An OECD Working Paper on managing rising subnational fiscal risks was published on 13 June 2024. This paper, written by Luiz de Mello and Teresa Ter-Minassian, forms part of the series of working papers on fiscal federalism.

The working paper notes that subnational governments are confronted by a range of fiscal risks, reflecting unforeseen macroeconomic developments or structural shifts in the economy. A framework is required for identification, analysis, mitigation, sharing and prudent accommodation of risks. Subnational governments must strengthen their capacity to manage risk, but national governments must help by mitigating risks created by national policies, and legislating to avert excessive subnational risk-taking. Effective intergovernmental cooperation is therefore the key to management of subnational fiscal risks.

SNGs are affected by macroeconomic risks; risks from climate change and natural disasters; public health risks; contingent liabilities; and weaknesses in budget institutions and processes. There are also challenges from digitalisation. The way in which revenue is raised by subnational governments and the role of shared revenue is therefore important in determining the amount of risk.

Macroeconomic risks

SNGs’ own revenues are affected by changes in real GDP growth, and by inflation. Subnational income taxes (or surcharges on national income taxes) can be expected to exhibit larger income and price buoyancies (and therefore greater volatility) than taxes based on consumption or taxes on property, which are the main revenue source for local governments. Shared revenues tend to be more volatile than subnational own revenues, reflecting cyclical fluctuations in income and in some cases consumption. Taxes are the national revenues typically shared with SNGs, as well as shared royalties in countries dependent on non-renewable natural resources.

Shared revenues can be adversely affected by unexpected changes in national tax policies, such as the granting of tax reliefs. Intergovernmental grants, especially those of a discretionary nature, are generally volatile and may be cut back during cyclical downturns. The vulnerability of SNGs’ revenues to macroeconomic shocks is therefore likely to increase according to their degree of dependence on intergovernmental transfers and the sensitivity of their own tax bases to the business cycle.

Weaknesses in budget processes

Fiscal risks may also be created for subnational governments where there are inadequate national forecasts of the key macroeconomic variables used for their fiscal projections. This could include inadequate capacity to forecast and collect their own revenues, or to budget for tax expenditures, particularly if the power to grant tax benefits is dispersed among different agencies. Also, subnational budgets are often adversely affected by unexpected shortfalls in transfers from higher levels of government. In relation to spending, weaknesses in forecasting capacity and expenditure management can also create fiscal risks.

Role of SNGs in managing risk

Subnational governments have a primary role in managing their fiscal risks. This must include risk identification, analysis reporting and disclosure. They must select options for risk prevention, mitigation, sharing or transfer.

Role of national governments in managing of subnational risks

Most subnational risks are directly affected by the nature of the intergovernmental fiscal relations, and several are also affected by policy decisions of the national governments. Poor management by subnational governments of shocks can have significant adverse spillovers on other subnational governments. Poor risk management that results in subnational financial crises can create significant fiscal risks for the national government.

The working paper therefore emphasises that subnational governments should strengthen their capacity to manage their own risks, with support of national governments through policy and institutional measures