Sub-national deficits in European countries: The impact of fiscal rules and tax autonomy

- The paper analyzes the deficit bias for European sub-national sectors.
- Innovative IV strategy for unbiased estimation of the impact of fiscal rules
- Fiscal rules are only effective for sub-national sectors in unitary countries.
- Deficits of regional and local sectors in federations can be limited by tax autonomy.

This paper empirically examines how fiscal rules and tax autonomy influence deficits of sub-national sectors across European countries. I use a new panel-data set to measure tax autonomy and the stringency of fiscal rules for EU15 regional and local government sectors over the period 1995 to 2008. I apply an instrumental variables approach to obtain an unbiased estimate of the impact of fiscal rules on deficits. I use political variables describing the central governments characteristics as instruments for fiscal rules at the sub-national level. The results show that the effectiveness of fiscal rules and tax autonomy depends on the constitutional structure. Fiscal rules decrease deficits only in unitary countries. Deficits of sub-national sectors in federations can be avoided through tax autonomy.