Sub-national Government Fiscal Sustainability

Abstract

The world is now facing what seems to be the biggest crisis since the Great Depression. An unparalleled pandemic of a highly contagious virus in a globalized word. Early economic indicators and the death tolls are suggesting a gloomier situation than expected. Sub-national governments (SNGs) are at the forefront of this crisis, since they are both responsible for the provision of critical health and social protection services and are severely hit financially by it. SNGs may be impacted by a “scissors effect” of SNG expenditures surging, while at the same time their revenues collapsing. This thesis analyses how SNGs' revenue and expenditure compositions affect their fiscal vulnerability to the COVID-19 crisis. To that avail, fiscal sustainability at the sub-national level is defined, the SNGs' revenue and expenditure composition are analysed and compared between 24 countries. Also, the impact of external variables on their fiscal sustainability is assessed under different scenarios.

Through the use of the machine learning technique, LASSO (least absolute shrinkage and selection operator), different external variables were tested and only the economic activity (i.e. gross domestic product - GDP) was selected as a good predictor and only for SNGs' revenue. The impact of the GDP on SNGs' revenue differ significantly depending on their revenue composition in terms of taxes and inter-governmental grants. A panel data model was used to estimate each revenue item elasticity and those elasticities were used to simulate the expected revenue under six different GDP scenarios for the COVID-19 crisis. For the SNGs' expenditure, sixteen scenarios were made considering different policies (e.g. expansionary, contractionary), shocks on health and social protection expenditure and SNGs' expenditure composition.

In total, 96 scenarios were created through the combination of the six GDP scenarios and sixteen expenditure scenarios. The experiments' results revealed that the higher the property taxes and inter-governmental grants share as a proportion of the revenue the smaller the impact of the COVID-19 crisis on SNGs' fiscal sustainability. For income taxes, the opposite is true. Regarding expenditures, the higher the investment and capital transfers budget share, the better SNGs adapt and handle the crisis. Social protection expenditure share, on the other hand, has negatively affected fiscal sustainability.