Fiscal rules, fiscal performance and tax competition among municipalities in Switzerland

Fiscal rules have been introduced at national or sub-national levels in many countries around the world with the aim of reducing public deficits and public debt, strengthening fiscal discipline and fostering economic performance. The recent financial and economic crises have put these fiscal rules (or the lack thereof) at the center of the policy debate.

Switzerland, with its long history of political and fiscal decentralization, has been an ideal setting to study the effects of fiscal rules at the sub-national level. The existing literature has used the rich institutional diversity of different balanced budget rules at the cantonal level to study their effects on cantonal policy outcomes, such as public debt or deficits (Feld and Kirchgässner, 2001a, 2008; Krogstrup and Wälti, 2008; Feld, Kirchgässner and Schaltegger, 2010; Luechinger and Schaltegger, 2013; Yerly, 2013). Thus, the focus, so far, has been the cantonal level. Studies of the effects of fiscal rules at the municipality level have been scarce and limited by the use of cross-sectional variation on a small sample of municipalities. Moreover, the existing literature abstracts from vertical interdependencies between municipality-level and canton-level fiscal rules. These vertical interdependencies have been shown to be crucial in the context of direct democracy, as the effects of institutions of one level of government could potentially be canceled by the lack thereof at another level (Galletta and Jametti, 2012).

The aim of this project is, first, to extend the existing literature and analyze the effect of fiscal rules at the municipality level on their fiscal performance. Several cantons have introduced in the last 15 years different balanced budget requirements for their municipalities, creating cross-sectional but also time variation to exploit empirically. A key aspect of this analysis will be to take into account vertical interdependencies between canton-level and municipality-level fiscal rules.

The second aim of this project is to investigate how fiscal rules affect tax competition among local jurisdictions. This part of the project contains both a theoretical and empirical part. First, balanced budget rules plausibly create different incentives for local governments in their tax setting, which might therefore change their strategic interactions. However, most current models in tax competition assume that governments have to balance budgets at all points in time. Variations in the stringency of fiscal rules implies, theoretically, that governments’ budget constraints need to be balanced over variable time horizons, resulting in different strategic reaction choices. Empirically, fiscal rules could be a fruitful explanation of the recent findings in Parchet (2014), who shows that Swiss municipalities do not engage in a “race-to-the-bottom” in their tax rates, but rather increase their tax rate when tax rates of neighboring municipalities fall. One hypothesis is that, under more stringent rules, municipalities are less likely to pursue a tax-base preservation strategy by lowering their tax rate than to pursue an expenditure-preservation strategy by increasing their tax rate. This project aims at investigating this hypothesis by following closely the methodology developed in Parchet (2014) and exploiting empirically the existence of cantonal borders together with a rich institutional variation.