Political budget cycles: evidence from Italian cities

Alberto Alesina, Matteo Paradisi

Most of us intuitively believe that politicians reduce taxes and increase spending in the run up to elections to curry favour with voters. But our logic may well be flawed. This column presents evidence from recent Italian elections suggesting that things aren’t so black and white. Yes, some municipalities set lower tax rates in the run up to elections. But the evidence also suggests that municipalities running deficits will think twice about tax breaks and spending sprees. Politicians in big cities are also more cautious, choosing to focus not on tax but on more pressing local issues.

Is it mere coincidence that Governments often reduce taxes or increase spending close to elections? Intuitively, many of us think that governments manipulate fiscal policy for electoral reasons (see Drazen 2001).

However, the empirical evidence is far from a clear cut.

Testing the hypothesis that government’s tweak their fiscal policy in order to lure voters is difficult. An increase in government deficits before an election is not a ‘smoking gun’. It could be a chance –deficits move for a variety of other reasons that can be entirely unrelated to the political cycle. Indeed, if politicians are able to influence the date of an election they would have an incentive to time them after expansionary fiscal policies (that are needed for a variety of reasons) in order to gain electoral support.

New evidence from Italy

Italy’s recent policy changes regarding real estate taxes provided an excellent opportunity for exploring these issues. In 2011 a new property tax, the ‘imposta municipale unica’ or ‘unique municipal tax’ replaced the previous property tax. This tax is levied at the municipal level. The national government allowed cities flexibility on the rate but made the introduction of the tax mandatory and imposed a deadline – 2012 – for the deliberation of rates.

The fact that Italian cities have staggered election terms allows us to test whether municipalities’ choice of tax rates were affected by the time period between choosing the tax rate and the next election (Alesina and Paradisi 2014).

The unique municipal tax is important for Italian cities for a number of reasons:

It represents a very large proportion of independent revenue for most municipalities;

The reform was high-profile, having being discussed at length in Parliament and in the press;

Given the large share of real estate wealth held by some Italians, property tax is a perennial and important policy issue;

The new tax was one of the main interventions included in a stabilisation package passed in December 2011 by a newly appointed government.

Thus this measure was independent from and unaffected by the specificity of any particular city or town. Rather, it was a response to a period of high political and economic instability.

The structure of the new tax allows us to look at tax rates, not tax revenue, as the correct measure of a policy change – this guarantees a more precise estimation of political budget cycles and a more credible assessment of their magnitude.

Importantly, municipalities could choose whether to deliberate on the tax – or not – before an election. If it wanted to, a municipality could decide to deliberate only if electoral polls were favourable. While other municipalities in more competitive districts could postpone deliberations of these higher tax rates and thereby avoid losing precious electoral support.

Politics is less influential than expected

Municipalities had to set the new tax rate in 2012. Because municipal elections in 2012 fell in the middle of the allowed deliberation period, we cannot use 2012 elections as our variable of interest. Instead, we consider the tax rate chosen by the municipalities with elections in 2013.

First, we find that cities with elections in 2013 set lower tax rates in 2012.

That is, across our sample of municipalities, we discover significant political budget cycles. The effect is large. We estimate that an average municipality election led to a 3% deterioration in the budget deficit per capita in a single year.

When we compute the effect of political budget cycles using the characteristics of a big city like Milan, we find a loss around €6.1 billion in 2012. We then look at what choices were made in 2013 when the main residence tax was abolished but when the tax on additional residences remained. We find that the tax rate was significantly lower for municipalities with elections in 2014.

Second, we find that strategic manipulations of the new tax were more common in smaller cities with fewer than 15,000 inhabitants.

In these municipalities the unique municipal tax was by far the most-discussed issue of the day, while bigger cities had a host of other political issues in play.

Third, we split the sample in three parts and find that the presence of political budget cycles is stronger in the south compared to central and northern Italy;

Finally, we find that the presence of a deficit posed a constraint on the political budget cycle.

Municipalities with large deficits in 2011 changed their fiscal policy in line with the 2013 political cycle to a lesser extent than if they had had smaller deficits.1

Footnotes

This is especially the case for the municipalities which were affected by the Local Stability and Growth Pact, a cumbersome set of rules which limit the fiscal flexibility of cities about a certain threshold of population.

References

Drazen, A (2001), “The political business cycle after 25 years”, in B Bernanke and K Rogoff (eds.), NBER Macroeconomics Annual 2000, Cambridge, MA: MIT Press.

Alesina, A and M Paradisi (2014), “Political Budget Cycles: Evidence from Italian Cities”, NBER Working Paper 20570.