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Arranging competences, transfers & debt, key for reunited, federal Cyprus

By Stelios Orphanides

The choice of model for a federal Cyprus, which will set out the assignment of competences and the regime governing transfers and debt creation, may likely determine the degree to which the post-reunification island will be a successful state, a German academic said.

“Federalism has to be designed carefully and that requires a balance of several aspects,” economics professor Juergen von Hagen said. “In a viable federation you need a balance of power between the states and the federal government which is very delicate and depends on initial economic and political conditions”.

Juergen von Hagen, who teaches at the University of Bonn and at the Indiana University, was addressing an audience at a lecture organised by the Cyprus Economic Society in Nicosia on June 2. His lecture was six days before President Nicos Anastasiades and the Turkish Cypriot leader Mustafa Akinci were to meet for their first scheduled meeting following the May 22 parliamentary elections.

The two leaders are attempting to end Cyprus’s division by agreeing to a bizonal, bicommunal federation.

In 2004, von Hagen, co-authored together with Barry Eichengreen, Ricardo Faini and Charles Wyplosz a report for the government of Cyprus on the economic aspects of the Annan Plan, a United Nations-mediated settlement blueprint that Greek Cypriots rejected in a referendum in April that year.

“There is no such thing as a typical federation,” said the German academic who is also vice chairman of the Portuguese Fiscal Council. “There is a lot of freedom in designing a federation. Every federation is different”.

Around 40 per cent of the world’s population live in 28 federations around the globe, with the vast majority consisting of more than ten states. The Caribbean island state of St. Kitts & Nevis has the smallest number of member states with just two, he said.

“If you are in the process of designing a federal country, to some extent this is a good lesson, because it means there is no prototype federal country that you have to adapt the characteristics of,” von Hagen said. “At the same time, you have to think carefully what the local conditions are, the local circumstances, what can make a federation in this country viable”.

Von Hagen said that the assignment of competences of both the federal government and the states is key to defining which public goods and services will be produced by whom and also which taxes will be collected, again by whom.

Assigning revenues to the federal government or the states needs to take into account what the tax base will be, and that the geographical mobility of taxes may create tax competition among states, he said.

While assigning mobile taxes to the federal government could be an obvious solution of how to avoid tax competition among states, doing so may result to a “vertical imbalance” of a “tax-wise relatively rich” federal government and “tax-wise relatively poor” states, which entails the moral hazard for states to improve their economic capacity.

Another possible solution could be a tax harmonisation among states, he continued.

Similarly, competition among states can also result depending to whom welfare policies are assigned, von Hagen said. It might lead to a situation in which one state attracts richer citizens as it spends less on welfare – and therefore also keeps contributions low – and a state offering more welfare, attracting more, poorer citizens while imposing high contributions, which ultimately can result in too little redistribution of income.

On the other hand, introducing a centralised welfare system in an attempt to avoid welfare competition, may not be as effective, even as it allows more economies of scale and cost savings.

When central governments are in charge of delivering a certain public service or good, citizens will demand more of it, which ultimately results to excessive spending, von Hagen said.

On the other hand, state governments which know better the preferences of their respective citizens, “have always an incentive to build economic kingdoms, to raise trade barriers to enhance barriers against the mobility of labour,” von Hagen said. He referred to the U.S. as an example where a lawyer in one state cannot practice law in another state. On the other hand, having a federal government empowered with more authorities to protect property rights and enforce contracts, can also be in position to “confiscate the wealth of its citizens”.

The academic economist said that also the regime under which transfers in a federation are governed in an attempt to alleviate horizontal or vertical imbalances, also needs to be carefully designed.

“Horizontal tax equalisation,” as the process of revenue transfers from richer to poorer states is known, is much preferable to vertical grants because it is much more transparent, he said. “You can always figure out who gets what, for what purposes”.

While a horizontal tax equalisation is not an easy process, as “no state gives up tax revenues, at least not large amounts” which often results in conflicts, vertical transfers, i.e. transfers from the federal government to the states, and may prove counter-productive, he said. “They increase inequality in tax revenue probably because they follow political considerations more than economic considerations”.

In Latin America, von Hagen continued, there have been cases of states threatening to stop delivering certain public services unless they got extra money from the central government, which ultimately gave in.

Also, under “soft budget constraints” states that run out of money may ask and get “ex post” more vertical grants than initially budgeted, as federal governments are often willing to pay them on fears that by not doing so, “foreign investors will treat the country worse than before,” he said.

“Empirically bailouts always go to small states, they never go to big states,” as they have more incentives to be disciplined, von Hagen added.

With respect to public debt, there are three types of debt pools, von Hagen said. One that gives more autonomy to the states, as is the case in the U.S. or Switzerland giving complete fiscal independence to the states and no bailout if things go wrong. The antipode of the complete autonomy in federations is the fiscal union seen in Australia with its “loan agreement” which remained in force until the 1990s and provided for strict enforcement by the federal government which eventually abused it. The third possibility, is the debt union, practiced in Germany, Spain and elsewhere in the Americas. The latter allows states to borrow on their own right and all the federal government guarantees is the debt of the state, and has the right to intervene with a bailout if things get out of hand – which is possible, given that it encourages more borrowing.

“In the U.S. the typically debt to gross domestic product ratio of a state is 20 per cent,” von Hagen said. “In Germany, it’s much bigger than that because the states borrow very heavily”.

The problem is exacerbated by the lack of market and federal discipline, as state debt is treated and traded the same way as federal debt and federal governments cannot enforce fiscal rules to the states.

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