Revenue decentralization, central oversight and the political budget cycle: Evidence from Israel

•We examine if decentralization and supervision affect political budget cycles.•We find that tight monitoring eliminates political budget cycles (PBC).•We find that high dependence on central government transfers exacerbates PBC.•This pattern is predominantly accounted for by development expenditures.•PBC can result from fiscal institutions that create soft budget constraints.

This paper examines whether revenue decentralization and direct external financial supervision affect the incidence and strength of political budget cycles, using a panel of Israeli municipalities during the period 1999-2009. We find that high dependence on central government transfers - as reflected in a low share of locally raised revenues in the municipality's budget - exacerbates political budget cycles, while tight monitoring - exercised through central government appointment of external accountants to debt accumulating municipalities - eliminates them. We also find that this pattern is predominantly accounted for by development expenditures. These results suggest that political budget cycles can result from fiscal institutions that create soft budget constraints: that is, where incumbents and rational voters can expect that the costs of pre-election expansions will be partly covered later by the central government.