What Is Fiscal Imbalance?

Fiscal imbalance refers to a situation where all of the future debt obligations of a government are different from the future income streams. There are two types of imbalance that can impact a government's expenditures and revenues: vertical fiscal imbalance and horizontal fiscal imbalance. The obligations and the income streams are measured at their respective present values and will be discounted at the risk-free rate plus a certain spread. 

Fiscal imbalances can occur for a government at any given time. If there is a sustained positive fiscal imbalance, then tax revenues will likely increase in the future, causing current and future household consumption to fall.

Key Takeaways

  • Fiscal imbalance occurs when there is a mismatch between a government's future debt obligations and future income streams.
  • Vertical and horizontal fiscal imbalance are the two types of imbalance that can impact a government's expenditures and revenues.
  • A vertical fiscal imbalance occurs when revenues do not match expenditures for different government levels.
  • A horizontal fiscal imbalance occurs when revenues do not match expenditures for different regions of the country.

Understanding Fiscal Imbalance

A vertical fiscal imbalance describes a situation where revenues do not match expenditures for different levels of government. A horizontal fiscal imbalance describes a situation where revenues do not match expenditures for different regions of the country.

Horizontal fiscal imbalances require equalization transfers or payments to a state or province from the federal government to offset monetary imbalances between different parts of the country. A vertical fiscal imbalance is a structural issue and requires revenue and expenditure responsibilities to be reassigned.

A horizontal fiscal imbalance occurs when sub-national governments do not have the same capabilities in terms of raising funds from their tax bases to provide certain services. This type of fiscal imbalance creates differences in net fiscal benefits, which are a combination of levels of taxation and public services. These benefits are also the root cause of horizontal fiscal differences that eventually require equalization payments.

Real World Example of Fiscal Imbalance 

The Greek debt crisis had its origins in the fiscal profligacy, or wasteful and excessive expenditure, of previous governments. After Greece joined the European Community in 1981, its economy and finances were in good shape, but its financial situation deteriorated dramatically over the next 30 years. 

Over the decades, control of the government went back and forth between the populist Panhellenic Socialist Movement (PASOK) and the New Democracy Party. In an attempt to keep the populace happy, both parties enacted liberal welfare policies that created an inefficient economy. As a result of low productivity, eroding competitiveness, and rampant tax evasion, the government resorted to a massive debt binge to keep the government afloat. 

Greece's admission into the Eurozone in 2001 and its adoption of the euro made it much easier for the government to borrow. Greek bond yields and interest rates declined sharply as they converged with those of strong European Union (EU) members like Germany. As a result, the Greek economy boomed, with real gross domestic product (GDP) growth averaging 3.9% per year between 2001 and 2008. 

However, the financial crisis of 2008-2009 caused investors and creditors to focus on the massive sovereign debt loads of the U.S. and Europe. With default a real possibility, investors began demanding much higher yields for sovereign debt issued by Greece as compensation for this added risk. As Greece's economy contracted in the aftermath of the crisis, its debt-to-GDP ratio skyrocketed.