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

Abstract: 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 stabilit`a dei comuni, which was tightened unexpectedly in 2008 and applied only to municipalities with population greater than 5,000. Using a difference-in-differences 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. We explore, and ultimately discount, the possibility that our estimates are confounded by the 2008 financial crisis. The capital/investment sector is thus 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 that are more 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.