The design of public budget constraints and the effects of austerity policies are salient topics for both policymakers and scholars. The main goal of this literature is to understand whether and how fiscal adjustment can improve the sustainability of welfare systems (Alesina and Perotti 1996, Corsetti 2012, Born et al. 2015). Overall, previous studies find mixed effects on budget constraints in terms of deficit and public debt reduction (Asatryan et al. 2015, Grembi et al. 2016, Coviello et al. 2017, Heinemann et al. 2018). Recent studies have also focused on the adverse political effects of austerity policies (Stiglitz 2016, Fetzer 2019).
In a recent paper (Daniele and Giommoni 2020), we study the impact of fiscal austerity on corruption in the context of Italian municipalities. We find that these budget rules, the Domestic Stability Pact, has led to a reduction in corruption, driven by lower discretionary spending.
While fiscal policy is (and ought to be) motivated by considerations other than its potential spillover impact on corruption, these unintended effects might be of interest to international organisations and governments debating whether (and how) to introduce budgetary constraints. These findings are also timely, as we shed light on the effects on corruption of a salient and highly debated policy – EU fiscal rules – that affects a multitude of local governments on the European continent.
Fiscal rules and corruption
The Domestic Stability Pact is a set of fiscal rules adopted by the Italian government that constrains public spending at the local level. The national government sets numerical limits on budgetary aggregates and establishes sanctions for local governments that overspend their target. In the last decades, similar budget-constraint rules have become increasingly common in decentralised countries, due to the substantial rise in public debt. The IMF currently lists 96 countries that have adopted local, national, or supra-national fiscal rules (Lledó et al. 2017).
Ex-ante, budget constraints might have opposite effects on corruption. On the one hand, budget constraints might pressure politicians to reduce inefficient expenditures, resulting in a decrease in rent-seeking. Politicians could be motivated by accountability: to ensure they comply with fiscal rules, local politicians may be more willing to reduce inefficient expenditures because alternative policy choices, such as increasing local taxes, might be more likely to threaten their chances of re-election.
On the other hand, if electoral accountability is weakened or distorted, politicians might instead reduce welfare-enhancing expenditures without affecting their rent-seeking. For instance, this would be the case if some voters keep supporting a corrupt politician in exchange for targeted or clientelistic benefits (Nannicini et al. 2013, Boas et al. 2018).
To measure corruption at the municipal level, we rely on a novel dataset with details of investigation procedures authorised by the judiciary and carried out by police forces. The data, with a focus on corruptive phenomena (i.e., bribery, graft, malfeasance/resource embezzlement), cover the years 2004–2014 (Figure 1).
The analysis we conduct relies on the 2013 extension of the Domestic Stability Pact to Italian municipalities with a population below 5,000 inhabitants. The Pact already applied to towns with more than 5,000 inhabitants before the reform. We compare municipalities around this population threshold, before and after 2013 (difference-in-differences), to test whether being subject to the Domestic Stability Pact affects corruption rates and budgetary outcomes. Moreover, we restrict the sample to municipalities whose population is sufficiently close to the 5,000 threshold, employing a ‘local’ version of this estimation strategy.
Figure 1 Corruption investigations in Italian municipalities
Note: The figure shows Italian municipalities that experienced at least one corruption episode in the period 2004–2014.
Impact on corruption and budgetary outcomes
The Domestic Stability Pact reduced corruption rates from 6% to 30% of a standard deviation, depending on the strictness of the budget constraint. Figure 2 (left panel) shows the average effect on corruption rates per capita for many different population bandwidths: treated municipalities have lower corruption rates under fiscal rules (after 2013).
In the paper, we document that municipalities are induced by the Domestic Stability Pact to reduce public investments, i.e. capital and procurement expenditure. These components of the budget represent discretionary spending and, as such, are more liable to be affected by mismanagement and rent-seeking (Mauro 1995, Hessami 2014, Liu and Mikesell 2019).
Importantly, the effect on corruption is not just due to a mechanical decrease in public expenditure. Local politicians seem to cut the most likely rent-seeking-affected areas, as we also observe a decrease in corruption charges per euro spent. This means that corruption is decreasing more than public spending and suggests an improvement in the corruption-proofness of public spending (right panel of Figure 2).
Figure 2 Effect of the Domestic Stability Pact on corruption: Per capita (left) and per euro spent (right)
Note: The left plot shows the local DID estimation on corruption rates per capita (standardised), for different population bandwidths. The right plot shows the local DID estimation on corruption rates per euro spent (standardised), for different population bandwidths.
The role of political accountability and European Funds
These findings are heterogeneous along two dimensions. First, in line with the above-mentioned hypothesis, accountability incentives lead to lower corruption under the Domestic Stability Pact. We find that corruption decreases in treated municipalities especially during the electoral period, in line with the idea of politicians reducing rent-seeking for electoral purposes.
As Italian mayors face a two-term limit, we should expect electoral incentives to be at work for re-eligible mayors. Indeed, we find that corruption decreases mostly for mayors in their first term, as they can stand for re-election.
Second, municipalities in six less-developed regions (‘convergence regions’) received extra amounts of European Funds during our period of interest.1 Since expenditures financed by these transfers were not targeted by the Domestic Stability Pact, the capital expenditure in towns located within these areas were de facto much less constrained by fiscal rules. As expected, we do not observe any reduction in corruption in these municipalities nor any effect on public budget outcomes. EU transfers allowed these municipalities to comply with the requirements of the Domestic Stability Pact without cutting expenditures.
Local public goods
Overall, these findings imply a trade-off between the beneficial effects of budget constraints on corruption and a drop in potentially welfare-enhancing public investments. To investigate the overall welfare effects of fiscal rules, we test whether the Domestic Stability Pact affected local GDP, inequality, and a newly collected set of outcomes including all main municipal services (i.e. waste management, kindergartens, police, school canteens, and street lighting). We do not find any effect of fiscal rules on these local public services. These results suggest an allocative efficiency gain for local public finance, although the recent extension of the Domestic Stability Pact does not allow for an assessment of its long-term effects on local public-good provision.
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1 The status of convergence region is defined according to an exogenous criterion, dependent on regional GDP. These areas are less developed, as their per capita GDP is below 75% of the EU average.