Budgetary shocks and revenue adjustment: How governments respond to unexpected fiscal shocks

This paper uses panel data from seven Canadian provinces which received Equalization payments over the period 1980/81 to 1995/96 to examine how provinces adjust own-source revenue in response to past budget shocks. Governments respond symmetrically to past own-source revenue shocks: they increase or reduce own-revenue by $0.75 for every unexpected dollar shock in own-source revenue last year. In contrast, revenue responses to past grant shocks are asymmetric. Provinces lower own-source revenue by $0.87 in response to an unexpected extra dollar from Equalization last year. But, they make no adjustment following an unexpected Equalization shortfall. The magnitude of these responses suggest that provinces see a significant component of these shocks to be persistent. Lastly, the results with respect to past spending shocks are mixed. In contrast to recent empirical results on asymmetric responses to changes in grants, the results in this paper suggest that, at least in the short run, unexpected increases in Equalization are unlikely to have a large, stimulative effect on government spending.Received: February 2003, Accepted: November 2003, JEL Classification: H71, H77T. Snoddon: The author gratefully acknowledges the helpful comments of Ron Kneebone, participants at the CPEG conference, Calgary, June 2002, and seminar participants in the Department of Economics and Finance, La Trobe University, Melbourne, Australia, September 2002. I would also like to thank the two anonymous referees for their thoughtful comments.