Bailouts in a fiscal federal system: Evidence from Spain

Abstract

This paper investigates bailouts in the fiscal federal system of Spain. An equation is estimated in which central government grants to regions depend on the regions' issue of debt. The data is for the period 1986–2006. The results reveal partial bailouts. This holds for discretionary and in-principle non-discretionary grants. Bailouts are greater or more likely when there are limits on the borrowing autonomy of a region, when the region is responsible for providing health care; and when the region has a high proportion of swing voters).

Introduction

In many decentralized countries, sub-central governments are heavily indebted. These include regional governments in Brazil, Italy and Spain. Argentina has been a salient case (Rezk, 1998). The lack of fiscal discipline of sub-central governments is a major source of macroeconomic instability (Ahmad et al., 2006). The expectations of sub-central governments that they will receive additional resources if necessary can weaken fiscal discipline and can result in strategic use of debt. There is therefore moral hazard.

A sub-central government has a soft budget constraint when it has a budgetary deficit and issue debts in the expectation of receiving additional resources from the central government (Kornai et al., 2003). The additional resources are termed a bailout (Wildasin, 1997). The bailout can be explicit or implicit. In an explicit bailout, the central government provides a supplementary grant to the sub-central government.¹ Such bailouts may come with or without conditionality. In an implicit bailout, the central government provides an additional amount from existing grants to a sub-central government due to debt. In this paper, I empirically investigate implicit bailouts of Spanish regional governments by the central government.

Theoretical analyses (e.g., Goodspeed, 2002, Inman, 2003, Schaltegger and Feld, 2009) and the evidence from a number of case studies, including the USA (Inman, 2003), Canada (Bird and Tassonyi, 2003) and Hungary (Wetzel and Papp, 2003), indicate that fiscal decentralization per se does not necessarily weaken fiscal discipline of sub-central governments. The effect on fiscal discipline depends on whether the institutional setting provides expectations for sub-central governments that they will be bailed out (Rodden et al., 2003).

A bailout requires some discretion by the central government in the allocation of resources among sub-central governments (Rodden, 2001, Oates, 2005). The literature emphasizes the fact that, when regional governments are responsible for providing a key public service, such as health care or education, it is difficult for the central government not to bail them out when they face financial difficulties (Rodden et al., 2003, Bordignon and Turati, 2009). Likewise, an absence of sub-central fiscal autonomy (over taxes, expenditure or borrowing) can also induce the central government to bail out regions, because the regions lack the instruments to make fiscal adjustments (von Hagen and Eichengreen, 1996).

The number of people living in the region can affect the bailout decision. According to the “too big to fail” hypothesis (Wildasin, 1997), the larger is the population in a region, the greater is the probability of a bailout, because the negative externalities associated with financial difficulties affect a higher share of the population. The political characteristics of the regions can also affect the central government's bailout decision, as I shall show.

A number of empirical studies have examined the effects of bailouts on sub-central fiscal discipline.² Pettersson-Lidbom (2010) estimates the effect of the expectations of being bailed out on the fiscal discipline of Swedish municipalities for the period 1979–1992. He proxies these expectations by the explicit bailout-grants received by neighbouring municipalities and reports that such an expectation increases local public debt by 20%. Bordignon and Turati (2009) estimate the effect of bailout expectations, proxied by political characteristics, on regional public health care expenditure for the Italian regions during the period 1990–1999. They also find that bailout expectations increase these expenditures. Garcia-Milà et al. (2001) show that, for the period 1984–1995, the amount of additional grants expected by Spanish regions, proxied by the share of regions in terms of population, led to higher levels of regional public debt.³ By contrast, Lago (2005) empirically analyses the determinants of Spanish regional deficits for the period 1984–1996, and finds a role for, not bailout expectations, but lack of regional financial autonomy. The above studies are concerned with the fiscal-federal moral hazard problem or the effect of bailouts or expectations of being bailed out on the fiscal discipline of sub-central governments. The studies proxy bailout expectations using several characteristics identified as determinants of bailout expectations but do not empirically study the existence and determinants of implicit bailouts.⁴ Empirical evidence is lacking on the existence and determinants of bailouts. My aim is to provide such empirical evidence. To the best of my knowledge, my research question has not been previously addressed empirically.

Spain is a particularly well suited institutional environment for my study, because of an ongoing process of decentralization, gradually introduced over time, and characterised by significant differences across regions. Contemporary regional public expenditure accounts for approximately 40% of overall public expenditure. During the period analysed, there was a substantial increase in the issue of public debt by regional governments. Although the greater part of their resources was from formula-based grants, there was substantial scope for discretion in distribution of grants. Spanish regions have experienced considerable variation in their fiscal autonomy; moreover, they are responsible for providing basic public services, such as health care and education, from different points in time. These differences across regions and in time allow us to identify the existence and determinants of implicit bailouts.⁵

I find that the Spanish central government uses discretionary and (a priori) non-discretionary grants to partially bail out regional governments. Bailouts are more prevalent when there are limits on the borrowing autonomy of the regions; the region is responsible for providing health care; and the region has a high proportion of swing voters.

The paper is organized as follows. In Section 2 I describe when a bailout takes place and the main institutional characteristics that affect this decision. I also identify testable predictions. In Section 3 I set out the empirical strategy and briefly describe the characteristics of the intergovernmental relationships in Spain. The data base and econometric procedures are also discussed in this section. The results are presented in Section 4. The last section summarises the conclusions.