Fiscal transfers and regional economic growth

• Author: M. Neugart,H. Dawid,P. Harting
• Date: 01 August 2018
• DOI: http://doi.org/10.1111/roie.12317
• Published date: 01 August 2018

SPECIAL ISSUE PAPER

Fiscal transfers and regional economic growth

H. Dawid

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P. Harting

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M. Neugart

2

1

Bielefeld University, Germany

2

Technical University, Darmstadt,

Germany

Correspondence

H. Dawid, Department of Business

Administration and Economics and

Center for Mathematical Economics,

Bielefeld University, PO Box 100131,

33501 Bielefeld, Germany.

Email: hdawid@wiwi.uni-bielefeld.de

Funding Information

European Union: Horizon 2020 Grant

No. 649186 (Project ISIGrowth); Euro-

pean Union: COST Action IS1104 “The

EU in the new economic complex geog-

raphy: models, tools and policy

evaluation”

Abstract

In the aftermath of the financial crisis, with periphery coun-

tries in the European Union falling even more behind the

core countries economically, there have been quests for vari-

ous kinds of fiscal policies in order to revert divergence.

How these policies would unfold and perform comparatively

is largely unknown. We analyze four such stylized policies

in an agent-based macroeconomic model and study the eco-

nomic mechanisms behind their relative success. Our main

findings are that the core country sharing the debt burden of

the periphery country has almost no effect on the growth

dynamics of that region, fiscal transfers have a positive

short- and long-run impact on per-capita consumption in the

target region, and that technology-oriented firm subsidies

have the strongest positive long-run impact on competitive-

ness of the periphery country at which they are targeted. The

positive effect of the technology-oriented policy is rein-

forced if combined with household transfers.

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INTRODUCTION

There have been various calls for fiscal policies to foster the economic stance in the periphery countries

of the European Union. These quests have highlighted the need to gain a better understanding of the

actual effects of interregional fiscal transfers in an economic union that consists of regions that are

characterized by heterogeneities with respect to productivity, technology, skill endowments, and still

considerably large differences in per-capita income as well as population size.

In this paper we employ a two-region agent-based macroeconomic model (Eurace@Unibi) to study

the effects of a set of fiscal policies, taking into account the feedback between technological evolution

in a region and (global) competitiveness of local producers as well as the resulting (fiscal) revenues. In

the default setting fiscal policy is regional and policymakers finance transfers to households and unem-

ployment payments through taxes on household income and firm profit in their region only. As a result

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C2017 The Authors Review of International Econom ics Published by John Wiley & Sons Ltd

Rev Int Econ. 2018;26:651–671. wileyonlinelibrary.com/journal/roie

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DOI: 10.1111/roie.12317

of the endogeneity of firms’investment and technology choice the model dynamics in this default set-

ting exhibit a widening of the initial gap between the regions leaving firms in the periphery region at a

persistent competitive disadvantage. The malperforming economy in the periphery region implies that

the government of that region runs persistent deficits and eventually has access no longer to credit. In

the absence of fiscal transfers between regions this results in severe tax increases or cuts in public

spending in the periphery region.

Starting from this base scenario the paper studies how fiscal transfers from the technologically

more advanced region to the periphery region affects per-capita consumption in both regions. Different

variants of the policy, that is, how the money is spent, are compared and economic mechanisms under-

lying the relative success of the policies are studied. We find that sharing the debt burden of the periph-

ery country has almost no effect on the growth dynamics of that region. Fiscal transfers, our second

policy, however, strengthen demand and have a positive short- and long-run impact on per-capita con-

sumption in the target region. Third, we find that technology-oriented firm subsidies have the strongest

positive long-run impact on per-capita consumption of the periphery country at which they are targeted

and require a relatively small union-wide budget. Finally, the effect of the technology policy on per-

capita consumption can be leveraged if combined with transfers to households in the periphery region,

however, at the cost of a larger budget for the policies.

The model on which we base our analysis captures heterogeneity of firms with respect to the qual-

ity of their physical capital and of workers with respect to their specific skills. Specific skills of a

worker increase over time if her employer uses technology that is above the worker’s current specific

skills. Productivity of a firm is determined by a complementarity between the (evolving) quality of its

physical capital stock and the specific skills of its workforce. Physical capital is available in different

vintages and the firms’vintage choice when investing depends on a comparison of the firms expected

returns from different vintages. Because of this, diffusion of new vintages in a technology is driven by

the level of investment in physical capital undertaken by firms, which depends on the demand dynam-

ics, and the firms’vintage choice, which is strongly influenced by the specific skills in the firms’work-

force. Our policy analysis rests on systematic simulation studies based on large sets of batch runs

under the different policy scenarios. Policy effects are estimated using dynamic statistical models recur-

ring to penalized spline methods. Furthermore, the economic mechanisms driving the policy effects are

carefully analyzed employing time series of micro- and meso-level variables in the simulation data.

Our simulation model has been shown to reproduce a large set of empirical stylized facts on different

levels of aggregation. In this contribution and unlike previous policy analyses that we have conducted

with the Eurace@Unibi model (see, e.g., Dawid, Gemkow, Harting, Neugart, Kabus, & Wersching,

2008; Dawid, Gemkow, Harting, & Neugart, 2012a, Dawid, Harting, & Neugart, 2014), we consider a

setting where the economy consists of a core region and a periphery region, which differ both with

respect to size and their (initial) level of technology. The average quality of the physical capital endow-

ment and the specific skills are initially substantially larger in the core region. Firms from different

regions globally compete on product markets but labor markets are assumed to be local. Moreover, there

is a home bias for the consumption good produced in the region in which households live.

The policies of the simulation analysis are chosen to reflect European Union initiatives to get fiscal

imbalances under control, and a public policy debate that has brought forward various proposals to fos-

ter recovery and the catch-up of periphery regions.

First, under the European Stability Mechanism (ESM) put into place in 2012 as a follow up to the

temporary funding programs of the European Financial Stability Facility (EFSF) and the European

Financial Stabilisation Mechanism, member states can apply for funds when they are in financial diffi-

culties.

1

Bailouts are conditional on accompanying reform programs for fiscal consolidation, and on

member states having signed the European Fiscal Compact, a stricter version of the European Growth

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