Financial dependence and changes in the formula to assign federal transfers

After the implementation of the National System of Fiscal Coorination by 1980, one of the major modifications in the fiscal institutional framework faced by the Mexican states has been the 1991 change in the formula used to assign the revenue sharing transfers from the federal government. This modification introduced implicitly an equalization objective in a system that previously acknowledged the regional origin of the fiscal revenue. The literature on equalization transfers has established both theoretically and empirically, that such transfers induce incentives in the sub national governments to modify their fiscal policy. In this paper we use a panel data of the Mexican states from 1980 to 1995 in order to analyze the impact of this institutional modification in the degree of financial dependence. Financial dependence has been an issue of interest in the Mexican fiscal federalism since the implementation of the National System of Fiscal Coordination, an arrangement to vertically centralize the fiscal revenue in the federal government, and share it with state and municipal governments through a general transfer system. The results of this research have implications on the sub national fiscal policy not only of Mexico, but also are interesting for federal countries with fiscal federal systems similar to that of Mexico with equalization schemes. The results show that the formula modification reduced, in general, the degree of financial dependence. Our estimation strategy, that allows determining the effect on every state, leads us to conclude that the change in dependency is not homogeneous. We identify those states that reduced and increased its degree of financial dependence.