Regional effects of curbing future deficits– alternative ways to respond to increasing municipal expenditures

In this study we evaluate the regional effects of ageing and balancing of fiscal deficits by using a dynamic, regional AGE model for Finnish Economy. We use a MONASH-type dynamic model called VERM (dynamic TERM). To study the effects of ageing, we make use of econometric results and long term anticipation results conducted by the European Commission for the parameter values determining the population-driven demand for public services. Public demand for age-dependent services is driven by a general growth trend, and by age-group specific parameters. Thus, foreseen changes in the age composition of the Finnish population is reflected the composition and volume of public demand. State transfers to municipalities include a kind of Robin Hood-element that treats high- and low-income municipalities asymmetrically. In order to improve our description of the state transfers to municipalities, we introduced individual municipalities within each region for the purposes of the state transfer calculus. Transfers to municipalities are traced from statistics and preliminary calculations between 2004 and 2011. From that on, the development of income and population of each municipality is assumed to coincide with the development of the greater region it belongs to. However, the historical status of the municipality within the income distribution is reflected in the amount of transfers it gets during the simulation period. In addition to rules-based transfers to municipalities, around a third of the transfers are based on more ad-hoc policy decisions. This part of the transfers is our policy variable in the analysis. According to our simulation results, constraining the fiscal deficits of the public sector has considerable effects on the GDP growth. The size of effects varies between our alternative ways to curb the deficits: through state-level or municipal income taxation. The negative effects on GDP are greater if the public deficits are financed through higher state income taxes and transfers to the local administration than through municipal income taxation. However, using municipal taxation increases regional differences. From our sub-regional disaggregation of Central Finland we see how the sub-regions diverge in their development. Central region Jyvaskyla would gain if municipal taxation, rather than state income taxation is used in cutting the deficits. As in several studies using new economic theory framework, we find a trade-off between efficiency and cohesion. Future improvements of our model will include making the demographic development endogenous through migration. In addition, commuting between regions may be taken into account explicitly.