The fiscal response to revenue shocks

International Tax and Public Finance https://doi.org/10.1007/s10797-022-09727-z The fiscal response to revenue shocks Simon Berset1 · Martin Huber1 · Mark Schelker1 Accepted: 15 January 2022 © The Author(s) 2022 Abstract We study the impact of fiscal revenue shocks on local fiscal policy. We focus on the very volatile revenues from the immovable property gains tax in the canton of Zurich, Switzerland, and analyze fiscal behavior following large and rare positive and negative transitory revenue shocks. We apply causal machine learning strategies and implement the post-double-selection LASSO method to identify the effect of revenue shocks on public finances. We find that local policymakers predominantly smooth transitory fiscal shocks. Keywords Local public finance · Fiscal policy · Fiscal shocks JEL Classification D70 · H11 · H71 · H72 1 Introduction Identifying the individual drivers of fiscal policy is a daunting task. Observable fiscal outcomes are shaped by many factors such as past policy decisions, the business cycle, financial market conditions, and the institutional, political, and economic environment. All at the same time, these factors might be endogenous themselves to fiscal policy. Even though there is a voluminous academic literature on the drivers of fiscal policy (for recent overviews see, e.g., Alesina & Passalacqua, 2016; Yared, 2019), it remains notoriously difficult to disentangle the impact of such factors from underlying incentives and preferences of decision-makers. The ideal experimental * Mark Schelker Simon Berset Martin Huber 1 Department of Economics, University of Fribourg, Boulevard de Pérolles 90, CH‑1700 Fribourg, Switzerland 13 Vol.:(0123456789) S. Berset et al. setup would consist of exogenously and temporarily shifting the budget constraint of a jurisdiction for one fiscal period and observing the induced fiscal response (if any). Taking a balanced budget as a starting point, unexpected higher revenues (or lower expenditures) result in a surplus, while unexpected lower revenues (or higher expenditures) result in a deficit, ceteris paribus. The budget consists of a predetermined part (e.g., entitlement spending, investment spending, interest payments, depreciations, etc.), which cannot be easily adjusted in the short and medium term, and of a discretionary part (e.g., personnel expenditures, operative expenditures, subsidies, etc.), which is allocated contemporaneously through a complex political bargaining process among the relevant interests within the institutional setup. Thus, any active policy response to a temporary relaxation of the budget constraint in the short run must come from the discretionary part of the budget. Large fiscal fluctuations—especially unexpected shocks—create opportunities and the potential justifications for decision-makers to use their political leeway to deviate from the ex ante budgeted resource allocation in the discretionary part of the budget. We aim to exploit such unexpected and large short-term variations in the tightness of the budget constraint and analyze the fiscal response triggered by it. In order to credibly separate such reactions from larger macro-economic or monetary and fiscal policy dynamics, we focus at the local (instead of the regional or national) level and on revenues from a property transaction tax which is not tightly linked to macro-effects and to the usual tax bases such as income and profit taxes. We take advantage of arguably (conditionally) exogenous variation in property gains tax receipts in the canton of Zurich (Switzerland) and study the expenditure response of local jurisdictions to transitory fluctuations in their own tax base. The immovable property gains tax (IPGT) is a particularly volatile revenue source. The receipts typically vary around a municipality-specific trend, and, from time to time, we observe larger temporary shocks. Fluctuations result in short-term temporary shifts (positive or negative) of the budget constraint. The parameters of the IPGT are set at the cantonal level, while the proceeds entirely benefit the respective municipality. Municipal decision-makers are aware of the volatility related to IPGT receipts. We define regular flows as revenue fluctuations that are within a window of what a municipality could expect ex ante. In contrast, positive shocks and negative shocks are defined as large deviations from this expected trend window (in our definition, deviations larger than ± 3 standard errors away from a trend). For fluctuations to be credibly exogenous for our purposes, they must emanate from idiosyncratic investment and location decisions by private individuals and must be unrelated to municipal public policy or other economic fluctuations such as the business cycle. To identify causal effects, we limit our analysis to large revenue fluctuations, which are typically unexpected by local policymakers and largely driven by individual location and private investment choices, and we purge variation coming from municipality-specific policy as well as economic factors. To do so, we control for underlying trends in the specific tax base and select from a large number of municipality-specific covariates applying causal machine learning methods. We use the post-double-selection method by Belloni et al. (2014) based on the LASSO estimator (Tibshirani, 1996). Ultimately, identification relies on a conditional independence assumption. 13 The fiscal response to revenue shocks According to traditional, normative public finance theory, the optimal reaction to fiscal fluctuations consists of smoothing them over time. The theory holds that governments should smooth short-term fluctuations and keep tax rates constant to minimize distortions (e.g., Barro, 1979; Lucas & Stokey, 1987). However, there is a large literature in political economics providing evidence that revenue smoothing is often not the chosen policy. More frequently, political processes feature substantial deficit bias leading to unsustainable public finances in many countries (e.g., Alesina & Passalacqua, 2016; Yared, 2019). In a companion paper, we find that a large oneoff positive fiscal windfall in the canton of Zurich caused large and persistent fiscal imbalances (Berset & Schelker, 2020). Our baseline results are, however, predominantly in line with normative public finance theory suggesting revenue smoothing as optimal response to shocks. Only about 20% of positive tax shocks are spent as current expenditures, while no statistically significant effect on current expenditures is observed for negative tax shocks. However, the point estimates of negative shocks are substantially larger than those for positive shocks, but they are not very robust to specification changes. The rest of the paper is structured as follows. Section 2 reviews the literature and set the relevant theoretical framework. Section 3 formulates testable hypotheses. Section 4 briefly describes the institut (...truncated)