Chapter 5. Monitoring sub-central government debt: Trends, challenges and practices1

OECD-wide, sub-central government debt accounted for 13% of GDP and 17% of total public debt in 2013. This chapter begins by examining the main drivers of sub-central government debt, explains why it is important to monitor debt, and surveys monitoring practices in OECD countries. The chapter then goes on to explore the main challenges that governments face when they design monitoring mechanisms and identifies policy options. The chapter explores in detail how mechanisms to monitor sub-central government borrowing – e.g. fiscal rules or direct control – work in OECD countries. It also provides an overview of data requirements and accounting procedures at all levels of government. Finally, it considers insolvency procedures and other mechanisms for dealing with sub-central governments in financial distress. The chapter draws on an OECD Fiscal Network survey of sub-central fiscal rules and macroeconomic management conducted in 2013.

  

The drivers of sub-central government debt

Why should central governments monitor sub-central government debt?

Sub-central government (SCG) debt – the debt of state or regional and local jurisdictions – accounted for some 13% of GDP and 17% of total public debt on average in OECD countries in 2013 (Figure 5.1). It also rose at a much slower pace than central government debt in the wake of the 2008 crisis. However, although sub-central debt is lower than general government’s, it must also be seen in relation to its revenues.

Figure 5.1. The composition of public debt as a share of GDP, 2013
picture

Note: 2012 data for Korea and Switzerland. All countries use consolidated data in compliance with the SNA08 standard apart from Switzerland, the United Kingdom, the United States (non-consolidated, SNA08), Canada, Turkey (consolidated, SNA93), Japan, Korea (non-consolidated, SNA93).

Source: OECD National Accounts, http://dx.doi.org/10.1787/na_glance-2015-en.

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There are a number of reasons why sub-central debt policy is an issue that concerns all governments and why it is important to monitor and manage debt well.

  • Externalities. Debt creates externalities in all tiers of government. In other words, sustainability is determined by the joint action of all governments, and financial difficulties at one level of government can affect the others. The dynamics of this common pool problem are even more pertinent if discontinuities or threshold effects are present, i.e. if interest rates suddenly rise or growth starts falling once general government exceeds a certain level of debt, or if fiscal fatigue sets in (Fall et al., 2015). The risk of contagion can disrupt financial markets as even the problems of small SCGs can have a big impact on financial markets. Moreover, SCGs often own public enterprises whose debt is not accounted for in the national accounts, thereby creating contingent liabilities. Finally, in most countries, central government is held politically responsible for SCG debt, with a bailout implicitly or explicitly guaranteed.2 Safe in the knowledge of a bailout, SCGs may engage in unsustainable fiscal policy, so increasing general government debt.

  • Limited sub-central capacity. SCGs enjoy less autonomy than central government. One reason is that their revenue bases are smaller and their power to increase revenues is usually limited, as they have little or no power over tax rates or tax bases. Another factor is that an important share of SCG expenditure is mandatory and/or difficult to cut, and cuts entail high social and political costs. A large share of sub-central spending is on critical sectors such as education, health and social protection. Moreover, spending is expected to rise due to demographic factors. Finally, the rules and standards of SCG expenditure are often set by higher tiers of government, which affords SCGs little leeway for cutting spending.

  • Wide variations across SCGs. Average levels of sub-central debt can be misleading, as there are wide disparities between SCGs within countries (Figure 5.2). In most countries, the debt levels of some SCGs are far above the national average, which suggests that the issue of debt sustainability is more important for some SCGs than for others.

Figure 5.2. How sub-central debt-to-revenue in regions/states is dispersed
Debt as a percentage of revenues, various years
picture

Note: Accounting standards used for calculating debt differ between countries, limiting comparability to some extent.

Source: OECD Network on Fiscal Relations across Levels of Government and Territorial Development Policy Committee Questionnaire on Regional Finances, 2013.

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Who lends to sub-central governments?

The OECD National Accounts distinguishes five categories of debt, classified according to the different types of creditors. SCG debt varies widely in all the categories from one country to another, affecting the volatility and cost of sub-national debt (Figure 5.3). Overall, though, loans, bonds and commercial debt are the three most widely used by SCGs. Loans by the central government, commercial banks or SCG-related banks account for the largest share of SCG borrowing. In many countries, commercial debt is also large although it seldom exceeds 50% of total debt, apart from the case of Korea. Bonds make up a large share of SCG debt in federal and quasi-federal countries, but a low or no share in most other OECD countries. The share of debt for which bonds and loans account began rising in the mid-1990s, while commercial debt increased only during the 2007 global financial crisis as a result of deteriorating SCG finances.

Figure 5.3. Composition of sub-central debt, 2013
Percentage of total debt
picture

Note: Data for Korea and Switzerland relate to 2012. All countries use consolidated data in compliance with the SNA08 standard except Switzerland, the United Kingdom, the United States (non-consolidated, SNA08), Canada, Turkey (consolidated, SNA93), Japan, Korea (non-consolidated, SNA93).

Source: OECD National Accounts, http://dx.doi.org/10.1787/na_glance-2015-en.

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Commercial banks are the main loan providers and often the only source of loans (Table 5.1). In the wake of the crisis the Spanish central government replaced banks as the main lender for the regions with the Regional Liquidity Mechanism, which represented nearly 40% of regional debt in late 2014. In Ireland and the United Kingdom, central government is also a large lender, which facilitates monitoring. Lastly, SCGs in the Nordic and many federal countries are funded in large part through specific financial institutions which are either directly owned by sub-central governments or enjoy close relationships with state/regional or local authorities (Box 5.1).

Table 5.1. The institutions that lend to sub-central jurisdictions
Percentage of lenders, 2011

Loans from central government

Commercial bank loans

Loans from banks related to SCGs

Czech Republic

0.4

99.6

0

Denmark

0

0

100

Estonia

0

100

0

Finland

0

100

France

0

100

0

Germany (local)

0.7

41.7

57.6

Greece

0

100

0

Hungary

0

100

0

Ireland

85.4

14.6

0

Poland

10.9

89.1

0

Slovak Republic

37.4

62.6

0

Slovenia

0

100

0

Spain (state)

0

100

0

Spain (local)

0

100

0

Switzerland (state)

100

Switzerland (local)

100

UK (English Local Authorities)

81.3

18.7

0

UK (Devolved Authorities)

100

0

0

Source: OECD Network on Fiscal Relations across Levels of Government – Survey on Sub-national Fiscal Rules and Macroeconomic Management, 2015.

Box 5.1. Municipal funding in the Nordic countries

Sub-central governments in Denmark, Finland, Norway and Sweden have long established municipal funding agencies that provide low-cost funding. As a result, SCGs in those countries are less dependent on capital markets than those elsewhere. The four main municipal funding vehicles are: KommuneKredit (Denmark), KBN Kommunalbanken (Norway), KommuninvestiSverige AB (Sweden), and Municipality Finance PLC (Finland). These institutions were created at different times (in 1898, 1926, 1986 and 1989, respectively) and have different organisational structures. However, they share many similarities:

  • They are not-for-profit entities whose sole purpose is to provide sub-national governments competitive funding.

  • They hold large market shares of sub-national government lending in their respective countries: more than 90% for KommuneKredit in Denmark, around 50% for Municipality Finance PLC in Finland, 47% for KBN Kommunalbanken in Norway, and 40% for KommuninvestiSverige AB in Sweden.

  • They are owned by the sub-central governments or the central government, and they benefit from various forms of “last resort” support mechanisms from their owners.

  • They provide funding exclusively via the international bond markets, rather than via deposits.

  • They have low-risk credit portfolios. Their 100% exposure to individual sub-central governments is mitigated by the strength of the Danish, Finnish, Norwegian and Swedish local government sectors.

Nordic municipal funding vehicles were particularly helpful during the recent financial turmoil, as they prevented disruption in the financing of sub-national governments. At the end of 2008, loans granted by Finnish, Swedish, Norwegian and Danish agencies accounted for 5.1%, 2.8%, 3.8% and 3.9% of GDP, respectively. Similar agencies were created in France, New Zealand and the Netherlands, and are planned in England.

Source: Vammalle, C., D. Allain-Dupré and N. Gaillard (2012), “A Sub-national Government Perspective on Fiscal Policy in a Tight Fiscal Environment”, in OECD and KIPF, Institutional and Financial Relations across Levels of Government, OECD Publishing, Paris, http://dx.doi.org/10.1787/9789264167001-3-en.

The main drivers of sub-central debt

Designing an efficient monitoring mechanism requires understanding the drivers of sub-central debt. SCG deficits and debt have three main causes:

  • Structural mismatch between SCG spending obligations and allocation of revenues. Sub-central deficits and debts may be the result of impaired fiscal relations between levels of government, where the revenues assigned to SCGs are structurally insufficient to cover their expenditure responsibilities. The result is structural sub-central deficits or under-provision of public goods.

  • Economic downturns can generate temporary sub-central deficits. Economic downturns contribute to the build-up of SCG debt. While sub-central spending obligations tend to be stable over the economic cycle, their revenues are more often pro-cyclical. As growth recovers, short-term debt should disappear.

  • SCGs may be subject to soft budget constraints and moral hazard, causing them to over-spend and issue debt in the expectation that upper-tier government will increase transfers to them or bail them out in the event of financial difficulty. Monitoring mechanisms can be one useful way to prevent structural deficits and the accumulation of SCG debt.

Policy measures to address sub-central debt depend on how it originated. Rainy day funds can be a good tool for smoothing out revenues over the cycle, thus preventing SCGs from issuing debt to compensate for falls in revenue (Box 5.2). The formulas used for allocating grants are also crucial. If they are based on current revenues and GDP growth, for example, they can be pro-cyclical. And, on the contrary, if they are based on true sub-central needs they can help smooth the cycle (Blöchliger and Égert, 2012). So can the allocation of expenditure if central government assigns areas of least cyclical spending, such as education, to SCGs. Also used are off-budget funds, ad hoc increases of central government transfers and cuts in mandated expenditure (Table 5.2).

Box 5.2. Using rainy day funds to smooth the cyclicality of revenues

Several countries have introduced so-called “rainy day” funds for sub-national governments. They set aside reserves in the funds in periods of growth and disburse them in times of fiscal stress. Rainy day funds are an alternative to the cyclical “optimisation” of SCG revenue sources for reducing the volatility of sub‐national revenues.

Nearly all US states have introduced some form of stabilisation fund over the last two decades, with tight rules regulating the size of their funds. Most states require that the total accumulated amount of deposits in a fund should not exceed 5% of their budget. Other states set a 10% cap, and a few states put no limit on the reserves they can build up. Research tends to find that rainy day funds reduce the volatility of SCG revenues and expenditure (e.g. Sobel and Holcombe (1996), Gonzalez and Paqueo (2003), Wagner and Elder [2005]), but they have not proven sufficient to cope with crises as deep as that of 2009-10 (Blöchliger et al., 2010).

US cities also benefit from a sort of rainy day fund called “ending balances” to smooth fluctuations in revenues. In contrast to states’ rainy day funds, there are no trigger mechanisms to force the release of the funds. In 2012, a report estimated that ending balances accounted for 12.7% of cities’ expenditures (down from 25% prior to the recession).

In Sweden, county councils have been allowed to build up reserve funds to transfers budget surpluses from one year to another since 2013.

In Mexico, the central government is responsible for the Fondo de Estabilization de Ingresos de las Entidades Federativas (FEIEF). This fund is used to provide the federal entities with additional revenues when grants from the central government are reduced in times of fiscal stress.

Source: Vammalle, C., R. Ahrend and C. Hulbert (2014), “A Sub-national Perspective on Financing Investment for Growth II – Creating Fiscal Space for Public Investment: The Role of Institutions”, OECD Regional Development Working Papers, No. 2014/06, OECD Publishing, Paris, http://dx.doi.org/10.1787/5jz3zvxc53bt-en.

Table 5.2. Mechanisms to protect SCGs against cyclical revenue fluctuations

 

Rainy day funds

Off-budget funds

Higher revenues from CG offsetting projected fluctuations

Higher revenues from CG offsetting actual fluctuations

Special financial support for SCGs facing budget difficulties

Cuts on mandated expenditure

Allocation of less cyclical expenditure

Australia local

x

Australia state

x

Austria local

x

Austria state

x

x

Belgium local

Belgium state

x

Canada local

x

Canada state

x

x

x

Chile

x

Czech Republic

x

Denmark

x

Estonia

x

Finland

x

x

x

x

Germany local

x

x

x

x

x

Germany state

x

x

x

Ireland

x

Italy local

x

Italy state

x

Korea

Mexico local

x

x

x

Mexico state

x

x

x

New Zealand

Poland

Slovak Republic

x

Slovenia

Spain local

x

Spain state

x

Sweden

x

x

Switzerland local

x

Switzerland state

x

Turkey

x

Total answers

10

6

6

6

5

6

4

Source: OECD Network on Fiscal Relations across Levels of Government – Survey on Sub-national Fiscal Rules and Macroeconomic Management, 2015.

The drivers in the growth and composition of aggregate SCG revenues since the mid-1990s seem to be both cyclical and structural in nature. SCGs have suffered from several economic downturns which increased growth in their expenditure and reduced that of revenues. Moreover, SCG expenditure saw a gradual shift towards more spending on social benefits and other transfers, as decentralisation shifted social protection responsibilities to SCGs. Their increased share in SCG spending may have reduced the flexibility of sub-national budgets. Social protection tends to be rather pro-cyclical and the trend therefore seems likely to generate extra SCG debt over the medium term. Still, there appears to be currently no structural, long-term mismatch between SCG spending obligations and revenues.

Central government is usually well aware of the challenges faced by sub-national finances through upward pressure on social spending, particularly in the areas of health and old age pensions. A few countries have implemented reforms to increase efficiency in spending. In recent years, for example, fiscal federalism reforms to relieve pressure on SCGs have been undertaken. They include the health reform and municipal mergers in Denmark in 2007 and the pension reforms for Japanese provinces in 2005. However, other reforms, like the latest reform of the Belgian fiscal federalism system in 2012-13, transferred responsibilities for health and pensions from central government to the sub‐national authorities and so are likely to put further long-term pressure on SCG budgets.

Mechanisms for monitoring sub-central debt

Most central governments monitor sub-central debt. Monitoring mechanisms range from pure reliance on market discipline, with no oversight from central governments, to direct control by higher levels of government of the amount and purpose of debt issued by SCGs. Fiscal rules lie somewhere between the two extremes, as they set limits on and conditions for SCG spending, though they do not call for an examination of each loan request by SCGs. This section describes the practices used in OECD countries and the choices they must make when designing a system for monitoring SCG debt.

Market discipline

In the context of market-based discipline, banks and financial markets assess the creditworthiness of SCGs who wish to borrow or issue debt. They then impose higher borrowing costs on the more risky ones. The idea is to give borrowers an incentive to improve their solvability by reducing spending or raising revenues. Pure reliance on financial markets to exert fiscal discipline on SCG borrowing is rare in OECD countries. One exception is Canada where provinces do not follow any federal procedure for issuing debt and they are not subject to any federal borrowing limits.

For market discipline to work, a number of conditions need to be satisfied. First, markets should be open and financially deep and should afford no privileges to SCG debt. Adequate information about the borrower’s outstanding debt and re-payment capacity should be available to potential lenders, central government’s no-bailout commitment should be credible, and the borrower should have sufficient capacity to ensure a proper policy response to signals from the market before being excluded. In practice, it appears that the conditions above are rarely met, which impairs the effectiveness of market discipline (Box 5.3). A look at the credit ratings of SCGs and their yields reveals a clear lack of monitoring by financial markets. SCG ratings are very closely linked to their sovereign, and SCGs in the same country tend to receive a similar rating, irrespective of their own financial health (Vammalle and Hulbert, 2013).

Box 5.3. Bailouts, the solidarity principle and bond yields in Germany

Prior to 2009 when a change in the constitution introduced the debt brake, German Länder borrowing was subject to a weak golden rule. In practice, the solidarity principle in the constitution was equivalent to an explicit bailout guarantee or a joint liability system, backed by the financial equalisation system and judgments by the Federal Constitutional Court (Zipfel, 2011). There were two related outcomes. First, large disparities in the ratio of debt to revenues and fiscal balances among the Länder emerged (Figures 5.4 and 5.5). Second, financial markets took the bailout into consideration and did not charge higher borrowing costs on the more indebted Länder or, in other words, did not contribute to monitoring their debt. Spreads between the Länder and federal government were practically zero before the collapse of Lehman Brothers in 2008, and are still very narrow today. In addition, the spreads do not reflect the relative levels of debt. For example, Baden Württemberg has a much lower debt-to-revenue ratio than Berlin, but still pays a higher interest rate.

Figure 5.4. Debt and fiscal balance of the German Länder
picture

Source: OECD Network on Fiscal Relations across Levels of Government – Territorial Development Policy Committee Questionnaire on Regional Finances, 2014.

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Figure 5.5. Spreads between the Länder and federal government bonds
picture

Source: Vammalle, C. and C. Hulbert (2013), “Sub-national Finances and Fiscal Consolidation: Walking on Thin Ice”, OECD Regional Development Working Papers, No. 2013/02, OECD Publishing, Paris, http://dx.doi.org/10.1787/5k49m8cqkcf3-en.

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Market discipline may not always work for sub-national governments (European Commission, 2013):

  • market funding is typically less important for smaller SCGs, which have less access to credit;

  • transfers from other levels of governments usually represent a large share of SCG revenues;

  • and the data required to estimate SCG solvency may be scarce.

Moreover, relying on market discipline alone may not lead SCGs to adhere to prudent debt levels. Additional mechanisms might be needed, as shown by recent moves in several countries to strengthen limits on the borrowing of their states or regions and local governments. The following sections present the different tools available and how OECD countries use them.

Direct control and approval by higher levels of government

Direct central government control might, at first sight, seem highly effective in monitoring SCG debt. There are two main drawbacks, however:

  • First, it may be perceived by lenders as an implicit bailout guarantee in case of a SCG default, and thus favour moral hazard.

  • Second, central governments may not have the appropriate information to assess SCG projects when deciding which ones to finance. It may also generate a heavy administrative burden.

Most OECD countries require some sort of central control over sub-central debt (Table 5.3). In most cases, direct control involves the responsible ministry giving its approval. In Spain, for instance, state and local governments must obtain the agreement of the Ministry of Economy and Finance to issue debt and, in 2014, 6 out of 30 requests were rejected. Under the terms the Stability Act, all new SCG borrowing in Hungary has to be approved by central government. The Slovak Republic, too, is tightening up on the resource requirements for take on additional loans: entities belonging to municipalities or regions will no longer be able to assume liability for loans directly.

Table 5.3. Types of restrictions on sub-central debt

No restriction

Borrowing abroad prohibited

Requires approval from higher levels of government

Only for capital financing

Prohibited both for current and capital financing

Australia local

x

x

Australia state

X

Austria local

X

Austria state

X

Belgium local

x

Belgium state

X

Canada local

x

x

Canada state

X

Chile

x

Czech Republic

Denmark

x

x

Estonia

x

x

Finland

X

Germany local

x

Germany state

X

Ireland

x

Italy local

x

Italy state

x

Korea

x

x

Mexico local

x

x

Mexico state

x

x

New Zealand

x

Poland

X

Slovak Republic

x

x

Slovenia

x

x

x

Spain local

x

Spain state

x

x

Sweden

X

Switzerland local

X

Switzerland state

X

Turkey

x

x

Total answers

11

6

9

15

1

Note: Borrowing in foreign currency is prohibited except by Auckland Council (NZL).

Source: OECD Network on Fiscal Relations across Levels of Government – Survey on Sub-national Fiscal Rules and Macroeconomic Management, 2015.

National governments may exert control over all SCG levels or only some. In federal and quasi-federal countries, regions/states often enjoy great borrowing autonomy but control local government debt. In Austria for instance, states do not need to request federal permission to borrow, but municipalities need to apply to the Municipal Supervising Authority in their state. In Canada, there is no restriction on provincial borrowing, but municipalities must secure approval either from the provincial ministry in charge of municipal affairs or from an approval board. Most provinces require local governments to submit a capital plan in order to undertake long-term borrowing for capital purposes.

Central government approval for SCG debt may only be required under certain conditions – when SCG debt exceeds a specific ceiling, for example – or only for certain types of borrowing. In Turkey, for instance, provinces and municipalities must request approval by the Ministry of the Interior only if borrowing levels exceed 10% of their revenues. In Denmark, permission to raise loans is automatically granted to municipalities for certain kinds of investment in public utilities. However, SCGs must seek permission from the economic affairs and interior ministries to raise loans for financing investment in areas such as schools. Moreover, central government may ban financial instruments that could threaten SCG finances (Box 5.4).

Box 5.4. Prohibition of financial instruments and restrictions on SCG speculation

Several OECD countries recently introduced legislation to limit risk by prohibiting the use of certain financial instruments or tightening requirements.

In Austria, the national government has been negotiating with the Länder on banning the use of public funds for speculative transactions. Salzburg, Tyrol and Vienna have already introduced bans.

In France, a decree came into force in October 2014 stipulating that variable rates relative to local debt will have to be indexed on “usual” rates such as the European interbank market rate. Moreover, variable rates must always be lower than the double of the lowest rate observed during the first three years of the loan period.

In Italy, the 2014 Stability Pact introduced a ban on regions and local entities using financial derivatives.

In the Netherlands, a law passed in 2013 compels local governments to hold their reserves in an account at the Ministry of Finance instead of a bank. The aim is to limit financially risky positions for excess funds.

Source: National sources and OECD (2014a), OECD Economic Surveys: Netherlands 2014, OECD Publishing, Paris, http://dx.doi.org/10.1787/eco_surveys-nld-2014-en.

SCGs in some countries must consult bodies such as national or regional courts of audit or independent auditors before they can issue debt. However, their recommendations are seldom binding. In Poland, for example, local governments must seek the opinion of their Regional Accounting Chamber on their capacity to repay the debt.

The most extensive control exercised over sub-central debt is central government’s direct financing the bulk of SCG debt through specific loans. In Ireland and the United Kingdom, debt arising from loans accounts for above 80% of all SCG liabilities and nearly all of that debt is with the central government (Table 5.1). In the United Kingdom, a public body – the Public Works Loan Board – centralises all loans granted to the local authorities (Box 5.5).

Box 5.5. The UK Public Works Loan Board

The Public Works Loan Board (PWLB) is an independent public body responsible for granting loans to local authorities. It was established in 1793 and became permanent in 1817. Since 2002, it has operated within the UK Debt Management Office. The PWLB consists of twelve Commissioners considering loan applications and collecting repayments. The Commissioners are authorised “to make loans to any local authority in Great Britain for any purpose for which the authority has power to borrow”. Funds are drawn from the National Loans Fund, administrated by HM Treasury. All loan repayments, interest and premiums are paid to the Fund. The 1968 Act limits the total amount to be granted by the PWLB since 2008, this limit has been set at £70 billion. Fixed rates are set twice a day by the Debt Management Office.

Source: Vammalle, C., R. Ahrend and C. Hulbert (2014), “A Sub-national Perspective on Financing Investment for Growth II – Creating Fiscal Space for Public Investment: The Role of Institutions”, OECD Regional Development Working Papers, No. 2014/06, OECD Publishing, Paris, http://dx.doi.org/10.1787/5jz3zvxc53bt-en.

Fiscal rules

Fiscal rules are designed to restrain sub-national governments’ fiscal aggregates and are an alternative to direct monitoring. There are three main types: budget balance rules, expenditure ceilings and borrowing limits. The most common in OECD countries is the budget balance rule (see Chapter 2 of Fiscal Federalism 2014: Making Decentralisation Work). Borrowing constraints, for example on levels of debt or debt servicing are also frequently used. Many SCGs are subject to a golden rule, and may borrow for investment purposes only. Direct expenditure limits are less frequent. Fiscal rules usually introduce numerical targets based on ratios that use either the level of GDP, tax, or total sub-central revenues.

Although sub-central fiscal rules have long been in place in many OECD countries, the Great Recession spurred them to tighten their rules (Vammalle and Hulbert, 2013). However, the impact of fiscal rules on SCG debt is subject to debate (Box 5.6). Their effectiveness depends as much on SCGs’ ability to circumvent them as on requirements for monitoring SCGs.

Box 5.6. Fiscal rules for SCGs: Do they work?

Tight fiscal rules are designed to save governments from over-indebtedness, but the empirical evidence as to whether they do so is mixed. Some older studies find that balanced budget rules reduce budget deficits – e.g. Poterba (1994) and Bohn and Inman (1996), both of which look at a selection of US states. Other studies conclude that fiscal rules do not play a prominent role in ensuring better fiscal performance (Escolanoet al., 2012). In this case, a plausible explanation is that sub-central fiscal rules might not be adequate to ensuring good performance when SCG spending mandates are underfunded. In any case, analysis of the impact of fiscal rules is prone to a severe endogeneity problem because, as highlighted by the recent economic crisis, fiscal rules are often the response to deteriorating fiscal balances rather than the cause. Grembi et al. (2011) get around endogeneity by using a quasi-experimental research design. Taking the example of Italy which, in 2001, relaxed fiscal rules for municipalities of less than 5 000 inhabitants, they estimated that, on average, relaxing fiscal rules triggered a shift from balanced budgets to a deficit of 2% of the budget size.

Borrowing restrictions may be easily evaded when dependence on transfers is high, responsibilities are not clearly allocated, or accountability is low. An example can be found in Italy (von Hagen et al., 2000). Italian local public finances went through deep crisis during the 1970s and 1980s due to a tax reform introduced in 1972-73.It reduced the fiscal autonomy of municipalities and made them extremely dependent on central government grants. Their expenditure rose constantly and the inability of local governments to raise revenue led them to borrow from commercial banks. As a result, municipalities verged on bankruptcy and had to be bailed out by central government through an increase in transfers in 1978. The unintended outcome was that over-indebted municipalities were in fact compensated for their poor financial performance through larger transfers. In sum, heavy reliance on transfers can generate a common-pool problem as SCGs do not fully bear the cost of overspending.

Source: Ahrend, R., M.Curto-Grau and C. Vammalle (2013), “Passing the Buck? Central and Sub-national Governments in Times of Fiscal Stress”, OECD Regional Development Working Papers, No. 2013/05, OECD Publishing, Paris, http://dx.doi.org/ 10.1787/5k49df1kr95l-en.

Fiscal rules may be imposed by higher tiers of government or they may be self-imposed by SCGs themselves. The United States has the longest history of self-imposed fiscal rules, with states incorporating balanced budget rules in their constitutions as early as the 1840s. Today, 49 of the 50 states have a constitutional balanced budget rule (Vammalle, 2008). Intergovernmental and co-operative approaches involve negotiations between tiers of government in the design of fiscal rules for sub-national authorities. Intergovernmental bodies often play an important role in such negotiations and, if SCGs take part in designing formulae, setting objectives and determining limits, they are more likely to heed the rules (Box 5.7).

Box 5.7. Examples of inter-governmental bodies

Australian Loan Council

The Australian Loan Council, established in 1923, is a Commonwealth-State ministerial council that co-ordinates public sector borrowing. The Loan Council considers each jurisdiction’s borrowing for the forthcoming year with regard to each jurisdiction’s fiscal position and the macroeconomic implications of aggregate borrowing. State participation in the Council was initially voluntary. In 1927, the six states and the Commonwealth signed a financial agreement that granted the Council the authority to determine the amounts, conditions and timing of all loans of the Commonwealth and the states (von Hagen et al., 2000). The Council first decided the total amount of borrowing, then allocation to the states. Today, the Loan Council operates on a voluntary basis and emphasises the transparency of public sector financing rather than adherence to strict borrowing limits.

Belgium’s High Council of Finance

Belgium’s High Council is specifically tasked with fiscal co-ordination between regions, communities and the federal government. Its recommendations are discussed at the Inter-ministerial Budget and Finance Conference. Further discussions between the Council and tiers of government are held at meetings of the Comité de Concertation, which is attended by the Prime Minister and federal, regional and communal ministers of budget and finance. Since 1989, the Council has been required to submit an annual report to central government on sub-national borrowing requirements. If the report points to a serious deterioration in a SCG’s fiscal position, the Federal Minister of Finance may limit borrowing. However, this ex post control mechanism has never been used.

The December 2013 Co-operation Agreement widened the Council’s duties to that of an independent body for monitoring budgetary outcomes. Besides advising on the budgetary trajectories of each level of government, the Council monitors the compliance of budgetary outcomes and the implementation of corrective measures in the event of deviation from the rules.

Germany’s Stability Council

The German Stability Council, created in 2010, is a joint body that represents the Länder finance ministers and the federal finance and economic ministers. Its mandate is to avert serious budget problems. Its main task is to regularly monitor the budgets of the Federation and the Länder. To that end, it uses four key ratios and related threshold values to assess budget situations:

  • structural financial balance (financial balance per inhabitant);

  • credit financing ratio (net borrowing to net expenditure ratio),

  • debt-to-revenue level,

  • interest-to-tax revenue ratio.

The Stability Council holds regular meetings every May and October. Resolutions require the votes of the federal level and two-thirds (or at least 11) of the Länder. However, a Land is not entitled to vote if it is affected by the decision to be made. At its second meeting in October 2010, the Stability Council suggested that four Länder were close to or actually experiencing a budget emergency. Moreover, as part of the implementation of the Fiscal Compact in Germany, the Stability Council was charged with monitoring compliance with the general government structural deficit twice a year. An independent advisory board was set up to support the Stability Council.

Spanish Fiscal and Financial Policy Council

The Fiscal and Financial Policy Council is the main public body for co-ordinating the central government and the autonomous communities. It is made up of the Minister of Economy and Finance, the Minister of Public Administration and the Economy and Finance Counsellors of each autonomous community. Every five years the Council may negotiate a change in the regional financing system. With regard to fiscal rules, each autonomous community agrees an individual limit on borrowingwith central government. If an agreement is not reached, all communities must seek to balance their budgets (Miaja, 2005). In a further move in 2013, the Independent Authority for Fiscal Responsibility was created. Its purpose is to oversee the sustainability of public finances.

Budget balance rules

Budget balance rules set a ceiling on a jurisdiction’s budget deficit. It can be a zero deficit (“balanced budget”), a maximum permissible deficit or even a budget surplus. The main drawback of budget balance rules is that they may entail pro-cyclical policies which would favour the introduction of cyclically adjusted or structural balance rules. There is consequently a trade-off between flexibility and enforcement. Designing balanced budget rules also involves answering the following questions: Should they include capital expenditure or should they apply only to current expenditure? Should off-balance funds be taken into account? Should they apply to submitted budgets, voted budgets or realised budgets? Should a deficit carry-over be allowed?

This section analyses the different options, and describes country practices in designing balanced budget rules (Box 5.8).

  • Should balanced budget rules cover current expenditure, capital expenditure or both? The most common fiscal rule at the sub-central level is the golden rule – which covers only the current budget – and the budget balance rule, which covers both current and capital spending. The number of countries setting budget balance rules grew in the wake of the 2008 crisis (see Chapter 2 of Fiscal Federalism 2014). Targeting only current expenditure (i.e. the golden rule) allows SCGs to carry out public investment. Indeed, SCGs are the largest public investors, accounting for an average of two-thirds of public investment by OECD countries (Vammalle and Hulbert, 2013). Some countries also include off-budget operations in the budget balance rule.

  • Should balanced budget rules target submitted, approved or realised budgets? Depending on the country, balanced budget rules may target different stages of the budget process. In most OECD countries, the balanced budget rule applies to the approved budget. Countries then go their different ways when it comes to treating realised deficits. Most do not allow realised deficits, but some carry them over and correct them in the following budget period. Such a scheme allows countries the flexibility to adjust to unforeseen events, while still ensuring sound fiscal management over the medium term.

  • Should balanced budget rules target actual or structural deficits? The most recent fiscal rule reforms have introduced either a structural budget balance rule (as in Germany, Austria, and Spain), or a multi-year balance rule (as Iceland has done). Yet structural budget balance rules for SCGs may be difficult to estimate. In some large decentralised countries, states and regions may project their own potential GDP and compute a structural deficit. If the requisite information is not available, the general government structural balance may be used and a share allocated to SCGs – the practice in Austria where the issue of diverging cycles and asymmetric shocks is considered negligible. Otherwise, a multi-annual budget balance rule may be a sound, pragmatic option. Iceland’s Local Government Act, for example, includes a new fiscal rule which obliges local governments to run balanced budgets for current operations over a three-year period.

Box 5.8. Reforms of budget balance rules since the crisis

Austria adopted a new Internal Stability Pact in spring 2012. It sets new fiscal rules which apply to all levels of government, requiring them to balance their budget in 2016. From 2017 a structural balance rule will come into effect, tying deficits to the output gap. It does not take asymmetric shocks into account. The new rules also include a debt criterion, whereby all tiers of government must reduce their level of debt by one-twentieth a year.

Belgium’s federal government, communities and regions signed a co-operation agreement in December 2013 that implemented the Treaty on Stability, Co-ordination and Governance. It requires the general government budget to be balanced with nominal and structural targets defined for central government and individual authorities.

The Czech Republic is considering a proposal that would require local and central governments to balance their budgets if total public debt exceeded 48% of GDP.

Denmark’s Budget Law, approved in 2012, introduced a balanced budget rule which stipulates that yearly structural deficits should not exceed 0.5% of GDP.

Estonia’s State Budget Act came into force in March 2014, introducing a balanced budget rule for general government, broken down into targets by level of government.

Germany introduced a constitutionally enshrined debt brake in 2009 to ensure that state budgets were structurally balanced and the federal structural deficit did not exceed 0.35% of GDP. It has also put in place a Stability Council. Its job is to review all public budgets on an annual basis against common benchmarks, monitor public borrowing, and co-ordinate medium-term financial planning in a multi-level government context.

Iceland’s Parliament passed a local government act in September 2011 which included two important fiscal rules for local government finances. The first was a budget balance rule, obliging SCGs to balance current revenues and expenditure over a three-year period. The second was a debt rule that limits the total debt of local authorities to 150% of total revenue. Those with total debt exceeding 250% of revenue are prohibited from raising debt except to refinance.

Italy’s Domestic Stability Pact, in place since 1999, introduced a budget balance rule for municipalities and provinces. The Stability Law for 2014-16 eases the budget constraints on local governments and excludes capital account payments of up to EUR 1 billion, plus another EUR 500 million to accelerate payment of past-due debts.

Japan introduced its Fiscal Management Strategy in 2010. It includes short, medium and long-term numerical targets to reduce central government’s and local authorities’ primary budget deficits.

Mexico’s Federal Budget Law (Ley Federal de Presupuesto y Responsabilidad Hacendaria [Federal Budget and Fiscal Responsibility Law]), approved in late 2013, incorporates a structural balance rule. Constitutional reform to limit state and municipal debt is currently under consideration.

The Netherlands central government signed an agreement in January 2013 with local authorities ahead of the coming into force of the Law on the Sustainability of Public Finances. It introduced a multi-annual budget balance path that local governments are required to follow. In 2013, the total local authority deficit was capped at 0.5% of GDP.

Poland’s local authorities have been required to balance their budgets under the terms of the Public Finance Act since 2011. In 2014, new rules came into force. They require local authorities to keep their debt-servicing-to-revenue ratios to less than the average ratio of current revenues (plus asset sales and operating expenditure) to total revenue over the last three years.

Slovenia’s Parliament approved a balanced budget amendment to the constitution in 2013. It came into force in 2015.

Spain adopted an amendment to the constitution in 2011 to underpin the fiscal consolidation targets of all tiers of government in line with the EU framework. General government must not exceed the EU limits and local governments are required to balance their budgets. The Organic Law on Budgetary Stability and Financial Sustainability (2012) requires all levels of government to achieve structurally balanced budgets from 2020 onwards. To ensure that the objective is met, debt reduction trajectories are revised in 2015 and 2018.

Source: Vammalle, C., R. Ahrend and C. Hulbert (2014), “A Sub-national Perspective on Financing Investment for Growth II – Creating Fiscal Space for Public Investment: The Role of Institutions”, OECD Regional Development Working Papers, No. 2014/06, OECD Publishing, Paris, http://dx.doi.org/10.1787/5jz3zvxc53bt-en. OECD (2014b), OECD Economic Surveys: Czech Republic 2014, OECD Publishing, Paris, http://dx.doi.org/10.1787/eco_surveys-cze-2014-en. OECD (2014c), OECD Economic Surveys: Denmark 2013, OECD Publishing, Paris, http://dx.doi.org/10.1787/eco_surveys-dnk-2013-en. OECD (2013), OECD Economic Surveys: Japan 2013, OECD Publishing, Paris, http://dx.doi.org/10.1787/eco_surveys-jpn-2013-en. Stability Programme 2014 (Belgium, Estonia, Italy, Netherlands); Convergence Programme Poland (2014); National Reform Programme Slovenia (2014).

Expenditure level and expenditure growth ceilings

Only a few OECD countries use sub-central expenditure limits, but they have become more inclined to rely on them since fiscal consolidation started in 2010 (Box 5.9). Canada’s provinces and Turkey, for example, cap revenues, while Slovenia and Spain’s local authorities link ceilings to objective needs criteria like population growth. However, most countries that do use expenditure ceilings – Denmark, Estonia, Italian local governments and Korea – cap current (operating) expenditure only. In Spain, growth in local public spending must not exceed nominal GDP growth over the past nine years, while local governments in Italy and Turkey have caps on specific budgetary lines, such as staff expenditure. Expenditure limits may apply to a sub-set of SCGs (only state/regional or local), or they may vary from one SCG to another, as in Switzerland, where a few cantons restrict their public expenditure when deficits are high (Sutherland et al., 2005).

Box 5.9. New expenditure ceilings in selected OECD countries

Austria. The new Internal Stability Pact signed in May 2012 introduces a limit on the growth of SCG expenditure: the aggregate expenditure growth of all tiers of government may not exceed potential GDP growth.

Denmark. A new system of expenditure control was agreed in March 2012, ushering in binding ceilings on the public expenditure of all levels of government. Only spending on investment and unemployment was spared. Municipalities and regions have agreed to limit their expenditure. Should they breach the ceiling in a given year, they will have to make up for it in the next one. Central transfers may also be cut in the event of non-compliance.

Finland. The Basic Public Services Programme, approved in mid-2012, introduced a target for municipal expenditure (average municipal spending growth must be reduced by 0.4% by 2020, assuming that local responsibilities remain the same). Moreover, as of 2015 local responsibilities may not exceed available funding. Municipalities must finance any new responsibilities either through increased revenues or cuts in other expenditure.

The Slovak Republic. Since 2014, a nominal spending freeze on each individual municipality has been in place.

Slovenia. The Fiscal Balance Act, which came into force in mid-2012, introduced several measures to rein in general government debt and deficit – particularly caps on public employee labour-related costs, including at the local level.

Spain. The Organic Law on Budgetary Stability and Financial Sustainability (2012) brought in new sub-central expenditure ceilings. Increases in spending may not exceed medium-term GDP growth (calculated over three years).

Debt and debt service restrictions

OECD countries widely use sub-central rules that govern debt levels, new borrowing, and debt servicing. The most common restrictions are limits on the total debt level and the issuance of new debt. They are mostly expressed as a share of sub-central total or current revenues, sometimes as a percentage of GDP and, in rare cases, a ceiling on total debt in absolute terms is set. There is considerable variation across countries: ceilings on the overall level of debt range from 60% to 150% of total revenues and those on debt service from 12% to 25% of current revenues (Box 5.10). In federal countries, state/regional governments often place debt and debt service restrictions on their local governments, while in rare cases, like that of New Zealand, local governments self-impose them.

Box 5.10. Debt and debt service restrictions in selected OECD countries

Restrictions on the level of debt

Austria: A brake on debt at all levels of government was introduced in 2012.

Czech Republic: The new Constitutional Act (approved in October 2012) ushered in new principles for budgetary discipline and accountability. It particularly restricted sub-central gross debt to no more than 60% of a 4 year average of revenues.

Estonia: SCGs’ total debt has been capped at no more than 60% of their total aggregate revenues since 2012.

Greece: Total debt should not exceed annual regular revenues.

Iceland: The Local Government Act introduced a debt rule that limits the total debt of local governments to 150% of their total revenue. Local governments with debt and liabilities above 150% are required to bring the debt ratio back under the ceiling within ten years. Local governments with total debt exceeding 250% of revenue are prohibited from raising new debt except to refinance.

Poland: Over 2009-14, individual local governments’ debt must not be higher than 60% of local revenues for the given year.

Portugal: The laws on the Finances of the Autonomous Regions, in force since 2014, stipulate that the autonomous regions’ liabilities should not exceed 1.5 times their three-year average net current revenue. At the municipal level, the 2013 law on Local Finances introduced the same requirement for each municipality. Moreover, regional floating debt should not exceed a fraction (0.35) of the three-year average of net current revenue, and local additional debt for a given year is capped to 20% of the financial margin available.

Slovak Republic: Since 2002 the law stipulates that total SCG debt should not exceed 60% of total SCG current revenues.

Spain: The Organic Law on Budgetary Stability and Financial Sustainability introduced overall debt ceilings for all levels of government. Debt may not exceed 13% of the GDP of autonomous communities and 3% of that of local governments. Moreover, SCGs will no longer be able borrow to finance current expenditure after 2020.

Turkey: Sub-central debt cannot exceed 100% of sub-central annual revenue. The ratio is set at 150% for metropolitan municipalities and provinces.

Restrictions on debt service

Czech Republic: SCGs’ debt service should not exceed 30% of their revenues.

Greece: Debt repayments should not exceed 20% of regular revenues.

Italian local governments: Interest payments should not exceed 12% of current revenues.

Italian regions: Interest payments should not exceed 25% of revenues from taxes, transfers and property sales.

Poland: The sum of loan instalments and interest payments could not exceed 15% of total debt up to December 2013. Since 2014, local governments’ debt service has not been allowed to exceed the three-year average sum of their operating surpluses and privatisation receipts.

Slovak Republic: Loan instalments and interest should not exceed 25% of current revenues from the previous year.

Restrictions on debt maturity

Mexico: A change to the constitution in 2013 placed stricter controls on sub-central borrowing. Debt may not finance current expenditure and should be repaid by the contracting administration.

Source: OECD Network on Fiscal Relations across Levels of Government – Survey on Sub-national Fiscal Rules and Macroeconomic Management, September 2015.

What happens if SCGs breach the rules?

Rules and controls are effective only if enforced. As part of their fiscal consolidation plans, several countries (e.g. Spain and Italy) have tightened sanctions for SCGs that fail to obey fiscal rules. Countries have also strengthened enforcement by improving transparency and reporting requirements, by levying financial penalties on offending SCGs, or by requiring them to follow restructuring plans. Some countries sanction elected officials severely if they flout the rules (Box 5.11).

Box 5.11. Enforcement of sub-central fiscal rules

Czech Republic. In addition to introducing new debt and deficit ceilings, the 2012 Constitutional Act strengthened enforcement mechanisms. If the debt and deficit limits are exceeded, central government may cut transfers to a municipality or region by 5% of the difference between the amount of its debt and the 60% ceiling.

Italy. Enforcement of the Internal Stability Pact was strengthened in 2011 by the introduction of a wide range of sanctions. Regions breaching fiscal rules may face a number of restrictions on such expenditure as hiring new personnel or borrowing, and may even have their central government grants reduced or suspended. Reporting rules have also been tightened, in particular in run-ups to elections. The regions must post their audited financial statements on their websites. If the results are not consistent with the Italian Internal Stability Pact, elected officials are liable to sanctions and automatic disbarment from office for up to ten years.

Spain. Autonomous communities that far overshoot their deficit restrictions are liable to sanctions under the terms of the Organic Law on Budgetary Stability and Financial Sustainability (introduced in 2012). They must submit a restructuring plan and, if they are recidivists, central government may temporarily reclaim (partially or totally) their budgetary powers.

Germany. The 2010 constitutional amendment put in place the Stability Council to monitor budgetary developments at federal and Länder levels. It also ushered in a federation-wide early warning system to prevent budgetary distress. In 2013, the Stability Council was tasked further with twice yearly monitoring compliance with the upper limit on the general government structural deficit under the Budgetary Principles Act. An independent advisory board was set up to support the Stability Council in its monitoring duties.

Austria. The fiscal rules foresee an excessive deficit procedure. If the deficit is exceeded for two years running, penalties apply. The offending sub-national jurisdiction is given two months to design appropriate action to restore its public finances. Sanctions are voted in a co-ordination committee that brings together all levels of government, but where the offending one is not allowed to vote. Financial penalties are equivalent to 15% of the overshoot, to be deducted from shared taxes.

Slovak Republic. The Fiscal Responsibility amendment to the constitution in 2011 stipulates that from 2015 onwards, sub-national governments exceeding the debt limit will pay a fine of 5% of the difference between the debt level and limit.

Turkey. If local authorities do not comply with fiscal rules, the related malpractice provisions of the Turkish Panel Code apply. Central government may sanction responsible personnel and local officials may be prosecuted under the Turkish Criminal Code.

Source: OECD Network on Fiscal Relations across Levels of Government Survey on the Impact of National Consolidation Strategies of SCGs and the Strategy of SCGs, OECD, Paris, 2012; Ministry of Finance of the Slovak Republic (2011).

Should a sub-national government fail to meet the rules, central government or SCGs themselves may take action. And in many OECD countries, central government may do so without making any changes to legislation:

  • The most common procedure consists of central government imposing sanctions on non-compliant SCGs, compelling them to make up for non-compliance with fiscal rules in future budgets or to take measures that ensure they will obey the rules in the future.

  • The financial penalties that SCGs may have to pay can be fixed fines, reduced transfers from central government, or cuts in the taxes they share with central government. In the Slovak Republic, the Ministry of Finance may levy a fine of up to EUR 17 000 on SCGs breaking fiscal rules. Austria’s fiscal rules introduce sanctions which include a reduction in shared taxes that is proportional to the overspend.

  • A few OECD countries use administrative sanctions that curtail the fiscal autonomy of SCGs. They generally take the form of greater central control over sub-national finances through the appointment of a public officer who monitors SCG revenues, spending and borrowing.

  • Finally, some countries have provisions for sanctioning sub-national officials. They range from removal from office (Poland sometimes dissolves local government councils or executive bodies) to possible penal sanctions, as in Italy and Turkey.

Main challenges for monitoring sub-central debt

Central governments must contend with a number of challenges when monitoring SCG debt. Some are specific to SCGs, such as the scarcity of financial information that enables comparison between jurisdictions. Others, like transparency, are general and relate to monitoring fiscal situations in all tiers of government. The OECD recently issued a recommendation on budgetary governance (OECD, 2015) that applies to both central and sub-national governments and may be useful for monitoring SCG debt.

This section reviews the different challenges that central government has to address when monitoring SCG debt, and suggests instruments for overcoming them.

Scarce information on sub-central budgeting practices

Sound fiscal management requires good budgeting practices that shape outcomes. The answers to the questions below help gauge SCGs’ budgeting practices and how likely they are to achieve positive fiscal outcomes:

  • How are economic assumptions made and are they sufficiently prudent?

  • Do SCGs carry out sensitivity analyses of economic assumptions and, if so, how?

  • Do SCGs have contingency reserve funds to cope with major forecasting errors?

  • Do SCG budgets incorporate medium-term outlooks?

  • To what extent do SCG budgets focus on performance and results?

In federal and quasi-federal countries, SCGs are often free to draft their own budgeting laws and establish their own practices. Yet central government knows little about them. A survey of the Canadian provinces shows a wide variety of budget practices, with some provinces using more modern budgeting instruments than central government itself (Rigaud and Arsenault, 2013). It would be interesting to replicate the study in other decentralised countries where SCGs enjoy budgeting autonomy so as to assess the impact of budgeting practices on fiscal outcomes.

Scarcity of appropriate, timely information on sub-central financial and debt situations

Budget documents and data should be open, transparent and accessible. Yet, SCGs often submit financial information late and with gaps. Timely information is important if central government is to react fast to deteriorating fiscal situations, identify early deviations from fiscal rules, and take corrective measures. The OECD recently had first-hand experience of the difficulty of obtaining information on sub-central finances. It sent out a survey to build a database of state/region financial variables (revenues, expenditure and debt). Only eight countries were able to provide the required information.

The length of time that SCGs have to report their financial statistics varies widely from one country to another. It is as little as 20 days in the Czech Republic with budgetary data having to be provided monthly. On average, though, SCGs have months to report their budgetary data. The frequency with which SCGs must report their balance sheets ranges from every quarter in the Czech Republic to every year in Poland. Recent EU directives, currently being implemented in a number of European countries, introduce new sub-central budget and financial reporting requirements such as the obligation to publish quarterly sub-national fiscal data. Some countries offer SCGs financial incentives to produce the required information. In 2012, the British government introduced a 20-base-point discount on loans from the Public Works Loan Board for local governments that provided improved, more transparent information on their long-term borrowing and associated capital spending plans (Vammalle, Hulbert and Ahrend, 2014).

Sub-central financial information is not always reliable

Effective public management systems seek to ensure that financial information is reliable. To that end, internal and external financial audits are necessary. They assess the quality of financial reporting and the reliability of financial information. Audits and inspections may be conducted either centrally or, in decentralised countries, sub-centrally. Even in decentralised contexts, however, central government still has an important role to play, setting the standards and monitoring the effectiveness of internal auditing systems at the local level (Baltaci and Yilmaz, 2006). Decentralised audits may be better suited to countries where SCGs enjoy strong financial autonomy, as they are directly responsible for preparing and executing budgets. In most OECD countries sub-central audit offices, or similar bodies, assess and inspect SCGs’ finances.

Sub-central data are hard to compare

The financial information that SCGs produce is seldom homogeneous. Local government accounting standards tend to be more uniform than those of states and regions (Figure 5.6). Particularly in federal and quasi-federal countries, state and regional jurisdictions do not abide by the same accounting standards when they draw up their budgets. While homogeneous standards make internal or external auditing easier, there is often strong resistance from SCGs. The harmonisation of regional and local governments’ accounting principles – budget rules, the treatment of publicly owned enterprises, depreciation rules, etc. – was one of the most fiercely fought elements in the 2009 reform of fiscal federalism in Italy (Blöchliger and Vammalle, 2012).

Figure 5.6. Accounting standards for budgets
2011
picture

Source: OECD Network on Fiscal Relations across Levels of Government, Survey on Sub-national Fiscal Rules and Macroeconomic Management, OECD, Paris, September 2011, updated March 2013.

 http://dx.doi.org/10.1787/888933342135

Few true, full and fair pictures of sub-central public finances

Budgets should paint a true, full and fair picture of public finances. Accounting gimmicks, the use of off-balance expenditure, and other practices obscure fiscal transparency. SCGs frequently use off-budget funds and local public enterprises or agencies, which should be closely monitored.

Off-budget funds

Much less information on off-budget funds is available at the sub-national than at the national level of government. SCGs should be encouraged to improve reporting, if possible in the same format as central government (Allen and Radev, 2007). Fiscal rules in OECD countries differ widely in their consideration of off-budget funds and only a few OECD countries include such funds in their budget balance rules (OECD 2014d, Chapter 2).

Public enterprises and agencies

  • Local public enterprises. In most OECD countries, sub-national governments own local public enterprises which they use to provide public services (water, infrastructure, etc.), sometimes in the form of public-private partnerships. SCGs are able to borrow freely from them with no constraints, which may generate contingent liabilities and obscure financial data. Yet reforms to improve the transparency of public enterprises encounter stiff resistance, as in Portugal when municipalities were required to consolidate their accounts with their enterprises (Blöchliger and Vammalle, 2012). Indeed, reform can be particularly difficult when it includes enterprises that are legally private, but owned by a sub-central government.

  • Local public agencies. Public agencies are autonomous bodies which are nevertheless closer to the government than public enterprises. SCGs rely extensively on them for the provision of public services. There is no universal system of rules for such agencies and SCG financial statistics seldom capture them. Self-funding agencies in particular escape sub-national governments’ control over their aggregate spending. Moreover, agencies may mask inefficiencies through the use of own-source revenues. Agencies that borrow when allowed, may generate significant contingent liabilities for sub-national governments. They should therefore be monitored and booked in sub-central financial documents.

Sub-central insolvency procedures

This section provides a preliminary overview of OECD practices in insolvency regulations and procedures for alleviating the financial distress of SCGs. Insolvency is a core element in credible no-bailout commitments. Be it through sub-national bankruptcy regulations or administrative procedures specifically for SCGs in financial difficulties, insolvency procedures help limit moral hazard and implicit guarantees. Bankruptcy procedures are particularly important when it comes to implementing hard budget constraints on SCGs.

In most OECD countries considered in this book, local governments are not able to go bankrupt.3 Where bankruptcy is not permitted, local governments in financial distress usually apply to central government for additional funding, although central government in some countries (e.g. France) can step in at an early stage to pre-empt bankruptcy. Bailout provisions often include financial consolidation plans for SCGs and/or sanctions for SCG officials.

Sub-central bankruptcy regulations

Sub-central bankruptcy procedures differ sharply from similar regulations in the private sector. Insolvency rules tend to be less stringent in order to safeguard key public services such as health, education and social protection. SCGs cannot be wound up and the ability of creditors to get hold of SCG assets is very restricted. Sub-central insolvency procedures involve debt restructuring rather than asset liquidation (Liu and Waibel, 2010).

Insolvency procedures also aim to put sub-national finances back on a sound footing so that SCGs can go back to the financial markets. To that end, and to give SCGs incentive to repay debt, they are required to balance their potential future revenues – chiefly from taxation – with reimbursements to their creditors. Bankruptcy procedures must also address the issue of holdout, i.e. the ability of a few individual creditors to threaten the restructuring process by imposing their own claims (McConnell and Picker, 1993). Debt may be restructured – i.e. transformed into longer maturities – or discharged, even partly, within a new binding legal framework.

Insolvency procedures may be voluntary or mandatory. In the United States, for example, municipalities file voluntarily for bankruptcy under Chapter 9 of the United States Bankruptcy Code. In Hungary, by contrast, local governments with commercial arrears must notify the court. In some countries, creditors are also able to trigger bankruptcy procedures.

The insolvency framework can be judicial or administrative (Box 5.12). When proceedings are judicial, the courts are responsible for allocating resources between the different creditors. Typically, a bankruptcy agreement is reached once a majority of creditors agree on a restructuring plan – even if there is a dissenting minority. The advantage of judicial procedures is that they neutralise political pressures during restructuring (Canuto and Liu, 2010). Administrative procedures usually consist of central authorities intervening directly and taking control of sub-central finances – by appointing an administrator, for example. Although administrative procedures may be faster, they may also trigger expectations of central government intervention among lenders and thus increase the risk of moral hazard. In most cases, bankruptcy frameworks require SCGs to draw up a consolidation budget.

Box 5.12. Sub-central bankruptcy procedures in selected OECD countries

United States

In the United States, sub-central government insolvency is regulated at federal level under Chapter 9 of the United States Bankruptcy Code. The code was enacted in 1937 during the Great Depression in response to multiple municipal defaults. The United States combines judicial and administrative procedures (Liu and Waibel, 2010). Under the provisions of Chapter 9, a debt restructuring plan acceptable to a majority of creditors may be binding on a dissenting minority. Since 1994, municipalities have been required to obtain state approval to file for bankruptcy. There may be several conditions attached to approval, and municipal governments may be denied the ability to file for Chapter 9. A few states, such as Georgia and Iowa, actually prohibit it. However, many states have introduced their own municipal insolvency regulations, so there is no nationwide procedure.

Hungary

The Hungarian Municipal Debt Adjustment Law came into effect in June 1996 after several years of acute sub-national financial distress which saw numerous bailouts by central government. One purpose of the law was to impose hard budget constraints on local authorities to lessen moral hazard. If a municipality fails to pay a supplier within 60 days of the due date, it must notify a court. Creditors, too, may petition the courts. Once a court initiates a debt adjustment procedure, creditors are no longer able to sue the local authority. At the inception of the procedure, an independent debt adjustment committee is formed. Its job is to draw up a debt restructuring programme. A crisis budget must then be adopted. A bankruptcy compromise can be reached if more than 50% of creditors consent to it, provided that their claims amount to at least two-thirds of all claims.

New Zealand

A bankruptcy procedure for insolvent SCGs exists, but has not been tested since 1930. Most local authority borrowing is secured against local property taxation, and legislation allows creditors to claim on property taxes in the event of a loan default.

Specific administrative procedures for governments in financial difficulty

Few OECD countries have bankruptcy procedures specifically for sub-central governments. Instead, central government intervenes directly, often with discretionary grants, to support them. Whether sub-central bailouts are institutionalised or case-by-case, they should come at a sufficient political or financial cost to the bailed-out entity to reduce moral hazard. Indeed, bailout expectations may have serious consequences, as creditors may consider that sub-central debt is implicitly guaranteed by central government. Consequently they continue willingly to lend to sub-central governments, which ultimately leads to higher debt (Box 5.13).

Box 5.13. The effects of bailout expectations

In a situation of economic stress and under soft budget constraints, SCGs may expect central governments to bail them out with additional resources. Clearly, there is a moral hazard problem at play, as both SCGs and their creditors assume that there is a probability of bailout, and debt continues to accrue.

The likelihood of being bailed out, in turn, is determined by several factors. First, according to the “too-big-to-fail” hypothesis (Wildasin, 1997), a highly populated sub-national jurisdiction is more likely to be bailed out because the negative externalities from a sub-national default would affect too many people. This hypothesis, though, has found no empirical evidence to support it. Indeed, if anything, the evidence points the opposite way. As noted by von Hagen et al. (2000), the two German states bailed out in the 1990s were the smallest in the West German federation. In Italy, too, smaller municipalities and regions seem to have a higher propensity to request bailouts. The reason may be that central governments are more willing to bail out smaller regions since the costs of doing so are lower.

Second, following the “too-sensitive-to-fail” hypothesis (Bordignon and Turati, 2009 and Sorribas-Navarro, 2011) the externality at stake is not the size of the population but the extent to which SCGs provide key public services such as health, education or social services.

Third, regions may be “too weak to fail” when large vertical imbalances exist. For example, central governments may feel obliged to bail out regions that depend heavily on central government transfers as they may not have the capacity to raise adequate resources by themselves. Although SCGs with large fiscal imbalances tend to be subject to borrowing restrictions (Eichengreen and von Hagen, 1996), it does seem, in practice, to prevent the need for bailouts.

A last factor that can influence the likelihood of bailout is the political clout of sub-central governments. As noted by Rodden (2002) “when constitutionally or politically constrained central governments take on heavy co-financing obligations they often cannot credibly commit to ignore fiscal problems of lower-level governments”. In other words, the more political pressure a regional government can exert on central government, the greater the likelihood that it will obtain a bailout.

Source: Ahrend, R., M. Curto-Grau and C. Vammalle (2013), “Passing the Buck? Central and Sub-national Governments in Times of Fiscal Stress”, OECD Regional Development Working Papers, No. 2013/05, OECD Publishing, Paris, http://dx.doi.org/10.1787/5k49df1kr95l-en.

Many OECD countries have introduced procedures specifically for bailing out sub-central governments (Box 5.14). Procedures frequently share the following features (similar to elements in the procedures being put in place to sanction or bring back into line SCGs that breach fiscal rules):

  • SCGs are required to implement drastic fiscal consolidation plans, and additional transfers are provided only if plans are sufficiently credible. In Estonia, local governments in financial difficulty can apply for central government aid. They must then prepare a four-year recovery and financial plan which is analysed by a special commission. It makes the final decision as to whether to grant financial aid. Central government in Finland may compel municipalities to follow a recovery programme. It appoints an advisory committee that makes recommendations to that effect.

  • Local government officials may be sanctioned. In Italy, if a region experiences serious financial difficulties, its president is compelled to resign. The regional council is dissolved and new elections are called.

  • An administrator appointed by central government may take over SCG finances. In Austria, the state government can dissolve a local government for serious breaches of the Local Government Act and appoint an interim administrator until an election is called. The state government has also the power to appoint a financial controller with statutory powers in certain circumstances. In Italy, when a local authority is in deep financial trouble, a commissioner may be appointed to take the measures required to put its fiscal position back on a sound footing.

Box 5.14. Addressing serious fiscal difficulties at the sub-central level

Countries have developed different procedures for addressing serious sub-central financial and fiscal difficulties. A few examples are shown below.

South Korea

In 2011, South Korea reformed its procedures for dealing with serious financial difficulties at the sub-central level and introduced a four-step “early warning system”:

  1. Sub-central debt is monitored through seven indicators that include the fiscal balance, debt service ratio, and local public enterprise liabilities.

  2. The indicators are analysed.

  3. A risk control committee deliberates.

  4. SCGs may be required to implement a consolidation plan.

Central government can intervene if it identifies SCGs as being in fiscal distress. In accordance with the Local Finance Act, central government issues an official statement to that effect. SCGs must then propose a budget deficit management plan that has to be approved by the Ministry of Public Administration and Security and local councils. During the process, local governments’ ability to issue debt is restricted.

Slovak Republic

A local government in serious financial difficulties may be forced to follow a “healing regime” if:

  • Its liabilities exceed 15% of current revenues of the previous year.

  • It has failed to repay a debt 60 days after the due date.

A local government with those liabilities and that overdue payment must propose fiscal consolidation measures. Ninety days after the beginning of the “healing regime”, it has to make a progress report to the Ministry of Finance on the measures it has taken. If the ministry deems that they are inadequate, it may decide to introduce forced administration, appointing an administrator to design additional consolidation measures. Under forced administration, SCGs may use local financial resources only with the permission of the administrator.

Spain

Since early 2012, the Spanish central government has introduced three mechanisms to alleviate financing and liquidity pressures:

  • A credit line of EUR 10 billion. It was opened by the national debt management office Instituto Credito Official (Official Credit Institute) to take over management of regional debt.

  • A fund to convert payment arrears into financial debt given the high levels of SCG debt to suppliers. This fund was allocated EUR 30 billion in the form of loans from 26 Spanish banks.

  • Fondo de Liquidez Autonomico (Autonomous Liquidity Fund). This fund was created in July 2012 to open lines of credit to autonomous communities unable to refinance their debt on the financial market. The fund is lead-managed by the Official Credit Institute under the aegis of the Ministry for the Economy and Competitiveness. In 2012, the fund was allocated EUR 18 billion, followed by another EUR 23 billion in 2013.

Source: OECD Network on Fiscal Relations across Levels of Government, Survey on Sub-national Fiscal Rules and Macroeconomic Management, OECD, Paris, 2015.

Summary and conclusions

The finances of sub-central governments deteriorated strongly in the aftermath of the 2008 global crisis under the combined impact of dwindling tax revenues and rising demand for social services. The result was a significant increase in debt. Subsequent efforts by OECD countries to stabilise sovereign debt resulted in a tightening of fiscal rules at all levels of government. Sub-central fiscal rules vary widely from one OECD country to another in many respects such as design:

  • the targeted variable – deficit, debt or expenditure – may differ from country to country;

  • threshold values may differ as well;

  • rules may apply to annual outcomes or cover several years;

  • public investment may or may not be excluded from the rule;

  • rules may be set for SCGs as a whole or for individual SCGs.

Good fiscal rules ensure economic stability and sound fiscal management. They also allow sufficient flexibility to cope with unforeseen events and safeguard SCGs’ financial capacity to deliver public services, particularly public investment. Monitoring and early-warning systems should help avoid pro-cyclical policies at the sub-central level. The harmonisation of accounting frameworks within a given country, as well as the consolidation of off-budget funds and local public enterprise budgets with SCG budgets, would enhance financial transparency and provide central government and the public at large with better information. Where there are provisions for sanctions and no-bailout rules, they should be strictly enforced to be credible. Rules should be carefully worded in order to prevent any circumvention. Lastly, an insolvency framework, whether judicial or administrative, should clearly spell out the procedure to follow in the event of sub-central government defaults.

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Notes

← 1. The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

← 2. For example, Danish municipalities receive specific financial help from central government if they get into financial difficulty and are put under administrative control (Mau-Pedersen, 2011). In Germany, the constitutional court ruled that the federal government had to help out two Länder (states), which were in financial distress.

← 3. These are Australia, Canada, the Czech Republic, Finland, France, Germany, Ireland, Italy, Korea, Mexico, Poland, the Slovak Republic and Turkey.