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.