Fiscal Rules for Subnational Governments: Can They Promote Fiscal Discipline? by Teresa Ter-Minassian published by OECD Journal on Budgeting (2007).
“Fiscal rules are often seen as devices to ensure fiscal discipline.1 They are typically enshrined in constitutional or legal provisions and are intended to influence policy design and anchor economic agents’ expectations about a government’s commitment to fiscal discipline over a relatively long horizon. At the same time, they also aim at enhancing accountability of policy makers, creating incentives for them to adhere to prudent policies.
Experience indicates that fiscal rules, while not a panacea, can be helpful as a disciplining device at the central government level. A related issue, perhaps less explored, is whether fiscal rules could also be used to limit policy makers’ discretion at the local level.2 In other words, could fiscal rules be usefully adopted in a decentralised framework, where the behaviour of subnational governments may undermine fiscal discipline? This article addresses this question.
The main conclusion is that fiscal rules are neither necessary nor sufficient to ensure fiscal discipline at the subnational level. In principle, both financial markets and co-operative arrangements across government levels could promote such discipline and provide the right incentives to local politicians to be fiscally responsible. Where, however, these arrangements are not feasible or fully reliable, fiscal rules could be useful. It should be recognised, nevertheless, that fiscal rules cannot secure fiscal discipline by themselves if the political will to adhere to them is lacking, or if the central government’s commitment to a no bailout policy is not credible, thus leading to moral hazard.
The article is structured as follows. Section 1 reviews the main challenges to fiscal discipline posed by subnational governments. Section 2 explores under what conditions markets can exert effective discipline on public governments. Section 3 reviews co-operative arrangements between levels of government, which could alternatively be adopted to ensure the formulation and implementation of appropriate fiscal policies. The role of fiscal rules and the conditions for their effective implementation are covered in Section 4. Section 5 concludes.”
