Tax Capacity Disparities and Fiscal Equalization T

TaxCapacityDisparitiesandFiscalEqualization:TheCaseofSpanishLocalGovernments*AntoniCastells([e-mail])AlejandroEsteller([e-mail])MaiteVilalta([e-mail])UniversitatdeBarcelona&Institutd'EconomiadeBarcelonaABSTRACT:Intheabsenceofanequalizationgrantsystem,likewejustifyoccursinSpainatthelocallevelofgovernment,thosegovernmentsthatbearadecreaseintheirleveloftaxcapacitywillhavetoadjusttheirbudgeteitherbyincreasingtheirleveloftaxeffort,byreducingtheirlevelofpublicservicesand/orbyincurringinadeficit.Bymeansofadynamicpaneldataanalysis,andusingadatabasefrommunicipalitiesoftheprovinceofBarcelona(1993-99),wedescribethatprocessoffiscaladjustment.Abouta25%oftheshockisinternalizedthroughanincreaseintaxeffort,a35%throughareductioninpublicexpenditure(mainlyinvestment),whiletherest(40%)iscoveredbyanincreaseinthelevelofdebt(i.e.,theadjustmentisdelayed).However,thisprocessoffiscaladjustmentisverymuchinfluencedbythepoliticalsituationofthemunicipality.Coalitionandminoritygovernments(“weak”governments)tendtodelaythe(unavoidable)fiscaladjustment,anda70%oftheirshockiscoveredbyanincreaseinthelevelofdebt,whiletherestofmunicipalities(“strong”governments)adjustimmediately(80%reductioninpublicexpenditureand20%increaseintaxeffort).Leftistgovernmentstendtoreactmostlythroughincreasesintaxeffort,whilerightistgovernmentstendtoreducepublicexpendituretoagreaterextent.Finally,wefindthatmunicipalitiestendtoreactdifferentlyinfrontofanegative(28%)andapositive(26%)shockwithrespecttotheleveloftaxeffort.Hence,municipalitiesarerelativelyreluctanttodecreasetaxes.JELCode:H61,H62,H71,H72Postaladdress:Departamentd'HisendaPúblicaFacultatdeCiènciesEconòmiques,UniversitatdeBarcelonaAvda.Diagonal,690,Torre4,Pl.2ª08034-Barcelona(SPAIN)Phone/Fax:[phone]*WewouldliketothanktheparticipantsintheALPESWorkshop“ReformsoflocalfiscalequalizationinEurope,2002,Speyer(Germany),speciallytoP.Else,G.Gilbert,andA.Solé-Olléforcommentsandsuggestions,althoughtheusualdisclaimerapplies.Financialsupportof2001-SGR30(GeneralitatdeCatalunya)andSEC2000-0876(MinisteriodeCienciayTecnología)aregratefullyacknowledged.11.IntroductionHowdoesamunicipalityreactinfrontofadecreaseinitsleveloftaxcapacity?Doestheequalizationgrantsystemfullyorpartiallycompensatethatlossoftaxrevenue?Inthecasetheequalizationgrantsystemdoesnotfullycompensateit,doestheprocessoffiscaladjustmentcarriedoutbythemunicipalitydependonitspoliticalsituation?ThesearethemainquestionsthatwewilltrytoanswerbymeansofanempiricalanalysiscarriedoutfromauniquedatabaseofmunicipalitiesoftheprovinceofBarcelonafortheperiod1993-99.Obviously,ifthereexistsanappropriatelydesignedequalizationgrantsystem,thatshockshouldbecompensatedbyanincreaseintheamountofequalizationtransferreceivedbythemunicipality.Thistransfershouldallowthemunicipalitytoprovideacertainlevelofpublicprovision,givenaleveloftaxeffortandindependentlyofitsleveloftaxcapacity.Forexample,iftheequalizationgrantsystemfullyequalizedthosefiscalshocks,onlyaslongasthemunicipalityexertedaleveltaxeffortabovethestandardfixedbytheequalizationgrantitcouldprovideahigherlevelofpublicservicesthantheaverageofmunicipalities.However,inSpainwewilljustifythatsuchequalizationgrantsystemisnotpresent.Therefore,permanentortemporaryfluctuationsintaxcapacitymustproducethreekindsofeffectsonthefiscaldecisionsofamunicipality:a)areductioninthelevelofpublicgoodprovision(itslevelofexpenditurewillberelativelysmaller);and/orb)anincreaseintheleveloftaxeffort;and/orc)anincreaseinthelevelofindebtedness,thatis,incurringinadeficit.Certainly,allthesethreehypothesesarenotmutuallyexclusive,andforinstanceinfrontofadecreaseintaxcapacityamunicipalitymightdecidetoreducepublicexpenditure,butalsoincreasetheamountofrevenuesatitsdisposalbyexertingahigherleveloftaxeffortand/orbyincurringinadeficit.2InSpain,thereareapproximately9.000municipalities.Differencesamongthemareacute:theydifferintheirsize,intheirgeographicalsituation,intheirincomelevel,orintheirtaxcapacity.Inthispaperweaimatanalyzingtheirfiscaldecisionsinrelationtothislastvariable,sincethisisthevariablethatwewillidentifyasthesourceofanadversefiscalshock.AscanbeseenfromTable1,thedifferencesintaxcapacityofthemunicipalitiesaresignificant1.Whilesomemunicipalitieshaveanindexoftaxcapacityabove2,othershaveanindexbelow0,62,3.Table1.Spanishmunicipalities’TaxCapacity.1998MunicipalityTaxCapacityTopTaxCapacitySitges2,133Castellbisbal2,103PremiàdeDalt1,776BottomTaxCapacityNavas0,601SantJoandeVilatorrada0,558SantaMargaridadeMontbui0,431Average1Standarddeviation0,324Max-min4,947Source:OwnelaborationfromfiscaldataoftheprovinceofBarcelona;Sistemad'InformacióEconòmicaMunicipal(SIEM),DiputaciódeBarcelona.Municipalitiesdonotonlydifferintheirleveloftaxcapacity,buttheyalsodifferin1Thesampleusedcontains104municipalitiesfromCatalonia.2Theindexoftaxcapacityhasbeencalculatedasaratio:inthenumerator,thereappearsthetaxrevenuethatwouldhavebeenobtainedbyamunicipalityapplyingthecorrespondingaveragetaxratetoitstaxbases,whileinthedenominator,thereappearstherevenuethatwo