The Maastricht Treaty on Europe Union features an Excessive Deficit Procedure limiting
the freedom to borrow of governments participating in the European monetary union.
One justification is to prevent states from over- borrowing and demanding a bailout
which could divert the European Central Bank from its pursuit of price stability.
We challenge this rationale. Using data for a cross section of federal states, we
find no association between monetary union and restraints on borrowing by subcentral
governments. There is, however, an association between fiscal restraints and the
share of the tax base under the control of sub-national authorities. Restraints are
prevalent where subcentral governments finance a relatively small share of spending
with their own taxes. Lacking control of the tax base, such governments cannot be
expected to resort to increased taxation to deal with debt crises. Prohibiting borrowing
by subcentral governments will not eliminate the demand for tax smoothing and public
investment. Governments whose ability to provide such services is limited may therefore
pressure the central government to borrow for them. We report evidence that the financial
position of central governments is more fragile where subcentral jurisdictions are
prevented from borrowing. The implications for the EU are direct. That EU member
states control their own taxes should strengthen the hand of authorities seeking
to resist pressure for a bailout. But in the longer run, borrowing restraints may
weaken the financial position of Brussels, transferring bailout risk from the member
states to the EU itself.
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