Policy Responses to Fiscal Restraints: A Difference-in-Discontinuities Design

We evaluate the effect of relaxing fiscal rules on policy outcomes applying a quasiexperimental research design. In 1999 the Italian central government introduced fiscal rules aimed at imposing fiscal discipline on municipal governments, and in 2001 relaxed the rules for municipalities below 5,000 inhabitants. This shift allows us to implement a “difference-in-discontinuities” design by combining the before/after with the discontinuous policy variation. Our estimates show that relaxing fiscal rules triggers a substantial deficit bias, captured by a shift from a balanced budget to a deficit that amounts to 2 percent of the total budget. The deficit comes primarily from reduced revenues is unconstrained municipalities show lower real estate and income tax rates. Finally, we investigate the heterogeneity in policy responses across municipalities to provide new evidence on the costs and benefits of restricting fiscal policy. The impact is larger if the mayor can run for reelection, the number of political parties in the city council is higher, voters are older, and the performance of the mayor in providing public goods is lower, consistent with models of the political economy of fiscal adjustment. JEL codes: C21, C23, H62, H72, H77. Keywords: fiscal rules, local government finance, difference-in-discontinuities.