(Page 3 of 31) - Fiscal Responsibility Laws for Subnational Discipline: The Latino Experience authored by Webb, Steven.

The second section enumerates and categorizes the institutions, including but not

limited to FRLs, that have served to discourage unsustainable subnational deficits. The
third section reviews the institutions that four countries have used to deal with
subnational deficits and evaluates the extent to which the institutions have succeeded.
The sample—Brazil, India, Colombia, Argentina, and Mexico—includes most of the
large developing countries with politically autonomous subnational governments and
with recent problems of excessive subnational deficits. The final section draws
conclusions about how the characteristics and circumstances of FRLs affect whether they
are needed and whether they succeed in promoting subnational fiscal discipline.

1. What purpose could FRLs serve?

Governments appear to be interested in FRLs for two related reasons: for an

individual government to control its impulses to run excessive deficits and for a group of
governments in the same country to make and enforce a mutual agreement that each of
them would avoid running excessive deficits. In both situations the FRL would function
as a commitment device—in the first case across time to commit future governments and
in the second context across space to coordinate governments in various locales.

Motivating Fiscal Sustainability. In a normative theory of good government,

people want to avoid the effects of fiscal crisis—inflationary finance, sudden increase of
taxes, disruption of service, and increased borrowing costs—so their governments would
equally want to avoid the crises. Governments may fail to follow sustainable fiscal
policies for a variety of reasons, however (see Alesina 1994 for a survey), and they have
adopted various institutions to try to restrain themselves, including balanced-budget rules,
autonomous central banks, and congressional oversight committees. Since the late 1990s,
governments have added FRLs to the potential and actual arsenal.

Dealing with Free Riders. Suppose that multiple governments share the same

currency, central bank, domestic credit market, and (at least to some extent) international
credit reputation. Then they will share a common interest in sustainable fiscal balances
for the country in the aggregate, to maintain stable prices, a healthy financial system, and
good access to international credit. Individual governments’ interests would diverge
from the common interest, however, in that electoral pressures, etc., would motivate them
to follow unsustainable, or at least risky, fiscal behavior. The individual government
would bear only part of the cost of this, but would still receive all of whatever benefit
accrued. They could benefit from this, however, only if (most of) the other governments
continued to follow good fiscal behavior. So, there might be a prisoners’ dilemma, or a
situation where the equilibrium of isolated individual choices leads to a sub optimal
outcome. All the governments would, therefore, benefit from having a system of rules to
discourage such defection and free-riding.

When the European Currency Union formed they made such a set of fiscal rules

that countries had to agree to as a condition of entry. The history there is still short, and
enforcement problems have already emerged, but the rationale for fiscal rules in a
monetary union is clear and compelling.