Effect of Vertical Fiscal Imbalance on GDP

Effect of Vertical Fiscal Imbalance on GDP

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Fiscal imbalance pertains to the mismatch of expenditure and revenue responsibilities of a government while vertical fiscal imbalance definition involves the share of own sub-national spending which is not financed by own revenues. Therefore, its counterparts are sub-national net transfers and borrowing which are received from other levels of government. Both of them are expressed as portions of sub-national own spending. However, it is a fact that across countries, there can be a large difference in vertical imbalances because the financing of sub-national spending varies significantly due to cross-country differences and distinctive factors.

Thus, the revenue and spending of sub-national governments play a major part in determining the imbalance and the vertical fiscal imbalance formula also highlights this fact as both the parameters are involved in it. Thus, VFI can be determined by using the following formula.

VFI = 1 – (SNG own revenue / SNG own spending)

It is also a fact that sub-national net borrowing and transfers which come from the center cover VFI and therefore the SNG spending can be calculated as the sums of SNG's self revenue, SNG net borrowing and the transfers received by SNG. Thus, VFI can also be calculated as follows.

VFI = SNG deficit + transfer dependency

Thus, while taking a look at the vertical fiscal imbalance bill, it will be clear that although VFI is mostly covered by its revenues and transfers, the borrowings at the sub-national level are very essential to understand VFI changes over a period. In a lot of cases, the sub-national borrowing may be low but they can be very volatile which explains their relatively high contribution.

This can also be evident in the vertical fiscal imbalance year wise data of various economies and that further suggests the measurement of vertical gaps by using ‘transfer dependency’ can help eliminate a major part of the volatility. Most empirical results that are widely available seem to suggest that decreasing VFIs can potentially lead to massive financial gains, especially in developed countries. It is widely considered that the fiscal balance of a government gains by one percent of gross domestic product (GDP) whenever there is a decline of ten percentage points in the VFI. In other words, one-tenth financing equivalent of sub-national expenditure shifts from borrowing and/or transfers towards own revenue.