1 Federalism and Economic Performance: Evidence for Swiss Cantons Presentation at the BMF-ZEW-Conference on Fiscal Policy Challenges in Europe, Berlin,

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Federalism and Economic Performance:

Evidence for Swiss Cantons

Presentation at the BMF-ZEW-Conference on Fiscal Policy

Challenges in Europe, Berlin, March 23, 2007

Prof. Dr. Lars P. FeldUniversity of Heidelberg,

University of St. Gallen (SIAW-HSG), ZEW Mannheim, Crema Basel and CESifo

Munich

Berlin

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In a Nutshell

• Difference to the Literature– Literature is on fiscal decentralization and economic

growth

– Here: Instruments of fiscal federalism and economic performance.

– ‚Instruments‘ are tax competition, grants, fragmentation.

• Message– Tax competition is not harmful to regional performance.

– No clear-cut results on grants.

– Fragmentation is not harmful to economic performance.

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Federalism and Economic Performance

Outline of the Presentation

• Introduction• Theoretical Background• Empirical Studies• Swiss Federalism• Results on Federalism and Economic

Performance in Switzerland• Conclusion

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Introduction

• Political Discussion around the World– Commission on Fiscal Federalism in Germany

• Is German federalism harmful for economic development?

• Joint Decision Trap

– Similar discussions in Austria and Switzerland.

• Academic Discussion– What is the impact of vertical separation or division of

powers on economic development of countries?

– Federations vs. unitary states.

– Cooperative vs. competitive federalism.

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Introduction

• Advantages and Disadvantages of Federalism– Broad discussion in the literature.

– Theory of fiscal federalism and plenty of interjurisdictional externalities.

– Political economy arguments.

– Specific problems in developing countries.• Corruption.

• Contradictory Hypotheses– Necessity to conduct empirical research.

• Empirical study on Switzerland is particularly helpful.

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Theoretical Background

F is ca l F e de ra lism a nd E con o m ic D eve lo pm e nt

F is ca l E xte rn a lit iesS p illo ve rs

E co no m ies o f S ca leE x it an d V o ice

F is ca l C o m p e tit ion a ndE x te rna lit ies

W e lfa re E con o m ics v s.P o lit ica l E co n o m ics V iew

Y a rd s tic k C o m p e tit ionP o lit ica l In n o va tion

H a ye k ia n V iew

F is ca l C o m pe tit iona s a D isc o very P roce d u re

M a rke t-P re se rv in g F ed e ra lismL a b o ra to ry F e d era lism

N e w E co n om ic G e o gra p hyR e g io n-s p e c if ic C o nd it io ns

fo r G row th Im u lsesK n o w le d g e S p illo ve rs

G ro w th T h e o ryF e d e ra lis m in G ro w th M o d e ls

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Theoretical Background

• Regional Development and Convergence– Competitive federalism

• Efficiency gains and political innovation

• vs. Brain drain

– Fiscal equalization/ grants• Income increase and attraction of new industries

• Disincentives for structural change and bail-out problems

• National Economic Growth– Competitive federalism:

• Efficiency reserves vs. decline of help to change economis structures

– Fiscal equalization/ grants• Negative incentives vs. development aid.

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Empirical Studies

• Cross Country Studies– Still ambiguous results on fiscal decentralization and

economic growth.

– Specific problems of LDCs.

– Autonomy vs. share of decentralized spending.

• China– First glance: Ambiguous results.

– Second evaluative view: Fiscal decentralization has a positive impact on economic growth of Chinese provinces.

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Empirical Studies• USA

– Xie, Zou and Davoodi (1999): • National level: U.S. are in a decentralization

equilibrium, because decentralization has no significant impact on national economic growth.

– Akai and Sakata (2002)• State level: Decentralization in the U.S. states has a

positive impact on their development.• Local Autonomy measured by the share of own from

total revenue does not have a significant impact.

– Stansel (2005)• Higher fragmentation is associated with significantly

higher growth in (log) real per capita money income at the municipal level.

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Empirical Studies

• Germany– Behnisch, Büttner and Stegarescu (1999):

• National level: Increasing federal share of total spending has a positive impact on total productivity growth.

– Berthold, Drews and Thode (2001)• State level: Horizontal fiscal equalization and vertical

supplementary grants have a negative impact on regional development of the German states.

• Panel of 16 states from 1991 to 1998: Methodological Problems.

– Berthold, Drews and Thode (2007)• Panel of 16 states from 1991 to 1998: Still Methodological

Problems due to Invalid Instruments.

• General Problems of the Studies– Too strong concentration on decentralization measures.– Autonomy and instruments of federalism.

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Swiss Federalism

Figure 1: Index of Tax Burden on Income and Wealth, 26 Cantons, 2005

0

40

80

120

160

2 4 6 8 10 12 14 16 18 20 22 24 26

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Swiss Federalism II

Figure 2: Cantonal and (Weighted) Local Income Tax Burden for Mar-

ried Couples with 2 Kids, 2005 with an Inome of SFr 1 Million and above

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CH:Population 7'261'200Foreigners 1'457'800Area: 41‘293 km2

26 Cantons(AI 14'900 Inhabitants)2903 Communes

BE FR

NE

SO

JU

GE

VD

VS

UR

LU

OW NW

SZ

ZG

BL

BS

SH

GL

ZH AG AR

AI

SG

GR

TG

TI

> 24%

19% – 24%

< 19%

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Swiss Federalism III

Figure 5: Share of Federal Grants from Total Revenue, 26

Cantons in 2004 Berlin

0

10

20

30

40

50

60

2 4 6 8 10 12 14 16 18 20 22 24 26

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Results on Federalism and Economic Performance in Switzerland

• Econometric Approach– Exogenous Growth Model

– Production function of Mankiw, Romer and Weil (1992)

– Organisation of federalism as technological progress.

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ititDitititit eKHALQ 0321 , (1)

.26...,,2,1

),,0(~ 2

i

IN itit

t = 1980, ..., 1998.

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Results on Federalism and Economic Performance in Switzerland

• Variables– Qit : Real GDP;

– Lit: Number of Employees

– Hit: Share of People with High School Degree or Cantonal Education Spending per Capita

– Kit: Private Investment

– Vit: Vector of Controls

0 to 4: Parameters

it: Error Term. Berlin

lnQit = 0 Dit+ 1 lnLit + 2 lnHit + 3lnKit + 4 lnVit + it (2)

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Results on Federalism and Economic Performance in Switzerland

• Federalism Variables– Share of Decentralization: Share of local spending

(tax revenue) from total local and cantonal spending (tax revenue)

– Grants per capita• Lump sum grants

• Matching grants

– Urbanisation as a proxy for agglomeration economies

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Results on Federalism and Economic Performance in Switzerland

• Federalism Variables– Fragmentation of a canton in communities as a

proxy for economies of scale in consumption.

– Tax competition• Difference between an canton‘s tax rate and the average

tax burden of other cantons (weithed by the inverse of distance) in the highest income tax bracket (1 million SFr).

– Language dummy

– Dummy Basel-City.

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Results on Federalism and Economic Performance in Switzerland

• Panel of 26 Cantons from 1980 to 1998• OLS and TSLS with time dummies• Instruments:

– Cantonal Dummies

– Lagged grants and federal index of mountainous areas

– Proxies for interest group influence

• Robust standard errors (Clustering-Method).

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Results on Federalism and Economic Performance in Switzerland

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Table 3: Regressions of real cantonal GDP on fiscal federalism indicators and controls,26 Swiss cantons, 1980-1998

Variable OLS OLS OLS OLS TSLS TSLSCapital investment 0.124***

(6.93)0.127***(6.75)

0.128***(6.74)

0.172***(8.73)

0.178***(8.52)

0.180***(8.37)

Education spending 0.195***(5.42)

0.201***(5.01)

0.202***(5.02)

0.103***(3.07)

0.101***(2.83)

0.103***(2.93)

Labor force 0.467***(3.28)

0.477***(3.27)

0.478***(3.27)

0.307**(2.41)

0.234*(1.80)

0.235*(1.79)

Population -0.453***(-3.15)

-0.465***(-3.14)

-0.466***(-3.14)

-0.306**(-2.40)

-0.235*(-1.80)

-0.234*(-1.79)

Decentralization ofspending

– 0.011(0.61)

– – – –

Decentralization of taxrevenue

– – 0.013(0.72)

0.017(1.45)

0.018(1.41)

0.012(0.80)

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Results on Federalism and Economic Performance in Switzerland

Lumpsum grants – – – – – 0.018(0.77)

Matching grants – – – -0.051***(-4.88)

-0.068***(-6.36)

-0.069***(-6.46)

Tax difference toneighbors’ tax rates

– – – 0.004**(2.50)

0.004***(2.64)

0.005**(2.48)

Fragmentation – – – -0.016*(-1.92)

-0.014(-1.58)

-0.013(-1.37)

Urban population – – – 0.019(0.50)

0.006(0.16)

0.003(0.08)

R2 0.787 0.787 0.788 0.840 0.836 0.833

SER 0.048 0.048 0.048 0.042 0.042 0.043

Observations 494 494 494 494 494 494

Jarque-Bera 14.111*** 12.706*** 12.253*** 7.853** 5.562* 9.270***Note: t-values are given in parentheses. All regressions contain 19 year-dummies whose coefficients are notreported. ***,** and * indicate significance at 1%, 5% and 10% levels, respectively. The Jarque-Bera teststatistic is a test on the null hypothesis of normality of the residuals.

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Conclusion

• Impact of Swiss fiscal federalism on cantonal economic performance– Production function approach– Panel of cantons from 1980 - 1998– Grants, in particular matching grants, is negatively

correlated with GDP per employee.– Tax competition is not harmful.– Economies of scale do not have a significant impact.

• Robustness Checks – Fixed effects regressions.– Growth regressions.– Interaction of population with tax competition proxy.– Political Controls.

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