Dissertation: Sustainable Federalism

Sustainable Federalism

Theory and Applications

Constantin-von-Ditze-Preis 2004

Buch beschaffeneBook-Anfrage

Schriftenreihe volkswirtschaftliche Forschungsergebnisse, Band 156

Hamburg , 236 Seiten

ISBN 978-3-8300-3493-3 (Print) |ISBN 978-3-339-03493-9 (eBook)

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When it comes to sustainability, most people, particularly in Europe, think of an environmental concept to conserve access to natural resources for our offspring. Rooted in forestry, any concept would be called sustainable that ensures long-term use of a certain resource without exploiting its stock. The United Nations’ environmental summit of Rio de Janeiro in 1991 further manifested sustainability as a purely environmental concept. Sustainable development was defined as a policy that ensures long-term growth without harming future generations’ access to environmental resources. However, one should note that access to resources is not only limited by environmental constraints, and resources themselves are not solely natural ones. Instead, resources should be seen as the sum of potential long-term wealth that can be used by individuals. Under this definition it is clear that the government, due to its power to enforce long-term legislation, might be able to influence the distribution of life-cycle resources for human beings within and across generations. The most prominent example for such a legislation is probably pay-as-you-go financed social security: Contributions are paid by the young who themselves trust the power of the government to enforce later contributions to pay for their own oldage income. Therefore it is also necessary to evaluate the long-term fiscal stance of the economy, which, for the remainder of this study, will be called the stance of fiscal sustainability. The only exception might be an economy where the concept of Ricardian equivalence is valid. This concept provides for dynastic and infinitely living families that eliminate any government’s action by a private transfer into the opposite direction in order to stay on their once chosen optimal consumption plan. We do not believe in this concept, but due to its influence in the field of public economics, Ricardian equivalence is presented in more detail within this work as well.

However, what exactly is a fiscally unsustainable situation? In a broad sense, any fiscal development would be called unsustainable if it is not possible to maintain it infinitely. More specifically, it would even be called unsustainable if several generations living over time would not be treated equally by fiscal policy. This last definition comes close to what sustainability means in the environmental context. Defined in this way, however, it is also very much akin to the well-known economic concept of stability, generally indicating an equilibrium state of the economy. These ideas have already been widely discussed and are presented in a consistent way as an overview here. Additionally, many studies have been conducted where the long term fiscal stance of a range of countries has been investigated. Nevertheless, no in-depth sustainability study has yet been carried out for federal systems. Based on some findings of fiscal federalism, the objective of this study is to close this gap.

What makes the question of fiscal sustainability such an important one is the demographic development in most western economies. Together with generous welfare systems or pay-as-you-go financed social security, shrinking populations, including a growing proportion of elderly people, put enormous pressure on the public budgets. This pressure affects not solely the expenditure side of the budgets. A decreasing working population directly translates into a declining income tax base. Fiscal sustainability concepts allow for a closer look at the content and development of public debt by explicitly including such trends. Due to the great importance of public debt management for fiscal policy, fiscal sustainability considerations are a necessary supplement for the traditional toolbox of fiscal evaluation. The reason why such concepts might be additionally useful to evaluate federal systems are the linkages between the single units in these systems. One example is the great importance the Treaty of the European Union ascribes to the strict keeping of certain fiscal indicators such as the development of public debt. This indicator explicitly refers to the total debt of the federal governments plus the debt of their subunits. Given a high degree of autonomy regarding the subunits’ budgets, it, therefore, is important to evaluate its long-term impact on the overall system. In Chapter 2 an overview about the most prominent ways of measuring fiscal sustainability is provided. The chapter starts with a historic description, beginning with some ideas of Keynes and finally ending with the derivation of the intertemporal government budget constraint as developed by Barro. The crucial meaning of this constraint for any approach of measuring fiscal sustainability is explained. It follows one section for each of three sustainability approaches. Each section contains, first, a theoretical part where the concept itself is derived and explained and, second, an empirical part where the most important studies are presented, conducted so far using the respective method. The chapter ends with an abstract about today’s practical use of each method, a discussion of the major advantages and drawbacks, and a description of what is currently done to further develop the concept of fiscal sustainability.

Chapter 3 explains the need for sustainability concepts when it comes to federal systems. The chapter begins with a short introduction into well-known results and current research about fiscal federalism. The concepts of cooperative and competitive federalism are presented in a theoretical way. They are later used in this chapter for empirical evaluations of the systems of Germany and the U.S. We will show that although in both countries extensive use is made of intergovernmental transfers, the purpose of these grants largely differs between the systems. Finally, it is explained how fiscal sustainability concepts can extend the meaning and use of traditional results about fiscal federalism and how this could be used for the two countries under investigation. Chapter 4 contains the first of two practical cases. The long term fiscal stance of the 16 German states is investigated. Since Germany represents a cooperative federal system, the question of an appropriate intergovernmental transfer system is especially important. Another aspect, very typical for Germany, is the extremely high share of personnel costs of the overall state budgets. This is due to the organization of many regulated sectors like education, where most employees are working as civil servants. They are paid directly out of the states’ tax income and, what might be even more important, even their pensions are provided in the same way. The described demographic development together with a rigorous extension of state-employees due to educational purposes during the 1970’s will put enormous pressure on some of the states’ budgets. This, again, directly translates into severe sustainability problems.

Chapter 5 makes the same case for the 50 states of the U.S. For this chapter, we drew heavily on a common work with Bruce Baker and Laurence J. Kotlikoff. Also, some helpful comments were given at the CESifo public finance workshop in July 2002. The U.S. represents more the case of a competitive federal system. It is shown that there exists a wide spread in the sustainability situation among certain states. And, although there is not much of an inter-state transfer system, it is shown that fiscal sustainability concepts might be a useful extension of currently used instruments to evaluate fiscal strength of states. It is extremely important that such an evaluation be conducted in a fair way, since the states have to finance themselves at private capital markets when there are no huge transfers as they exist in Germany.

The last chapter of this study summarizes and attempts to give an outline for further research in this field. Although many of the quantitative results presented in this study are out-dated already, even recent fiscal federal reforms, e.g. in Germany, did not consider longterm aspects in any way. In this way, the results presented here are still up-to-date.

Constantin-von-Ditze-Preis 2004

der Albert-Ludwigs-Universität Freiburg

Ihr Werk im Verlag Dr. Kovač

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