Direct Propagation of a Fiscal Shock: Evidence from Italy's Stability Pact

This paper documents: the channels through which local governments propagate a fiscal shock; and the corresponding reaction by firms in the affected upstream sector (municipal procurement). The shock is provided by an Italian fiscal rule, called Patto di stabilita' dei comuni, which was tightened unexpectedly in 2008 and applied only to municipalities with population greater than 5,000. Using a difference-indifference identification strategy, we estimate that this shock led to a 13-20% reduction of infrastructure spending in treated municipalities, or equivalently, an 80% reduction in the average municipality. In contrast, current expenditure was not affected. In the upstream sector, i.e., the infrastructure procurement sector, firms reacted to the demand shock by cutting capital rather than labor. In both cases, then, the capital/investment sector is found to be a pre-eminent channel of direct shock propagation. In addition, the fiscal demand shock is found to propagate disproportionately through those private-sector firms which are most exposed to the shocked sector. This finding suggests that direct shock transmission depends on the higher moments of the exposure distribution, beyond the average sectoral exposure that is represented by the input-output linkages. Using procurement-market data we rule out the possibility that our estimates are attenuated by spillover effects operating through competition in the procurement market.