Fiscal Decentralization and the Business Cycle: An Empirical Study of Eight Federations

Though fiscal policies of central governments sometimes provide modest insurance against regional income shocks, this paper shows that pro-cyclical fiscal policy among provincial governments can easily overwhelm these stabilizing effects. We examine the cyclicality of budget items among provincial governments in eight federations, showing that own-source taxes are highly pro-cyclical and contrary to common wisdom, revenue-sharing and discretionary transfers are either acyclical or pro-cyclical. Constituent governments are thus left alone to smooth their own shocks, even though various restraints on borrowing and saving undermine their ability to do so. These results have important policy implications for Latin America and the European Union.