* Economic Analyst, Desk Officer Austria

The views expressed in the ECFIN Country Focus are

those of the authors only and do not necessarily
correspond to those of the Directorate-General for
Economic and financial Affairs or the European
Commission.



European Union, 2014

KC-XA-14-001-EN-N
ISBN 978-92-79-35115-0
doi: 10.2765/68747

Reproduction is authorised
provided the source is acknowledged.

HIGHLIGHTS
N THIS ISSUE:
HIGHLIGHTS
IN THIS ISSUE:
Different patterns of
tax-transfers
balance in States
and municipalities
have an influence
on their fiscal
performance;
Subnational
expenditure
dynamics are
mainly driven by
specific factors such
as developments in
the health sector;
Linking subnational
budgetary targets
to national
macroeconomic
variables may
reduce the
effectiveness of the
rules at subnational
level;
Subnational fiscal
rules effectiveness
depends on their
ability to foster
specific
organisational and
sectorial reforms.



Volume 11 | Issue 1 | January 2014 ISSN:1725-8375

Austria's fiscal rules: climbing the
mountain towards effective fiscal
relations
By Raffaele Fargnoli*
Summary
This study of Austria's fiscal framework discusses positive aspects and weaknesses of recent
reforms in intergovernmental fiscal relations by analysing from a backward and forward
looking perspective some of the factors driving subnational fiscal performance. Looking
back, transfer dependency has differed between various levels of government and coincided
with different fiscal outcomes for State governments (Lnder) and local governments. The
fiscal framework has not been able to prevent State governments from consistently missing
their budgetary targets from 2001 to 2009, causing a significant drag on Austria's overall
budgetary position. In response, reforms going in the direction of higher tax sharing and
lower transfer dependence for subnational governments have provided stronger incentives to
curb expenditure, paving the way for better fiscal performance in recent years. Looking
forward, the analysis focuses on the new system of fiscal rules adopted in Austria, aimed at
reinforcing the budgetary framework through the introduction of multiple fiscal rules that
are extended to subnational governments. The reform has reinforced the link between
structural macroeconomic variables and subnational budgetary targets, in particular by
capping subnational expenditure dynamics to national potential output growth. Although the
new rules constitute progress, their design may in some respects be ineffective to ensure the
respect of the targets. In particular the link between potential output and subnational
expenditure growth may prove difficult to maintain in light of the volatile nature of
subnational spending in Austria, which is often caused by specific recurrent expenditure
overruns. In this respect, the study presents the underlying factors driving the dynamic of
subnational health sector expenditure, such as recurrent subsidies and capital transfers to
the health sector, and confirms that the effectiveness of Austria's new fiscal framework will
depend on the interplay of comprehensive organisational and structural reforms in order to
tackle inefficiencies and reduce the underlying trend expenditure growth.
ECFIN Country Focus Issue 1 | January 2014
2


















State governments'
budgetary targets have
been often missed.












Introduction
The EU budgetary surveillance increasingly focus on budgetary frameworks in Member
States since past developments show that they are crucial to ensure that obligations at EU
level can effectively be met. Also, preliminary evidence points to a certain correlation
between the average fiscal outcomes in the EU and some features of the budgetary
framework, notably the extent of fiscal decentralisation, the rate of coverage of
subnational expenditures by own resources and the weight of taxes in subnational
revenues (see Public Finances in EMU 2012, chapter 3).
Overall, Austria's fiscal framework has been conducive to enhancing budgetary discipline
and avoiding pro-cyclical policies. However, it has not enabled Austria to achieve a
balanced budget over the business cycle. The country specific recommendations
addressed to Austria in the framework of the European Semester emphasise the need for
strengthening the fiscal framework and streamlining fiscal relations between levels of
government. Fiscal framework indicators by the European Commission (see European
Economy, Occasional paper n.92, 2012) point out that Austria is not among the best
performers on the fiscal rules index
1
. In particular, fiscal relations between different
levels of government remain complex and marked by overlapping competencies in key
expenditure categories, such as healthcare, education and social transfers.
In December 2011 Austria adopted a broad reform of its fiscal framework through a new
and strengthened Austrian Internal Stability Pact (AISP). This followed the 2008 reforms
of the equalisation law, which went in the direction of increasing the source of
subnational revenues coming from shared taxes while reducing intergovernmental
transfers. The 2011 reform introduces a system of multiple fiscal rules applying to each
level of government, including nominal and structural deficit targets, expenditure rules
and enhanced sanction mechanisms. This country focus looks at past outcomes in States'
and local governments' fiscal performance and examines some of the factors underlying
subnational budgetary developments. Against this background, it aims to discuss positive
aspects and weaknesses of these reforms by analysing subnational fiscal performance
from a backward and forward looking perspective.
Subnational deficit targets and outcomes
In the last decade, the centrally established deficit targets for subnational governments
have been often missed. State governments (Lnder) consistently failed to meet their
budgetary targets from 2001 to 2009
2
. As a result the long-term average of States' budget
balance decreased from a surplus of 0.6% of GDP in the period 1988-2000 to a deficit of
roughly 0.1% of GDP in the period 2001-2011. On the contrary, local governments have
shown better compliance since they over-achieved their targets in most years (charts 1
and 2).
Graph 1: State balance as % of
GDP
Graph 2: Local governments
balance as % of GDP


Source: Commission Services based on OECD, Eurostat data



ECFIN Country Focus Issue 1 | January 2014
3

Subnational revenues
are composed of high
tax sharing, medium
transfers and low
autonomous taxes
From 2009 the large economic downturn, the functioning of automatic stabilisers and
counter-cyclical discretionary measures have led to higher deficit in both States and local
governments. Consolidation started in 2011 when the different layers of government took
measures to reduce their budget deficit. States over-achieved their targets in 2011 and
2012, while local governments over-achieved their target in 2012.
Subnational governments' expenditure can be financed by own subnational revenues, tax
sharing and intergovernmental transfers. Although the distinction is not straightforward,
the composition between these three sources of revenue differs considerably among
countries. The OECD includes Austria among the countries characterised by low
autonomous taxes, high tax sharing and medium transfers (chart 3).The share of own
taxes is particularly low with respect to other countries (chart 4). In addition, subnational
governments have little discretion in setting the tax rate and the tax base.






















States rely more on
transfers and have a
lower share of own
taxes than
municipalities


Graph 3: Sources of subnational
revenues in selected EU countries
in 2011
Graph 4: Subnational own taxes
as % of GDP in 2011


Source: OECD
Different studies (European Commission, IMF) classify Austria as a country with
relatively low vertical imbalances
3
considering together state and local governments'
revenue and expenditure. However, by looking at the revenue composition of States and
municipalities separately, two different patterns emerge. Tax sharing and own taxes
constitute a much larger portion of local governments' revenue than that of States, while
transfers play a bigger role in the States' revenue (charts 5 and 6). Furthermore the share
of municipalities' own taxes in total local revenues is more than double that of States,
implying larger vertical fiscal imbalance in the States then in municipalities (charts 7 and
8).










Graph 5: States revenues 2011

Graph 6: Municipalities revenues
2011

Source: OECD
ECFIN Country Focus Issue 1 | January 2014
4


leading to higher
vertical imbalances and
possibly lower fiscal
performance




The fiscal performance of Austrian subnational levels of government, assessed in terms
of compliance with the targets established in the previous AISP, seems to confirm the
general findings of the theory of fiscal federalism. The literature generally emphasizes the
risks associated with large vertical imbalances. A common finding is that a high reliance
on transfers softens the budget constraint of sub-national governments, leads them to
overspend, and lowers their tax effort, mainly because they do not fully internalise the
cost of spending and/or because they are aware that their financing gap will be covered
by additional transfers. Conversely, allowing sub-national governments to dispose of
more own revenue mainly through local taxation is seen as promoting fiscal discipline
(Oates, 2006; IMF, 2009; Blchliger and Petzold, 2009). Other studies show that transfer
dependency is often linked with larger fiscal deficits, especially if associated with a large
extent of expenditure decentralisation and soft borrowing constraint (Rodden and
Wibbels, 2009).


























Graph 7: Vertical fiscal imbalance
states

Graph 8: Vertical fiscal imbalance
local governments

Source: OECD
Fiscal outcomes at State level started to deteriorate after 1997, when States' vertical
imbalances gradually widened and transfer dependency increased. Up to 2007 sluggish
revenue growth and higher expenditure dynamics explain the increase of States' vertical
imbalances. In the following years the higher correlation between revenue and
expenditure is also due to the 2008 reform of the fiscal equalisation law which brought a
change in the direction of higher tax sharing and reduced transfers. This could have
facilitated the ability of State governments to meet their targets in an environment of
strong consolidation needs. On the other hand, local governments have shown, over time,
good compliance with their targets, with revenue and expenditure more correlated in most
years. The higher tax sharing and a wider portion of autonomous taxes, resulting in lower
vertical imbalances, may be one factor behind this better track record.
The reform of the Austrian Internal Stability Pact
At the end of 2011 the government approved a new AISP, which broadly mirrors the
design and targets of new rules adopted at European level. The aim is to reinforce the
budgetary framework, mainly through the introduction of a new system of multiple fiscal
rules that are extended to subnational governments. The main rules involve: a) more
stringent deficit targets for the different levels of government; b) a new structural balance
rule, which will be applied from 2017 onwards, that sets a lower limit of general
government structural deficit at -0.45 % of GDP (-0.35 % for the central government and
-0.1 % for states and local governments); c) in line with the preventive arm of the
European Stability and Growth Pact, expenditure growth in all government levels (net of
discretionary measures) must not exceed average potential growth and must follow the
adjustment path towards the MTO; d) a new debt rule designed as the European one
covering all levels of government. The new AISP as well as the presence of stronger
enforcement mechanisms are important novelties compared to previous arrangements.
4

ECFIN Country Focus Issue 1 | January 2014
5



Some factors could
reduce the
effectiveness of the
new fiscal rules at
subnational level

















Health expenditure
accounts for a large
part of expenditure
growth both in States
and municipalities



Subnational
expenditure often
departed from average
potential growth.


However, in light of past outcomes, where subnational deficit targets were frequently
missed or renegotiated, the actual effectiveness of the new rules will require diligent and
strict implementation.

In addition, the design of the rules at subnational level could in some respects potentially
jeopardise their application. National potential output is used as the key reference value
both for the structural budgetary targets and for the expenditure rule. Although revenue
sharing and cyclical unemployment expenditure at central level to some extent insulate
subnational budget balances from the business cycle, the volatility of subnational
expenditure combined with the absence of revenue-raising power could, by design,
endanger the respect of the targets. In addition, building the credibility of subnational
rules linked to macroeconomic variables will require reducing the number of incidents
where expenditure overruns at subnational level are driven by specific expenditure
developments in particular sectors, most notably in the health sector. Hence, a crucial
prerequisite for success of the new framework is that the set of rules will be able to foster
a comprehensive overhaul of those sectors, where expenditure slippages systematically
materialise.
Exploring the dynamics of subnational expenditure, in particular by looking at the
underlying variation of the expenditure/GDP ratio by sectors, allows identifying some of
the main drivers behind the expenditure developments over the last decade

Graph 9: Change in expenditure /
GDP ratio by Gov. levels (%)
Graph 10: Change in the
expenditure / GDP ratio by sector
2011-2001 (nominal value)

Source: Commission Services based on Eurostat data
State governments experienced the lowest reduction in the expenditure ratio in the period
2001-2007, while from 2008 the rise was among the highest and more than offset the
previous decrease (charts 9 and 10). Central and local governments experienced the
largest expenditure reduction until 2007, which was for the most part safeguarded in
2008-11. The marked increase of the social security expenditure ratio since 2008 is
mainly due to its strong cyclical features. The pattern of sectorial expenditure shows that
most of the increase in the expenditure ratio in both state and local governments occurs in
the health sector. Health expenditure increase accounts for the bulk of the overall rise of
the State governments' expenditure ratio, while for local governments the increase in
health spending has been offset by expenditure reductions in other areas.
States' and local governments' expenditure appears quite volatile especially when
compared to other EU Member States, even if Austria's subnational expenditure is found
to respond less to cyclical factors than in a number of EU Member States (see OECD
2010, OENB 2013). The annual nominal expenditure growth of both States and
municipalities overshot in many years an approximation of the new expenditure rule
(including only its main component, namely multi-year average potential GDP growth
computed broadly in line with the benchmark of the new EU economic governance).
Moreover, States' average expenditure growth has in the past been above this benchmark
(charts 11 and 12). Subsidies and capital transfers are the main drivers of expenditure
overruns. Local governments perform slightly better, since the average expenditure
ECFIN Country Focus Issue 1 | January 2014
6





















Health expenditure is
very fragmented
among different
government levels










growth remains below the reference ratio. However, in some years expenditure growth
departs considerably from the reference ratio such as in 2008 when subsidies to the health
sector drove up local expenditure growth.
Graph 11: States expenditure and
potential GDP growth
Graph 12: Local governments
expenditure and potential GDP
growth


Source: Commission Services based on OECD data
Overall, the expenditure profile of subnational governments shows clear-cut patterns: i)
subnational expenditure is quite volatile; ii) States' expenditure to GDP ratio grew more
than that of municipalities; iii) a sustained rate of expenditure growth occurred in the
health sector for both levels of government; iv) expenditure overruns are often due to
specific recurrent circumstances related to the financing of the health sector.
Against this background subnational budget balance targets could be undermined by
expenditure dynamics, with expenditure overruns often caused by structural factors. The
effectiveness of the fiscal rules will therefore depend on their ability to foster reforms in
specific areas such as the health sector.
A case in question: Organisation of the health system
Sustained health expenditure growth is a common characteristic in EU countries due to
ageing dynamics. Austria's health expenditure evolved in line with the European average
between 2001 and 2011. That said, Austria's total general government outlays for the
health sector have traditionally been among the highest in Europe. Data for 2011 shows
that Austria is among the countries that devote the highest amount of public resources to
the health system, while projections up to 2060 place Austria in the third position in this
respect (see European Commission, Ageing Report 2012).
The health system is generally regarded to perform well on standard output indicators.
However the organisation structure appears very complex due to high fragmentation of
organisational responsibilities and spending and funding powers among the different
layers of government. Austria is the only EU country where all levels of government,
including social security funds, account for a considerable share of total public health
expenditure (chart 13). Consequently any level of government plays a strategic role in
steering the system. The federal level, States and local governments are simultaneously
involved in providing hospital services, while outpatient care is provided by social
security services. The outcome of this complex architecture is that inpatient care is
strongly predominant over outpatient care. States provide most of the inpatient services
through their own hospitals while funding is provided by transfers from central
government and social insurance funds. Thus the States do not have any clear incentive to
consolidate hospitals capacity and shift it towards outpatient care.



ECFIN Country Focus Issue 1 | January 2014
7












Spending for hospitals
suffers from efficiency
concerns















Past developments
show that bringing
health expenditure in
line with GDP growth is
difficult without
substantial reforms
Graph 13: Health expenditure by government level as % of GDP, 2011

Source: Eurostat

From the second half of the 1990s to the early 2000s, many State and municipal hospitals
were transformed into private corporations owned by subnational governments, but
recorded outside public accounts. This has led to a large reduction of health expenditure
in States and local governments, accounting for roughly 0.5% and 0.8% of GDP
respectively. In the following years the steady rise of ordinary subsidies to hospitals for
their day-to-day functioning, together with occasional capital transfers to cover hospitals'
debt, brought States' health expenditure up to their pre-privatisation level (in % of GDP).
In local governments, although expenditure remained well below that of the pre-
privatisation period, a similar pattern can be observed (chart 14). In addition, studies on
hospital funding efficiency (Hofmarcher et al, 2005, Czypionka et al, 2008) estimate that
large potential efficiency gains could be reaped. Hospitals owned by local governments
seem to be more efficient than hospitals owned by the States, although variation is high
within both groups.
Graph 14: evolution in the health expenditure as GDP ratio

Source: Eurostat

In the context of the reform of the AISP, an agreement has been reached among the
different level of governments to limit health expenditure growth to average nominal
GDP growth until 2016. From 2016 onwards, public health expenditure growth will be
limited to 3.6%, in line with expected average nominal GDP growth. In the past, general
government health spending followed GDP growth in years when output growth was
quite robust. However, when the economy slowed down or specific events drove up
health expenditure, past experience shows that such a rule may be difficult to sustain. It
ECFIN Country Focus Issue 1 | January 2014
8
is, however, promising that States' health expenditure after having exhibited for many
years a rate of growth above those of other levels of government and above nominal GDP
growth, was much better controlled in 2010 and 2011 (chart 15). Yet, with an average
annual growth of 4.5% in the period 2002-2011, respecting a 3.6% annual growth as
targeted by Austrian authorities for the future may be challenging against the background
of the full effect of ageing.











Graph 15: Health expenditure growth by subnational Gov. and GDP
growth

Source: Eurostat
Conclusions
Over recent years, reforms have strengthened Austria's fiscal framework. While the 2008
reform of the fiscal equalisation law focused mainly on the relations among different
layers of government, the recent reform of the AISP introduces a system of fiscal rules,
mirroring those applied at European level, covering both the general government and the
different government levels. Although in many respects a step forward, the analysis has
shown that, beside political economy considerations, linking subnational budgetary
targets to national macroeconomic variables may not in itself be enough to limit
recurrent expenditure overruns at subnational level, driven by specific expenditure
developments in particular sectors, most notably in the health sector.
In the Austrian case, the ability of States and local governments to respond to
expenditure shocks is not high. The limited room for manoeuvre, in particular for State
governments, is the result of relying for a large part on intergovernmental transfers and
shared taxes, while having low tax autonomy and facing a dynamic of expenditure that is
difficult to contain in the short-run. The effectiveness of the new fiscal framework will
therefore depend on the ability to foster comprehensive organisational and structural
reforms that can tackle inefficiencies and reduce the underlying trend expenditure
growth.
The Austrian experience seems to confirm the importance of combining well-designed
fiscal rules with proper institutional arrangements able to provide an efficient incentive
structure for subnational governments. Past reforms going in the direction of higher tax
sharing and lower transfer dependence for subnational governments have provided
stronger incentives to curb expenditure, paving the way for better fiscal performance in
recent years. Looking forward, dealing with the fragmentation of organisational
responsibilities and the mismatch between spending and funding powers among the
different layers of government would naturally complement recent reforms of federal
fiscal relations and the reinforcement of Austria's fiscal framework.


ECFIN Country Focus Issue 1 | January 2014
9
References
Brothaler J . and Getzner M.(2010) "Effects of fiscal decentralisation on public sector growth in Austria" Public Finance and
Management, vol.10 2010;
Czypionka e al. (2008) "Case Management in Austria and Europe - Health-economic evaluation: Political implications and
utility outcome" Health System Watch, HSW I / 2008, Institute for Advanced Studies, Vienna;
European Commission (2012) "Fiscal frameworks across Member States: Commission services country fiches from the 2011
EPC peer review", European Economy, Occasional Paper n.91;
European Commission (2012) "Report on Public Finances in EMU 2012" European Economy, 4/2012;
European Commission (2012) "The 2012 Ageing Report", European Economy 2/2012;
Fuentes A. et al. (2006) "Reforming Federal Fiscal Relation in Austria" OECD Working Papers No.474;
Hofmarcher MM, et al (2005) Inefficiency in Austrian inpatient care: An attempt to identify ailing providers based on DEA
results. Central European J ournal of Operations Research, Vol 13, Issue 4, December 2005;
Izabela Karpowicz (2012) "Narrowing Vertical Imbalances in Four European Countries" IMF Working Paper;
OECD (2009) "Explaining the Sub-National Tax-Grants Balance in OECD Countries", OECD Network on Fiscal Relations
across Levels of Government;
OECD (2009) "Taxes and Grants: On the Revenue Mix of Sub-Central Governments", OECD Network on Fiscal Relations
across Levels of Government;
OECD (2010) "Fiscal Policy across Levels of Government in time of Crisis", OECD Network on Fiscal Relations across
Levels of Government;
OECD Economic Surveys, Austria: years 2001,2003,2005,2007,2011;
OENB: Structural budget balances: Calculation, Problems and Benefits in Monetary Policy and The Economy, Q1 201;
Von Hagen J . and Foremny D. (2012) "Subnational budgetary discipline during time of Crisis: The impact of fiscal rules and
tax autonomy".


1 The last update of these indicators does not take into account the recent reforms of the AISP.
2 On the basis of vintage data differences between targets and outcome were somehow lower. However this was due to accounting principles which
encouraged local entities to granting loans instead of injecting capital into the hospital sector. These operations are not recorded under general
government expenditure and do not cause increase in the deficit.
3 The concept of vertical imbalances used here refers to the share of subnational expenditure (minus intergovernmental transfers paid) not covered by
subnational revenues (both shared and autonomous, excluding transfers received from other level of government). By definition, the counterparts of
vertical imbalances are sub-national borrowing and transfers received from other units of general government.
4 The existing legally binding Medium-Term Expenditure Framework introduced in 2009 applied only to five main central expenditure categories,
covering about 75% of the central government outlays. The expenditure ceilings do not cover subnational level expenditure and therefore included just
40% of the total general government expenditure.