EIB Papers Volume 13. n°1/2008 - European Investment Bank

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30 Volume13 N°1 2008 EIB PAPERS Having described how the composition of government investment has varied between EU-15 countries and over time in the recent past, it is natural to ask what can explain such differences. Box 2 reports the results of a study into how the composition of government investment depends on the system of fiscal federalism, concluding that fiscal decentralisation tends to boost economically productive government investment, such as infrastructure. Box 2. Composition of government investment and fiscal federalism There are significant differences across European countries with regard to the level of government that provides a certain public service. Figure B1 shows the shares of the central and sub-national (regional, municipal) governments in the components of government investment identified in the main text. The figure suggests that the share of the central government is greater in all types of government investment in the new member states than in the old ones. In all three country groups the share of the central government is greatest in government investment in infrastructure and public goods, while it is smallest in redistributive government investment. Figure B1. Government investment by type and level of government (in percent of total; average 2000-05) 100 80 60 40 20 0 EU10 Coh. NMS EU10 Coh. NMS EU10 Coh. NMS EU10 Coh. NMS Infrastructure Source: Eurostat, own calculations Hospitals and schools central other Public goods Redistribution A study by Kappeler and Välilä (2007) seeks to disentangle the role of fiscal federalism in explaining the composition of government investment in EU-10 (EU-15 less the cohesion countries and Luxembourg). This box summarises the conceptual underpinnings and the empirical results of that paper. Starting with the conceptual underpinnings, the traditional economic literature on fiscal relationships between different levels of government emphasised the distinction between local and global benefits from government spending. The benefits of, say, investment in a municipal sports facility accrue chiefly to the local population. In contrast, the benefits of national defence accrue to the population at large. There are also intermediate cases, like motorways, whose benefits can accrue locally, regionally, and also nationally.
If the system of fiscal federalism changes – if for example spending power is decentralised from the central government to lower levels of government – one can easily see how the composition of government investment would change in this framework. Decentralisation would lead to more investment yielding local benefits, possibly at the cost of investment yielding country-wide benefits. Decentralisation would thus lead to more sports facilities and fewer military installations. More recent literature on fiscal federalism has focussed on the interdependencies in public policy decisions between sub-national units (regions for short, but the analysis applies equally well at municipal level). Consider regional tax competition. Regions compete against one another in order to attract firms and productive capital. If the competition concerns tax rates, such regional tax competition can result in a “race to the bottom”. With low tax rates and low tax revenues, regions’ ability to provide public services and to undertake investment projects is limited. Thus, in competing for the location of firms, regions may reduce their tax rates to such an extent as to unduly suppress government investment. But regional competition can also be about government spending. Good regional infrastructure (a “public input”) reduces production costs for private firms and may be more important for their location decisions than rock-bottom tax rates. In the extreme, this type of regional competition may induce regions to over-invest in infrastructure serving firms, at the cost of more consumption-oriented government spending such as sports facilities. This can also generate distortions in the composition of government expenditure, with decentralisation leading to an over-supply of government infrastructure and an under-supply of local public goods. To see how fiscal decentralisation actually affects the composition of government investment in the European context, the study by Kappeler and Välilä conducts two empirical analyses. First, the impact of decentralisation on the level of each type of government investment is estimated. Second, the impact of fiscal decentralisation on the share of each type of government investment in total government investment is estimated. Decentralisation in these analyses is measured as the share of taxes accruing to sub-national governments in relation to the overall tax intake of the general government. The country sample used in the analysis is EU-10, and the sample period is 1990-2005. The key results of these analyses are summarised in the table below. It shows the signs of the estimated coefficients for the decentralisation variable (sub-national tax share) in both levels and share analyses. A plus indicates that more decentralisation is associated with higher overall government investment of the type in question. A zero indicates a statistically insignificant relationship between decentralisation and government investment, while a minus indicates that more decentralisation is associated with less government investment. INF HS PG RED TOTAL Level + + + 0 + Share 0 + 0 - EIB PAPERS Volume13 N°1 2008 31
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The economic cost of public funds c
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Most taxes are distortionary in tha
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While distorting taxes lead to a we
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The modified approach suggests that
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Recent cost-of-funds estimates acco
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High GDP growth in the new member s
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Further productivity gains, includi
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Table 2. Business constraints perce
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Where fiscal positions were sound,
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Despite progress, infrastructure de
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Table 7. Infrastructure indicators
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EU funds provide additional resourc
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Various empirical studies confirm t
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In some new member states there is
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PPPs offer new opportunities to fin
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Strong legal and institutional fram
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Additional fiscal reporting - even
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Fiscal adjustment and reforms need
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