshiftismotivatednotonlybyspecific policy questions - such as countering area-specific recessionary shocks - but also by the opportunity to address econometric issues in identification: fiscal policy is highly endogenous to the business cycle and its effects are often anticipated by rational agents. This paper contributes to the debate on the effects of government interventions relying on a natural ex- periment, the 2009 "Aquilano" earthquake that hit the Italian region of Abruzzo. Specifically, we estimate the output effect generated by the event, as a result of two combined shocks, the negative supply shock due to the quake, and the positive demand shock driven by reconstruction grants to the region. Our empirical strategy relies on the following two factors: (i) a quantified measure of damages reported by the 75,424 build- ings classified after the quake, and (ii) the specific characteristics of the institutional arrangement of public grants providing insurance to the municipalities affected by the earthquake. With regard to the first factor, in the aftermath of the earthquake specialists from the Civil Protection Department (CPD) and the National Institute of Geophysics and Volcanology (INGV ) visited the epicentral area with the goal of surveying the affected buildings.1 Relying on the reported damages, we construct a synthetic index that captures the neg- ative supply shock generated by the event at the micro-municipal level. With regard to the second factor, as acomplementarytaskthedelegatesassignedasyntheticnumbertothemunicipalitiesintheepicentralarea reflecting the overall severity of the damages. Following a well-established practice, the rankings were based on the so-called Mercalli scale that classifies the destructive effects of an earthquake on twelve notches, rang- ing from "instrumental" (I) to "catastrophic" (XII).2 Once the list of affected municipalities was delivered 1The Department of Civil Protection is a structure of the Prime Minister’s Office which coordinates and directs the national service of civil protection. When a national emergency is declared, it coordinates the relief on the entire national territory. It coordinates activities in response to natural disasters, catastrophes or other events which, due to their intensity and extent, must be tackled using special means and powers. In this case, the council of ministers declares the "state of emergency" by issuing a law by decree and identifies the actions to be undertaken to manage the event. 2Contrary to the well-known Richter scale (which quantifies the moment magnitude of an earthquake meaning the energy 2 to the national authorities, the central government enacted a law by decree establishing a qualifying Mercalli threshold for reconstruction grants. This threshold, ex ante unknown to the delegates, was fixed at level VI of the scale (the lowest level associated to marginal damages to civil structures) and resulted in a sharp discontinuity in grants across ex ante identical neighbor municipalities. The assigned grants were then used by the qualified municipalities for two purposes: to finance the increase of local spending directed towards reconstruction activities and to compensate for the loss in local tax revenues due to the shock to the tax base and the temporary suspension of tax payments in the most affected regions. Studying the 305 municipalities in the Abruzzo region over the period 2002 to 2011 (3,050 observations in total) we estimate three things. First, we estimate the "reconstruction grants multiplier" - the elasticity of local output to exogenous reconstruction grants allocated from the central government to the qualified municipalities. Second, noticing that the discontinuity in local spending is identified at Mercalli VI as for grants while the discontinuity in local tax revenues is at Mercalli VII (due to an exogenous reduction in the local marginal tax rate which applied only to municipalities with severe damages), we estimate the "local spending multiplier" net of marginal tax rebates around the Mercalli VI cutoffand the the "local tax multiplier" net of variations of the tax base around the Mercalli VII cutoff. Finally, we estimate the output loss generated by the negative supply shock due to the destruction of physical capital relying on our index of damages. In our econometric analysis we rely on two identification strategies based on a linear fixed-effects panel data model. In the first identification strategy, in order to address the grants endogeneity issue, we rely on a difference-in-differences approach regressing output over the index of damages and the interaction between a dummy which identifies the treatment and control groups (around the Mercalli VI cutoff) and the per capita grants. The second identification strategy addresses the possible endogeneity of damages using an instrumental variable approach. As a strictly exogenous instrument we employ the distance of each municipality from the epicenter which confirms the prior to be highly correlated with the recorded damages and fully satisfies the exclusion restrictions criteria. released by the event), the Mercalli scale classifies the destructive effects of an earthquake. While every quake has only one magnitude recorded at the epicenter, the destructive effects (therefore the Mercalli ranks) vary greatly across municipalities according to a large set of factors, including the distance from the epicenter or the ex ante vulnerability of buildings. See AppendixC for details. 3 In our findings, the direct effect of the earthquake on output is unambiguously negative. Our instru- mental variables analysis shows that, on impact, the output loss from the quake averages 3.7 percentage points. Against the output effects of the negative supply shock, we document positive multiplicative effects of reconstruction grants. The estimated "grants multiplier" is bounded between 0.14 and 0.36 according to the model. Multiplying these elasticities by the magnitude of the fiscal shock, our results suggest that public grants compensate the output fall (which is instead suffered by the control group) generated by the quake. Therefore, although grants multipliers remain well below unity in