The Impact of the Mechanism for Aligning Horizontal Fiscal Imbalances on the Stability of the Financial System

Abstract

The growth of state transfers to offset disparities in regional development affects the stability of the country’s financial system. This article delves into this outcome, empirically analyzing whether the transfer system for horizontal fiscal alignment leads to decreased financial system stability through increased borrowing at municipal and national levels. To test this hypothesis, we employ a quasi-experimental analysis strategy, examining potential scenarios of configuring transfers to Ukrainian municipalities for addressing horizontal fiscal imbalance. Across various transfer calculation scenarios involving changes in the calculation period, the number of budgets in consideration, and the alignment subject, we find that a suboptimal system of horizontal fiscal alignment, transferring funds from financially secure municipalities to insecure ones, leads to a rise in the public finance debt, subsequently decreasing financial system stability. Additionally, we discover that the current mechanism in Ukraine for horizontal fiscal alignment, designed to mitigate inequalities in socio-economic development among communities and regions, paradoxically exacerbates these disparities, artificially inflates indicators of decentralization reform success, and undermines public finance stability.