The role of externalities in fiscal efficiency

Fiscal efficiency is determined not only by the municipality’s local characteristics but also by externalities from the neighborhood. In this paper, we study municipalities’ fiscal efficiency and assess the importance of such externalities in shaping local fiscal efficiency. The quantification of externalities is challenging because municipalities interact in complex ways. We build a municipality-specific indicator of externalities that considers the effect of the geographic and social neighborhoods. Externalities tend to increase when municipalities are close and have more significant differences in social development. To analyze the role of externalities in public spending efficiency, we propose a novel way to compare efficiency models by ensuring similarity in their structural properties (inputs, outputs, and orientation). In this situation, when one does not consider the network effect that a specific municipality receives, one could be misevaluating the municipality’s actual efficiency level. We apply our model to Brazilian municipalities and find that socio-economic externalities play an essential role in local public spending efficiency. Many municipalities are deemed efficient when they are not if we do not explicitly consider the effect of externalities on the municipality’s local performance. Our findings highlight the importance of socio-economic cooperation and integration among municipalities as a tool to achieve better fiscal performance.