What objectives shape the fiscal policy choices of regional governments?

Summarising a recent article from Regional and Federal Studies, Carmen Marín González and Diego Martinez Lopez argue that the standard fiscal policy trade-off between stabilisation and debt sustainability fails to explain the behaviour of subnational governments, whose dominant responsibility is delivering welfare services. Using a revealed-preferences framework applied to Spanish regions (2013–2023), she shows that public spending - especially health and education - consistently outweighs fiscal discipline as the primary driver of regional fiscal policy. The findings imply that effective fiscal governance and intergovernmental financing reforms must recognise service provision, rather than debt control, as the central objective shaping regional decision-making. 

Under the traditional view, it is assumed that national governments choose between macro stabilisation and debt sustainability. On the one side, policymakers may be interested in closing the output gap, i.e. the difference between the real and the potential output. On the other side, governments may intend to guarantee debt sustainability – for instance keeping under control their stocks of public debt. Or, they may choose a combination of both. This is the standard approach in fiscal policy analyses. 

However, when this analysis is extended to lower tiers of governments in decentralised countries, a new objective in the design of fiscal policy arises: the provision of public spending. The spending responsibilities on healthcare and education in many countries are assigned to subnational entities and make up a large share of their budgets. For example, in countries such as Switzerland, Italy, Denmark, Sweden, Spain or Finland, the degree of decentralisation of health care and education expenditures to subnational governments is above 80 per cent. This type of expenditures accounts for more than a half of their total budgets.

Additionally, subnational governments are less committed to debt sustainability and fiscal discipline. One reason is their lower responsibility in raising resources from capital markets, given the weight of vertical transfers and, sometimes, bailout expectations. Another reason is their minor commitment with the compliance of the duties as Member States of a monetary union as the Eurozone; this is a responsibility for the central governments. 

In this context, we have extended the standard framework of fiscal policy decisions to subnational entities but added a new objective: the provision of public services such as health and education. We have developed a new and enlarged model in which the analysed subnational governments are concerned not only with stabilisation and sustainability but also with providing a determined level of public spending. 

Here our study offers a novel approach. In a similar way to the micro-founded theory of the revealed preferences, we derive which preferences have featured the regional governments observing what they decide. In other words, based on their decisions, we infer their preferences on fiscal policy. Our sample has consisted of the Spanish regions between 2013-2023. About one third of the consolidated public expenditures in Spain is managed by the regional governments, with health care, education and social services as the most relevant. As in other countries, the Spanish territorial financing system combines shared taxes with vertical and horizontal intergovernmental transfers.

We also constructed original estimates of regional business cycles and used them in the model calibration, alongside indicators of each regional government’s fiscal stance (expansionary or contractionary). Together, these measures allow us to proxy their policy preferences for macroeconomic stabilisation and debt sustainability, respectively.

Our results indicate that, other than the unusual year of 2020, there is a strong policy preference for public spending, with a relative weight of between 40 and 60 per cent among the objectives driving their fiscal policies. The preference for debt sustainability has ranged between 20 per cent (with the maximum value reached in 2013 and then again after the pandemic) and 0. And finally, the weight of stabilisation has been estimated at between 40 and 25 per cent, depending upon the years.

There appears to be a break between the years immediately prior to the pandemic and those that follow it. Indeed, an upward trend in the concern for public spending is found until 2019. In the period 2021-2023, however, a substantial correction is observed, with values coming back to levels of 2013. The opposite happens with the policy preferences for debt sustainability: the decreasing profile between 2013 and 2019 is reverted in 2021-2023.

We also observe variation in behaviour across regions. There are some which exhibit remarkable preferences for public spending, which remains stable over the period. Many of these regions have enjoyed from financial assistance by the central government through extraordinary financing mechanisms. Under such shelter, the regions have been exposed to an implicit, but strong, incentive to borrow. By contrast, there are some regions with lower concern for public spending, especially at the beginning of the period and after the pandemic. They also show a relatively intense policy preferences for debt sustainability. Even considering, or precisely favouring it, they are among the less indebted regions. 

In the opposite side, the most indebted regions, with high concern for public spending, have not followed any fiscal consolidation strategy at all. We guess that this result could be related to the fact that these regions, given their high levels of public indebtedness, have internalised the expectation of being bailed out. We indeed think that to know the objectives driving the fiscal policy of subnational governments is crucial for reforming appropriately the territorial financing system. And more importantly nowadays, to design new frameworks of fiscal governance at national level after the renewal of the European economic governance in 2024. The Spanish case is a good example to be considered in other latitudes.

Several questions remain open. One is to check whether after the pandemic greater involvement of subnational governments to smooth the business cycle is expected. By contrast, we might ask whether a more direct concern for public spending will be recovered? Specifically for the Spanish case, we wonder if the recently proposed relief of public debt by the central government will likely play a role in the next years by guiding the regional fiscal policy.

This blog summarises the article Fiscal stabilization, debt sustainability, and public spending in subnational governments: the case of the Spanish regions from Regional and Federal Studies.

Carmen Marín González is Senior Analyst at FEDEA.

Diego Martinez Lopez is Professor in Applied Economics at Pablo de Olavide University Sevilla.

This article represents the views of the authors, and not those of Regional & Federal Studies, the Centre on Constitutional Change, or the University of Edinburgh. 

Image: The Basque Parliament or Eusko Legebiltzarra, Iker Merodio, CC BY 2.0 (via Wikipedia) .