If you want me to stay, pay!

VIVES BRIEFING 2017/07 If you want me to stay, pay! Can transfers to Catalonia prevent a secession? Jakob Vanschoonbeek* KU Leuven, Faculty of Economics and Business, VIVES * With thanks to Joep Konings, Jo Reynaerts, Cathy Lecocq, Geert Jennes and Sander Ramboer for their comments and suggestions.

2 VIVES BRIEFING 2017/07 SUMMARY 1 On October 1st, the population of Catalonia hoped to make its voice heard during a popular consultation on establishing an independent Catalan state. The political-economic theory on this topic warns, however, that Spain s national borders are likely to become too fragile if they could be unilaterally redrawn by each constituent region. This briefing analyzes two relevant policy tracks that the central government could pursue to prevent an inefficient Catalan secession, which would bring the entire country more costs than benefits. The first track, which the central government in Madrid appears to be pursuing at present, consists of the stringent application of strict constitutional secession rules. The second track, which the Spanish government could opt for, is to accede to the Catalan demand for budgetary autonomy. The idea of this alternative policy strategy is to convince Catalonia to voluntarily renounce secession, by reducing Catalan transfers to the rest of Spain in proportion to Catalan dissatisfaction with Spanish government policy. The briefing concludes that this second track - a policy of budgetary accommodation to the benefit of Catalonia - could be a less costly alternative for safeguarding the stability of Spain s national borders. Moreover, this second strategy could prove to be a more efficient means of protecting the interests of all Spanish citizens (whether or not residents of Catalonia) by allowing a Catalan secession only if it is efficient or would yield more benefits than costs for the entire country. 1 The title of this briefing was derived from Claeys, P. en F. Martire (2015) If You Want Me to Stay, Pay : a Model of Asymmetric Federalism in Centralised Countries, Environment and Planning C: Government and Policy, 33(2),

3 VIVES BRIEFING 2017/07 INTRODUCTION Following the Scottish independence referendum of 2014, October 1st of this year presented yet another opportunity for a European region to declare itself independent by means of a referendum. On that day, the Catalan government organized a referendum on the topic of an independent Catalan state. Nevertheless, the independence referendum was met by great resistance from Madrid, which declared it to be unconstitutional. According to the Spanish Constitution, all Spaniards must be consulted on matters that concern the sovereignty of the Spanish State. Two earlier VIVES briefings 2 explain how recent political-economic thinking essentially reduces the decision to declare independence to a trade-off between scale economies and heterogeneity costs. In a nutshell, this approach contends that smaller countries emerge to close the gap between government and the people. This is why regions with distinct policy preferences often demonstrate a greater tendency to secede. However, dissatisfied regions also take into account tax disadvantages associated with secession. Indeed, secession would force them to spread the cost of government policy over a smaller group of taxpayers. In light of the recent Catalan independence referendum, this briefing departs from one of the principal findings from this literature, namely that the borders of a country become too fragile if they can be redrawn by regional majority voting. The fundamental problem is that in such a case, regions with strongly distinct policy preferences and/or income distributions would proceed with a unilateral independence declaration too quickly because they do not have to take into account the welfare implications of this decision for the other regions in their mother country. In this light, the Catalan independence referendum of October could have given the rich region of Catalonia carte blanche to go it alone, irrespective of the impoverishment this decision may have brought for their former Spanish compatriots. In an ideal world, however, secessions only take place if the total welfare gain in the new country is greater, strictly speaking, than the welfare cost incurred by the citizens left behind. An important question therefore concerns the instruments that democratic governments can use to prevent inefficient secessions. The most important levers arise from the fact that the electoral considerations at play during an independence referendum are influenced not only by economies of scale and heterogeneity costs, but also by the national political-institutional context. A first option is to apply stringent constitutional secession clauses by subjecting independence declarations to a national - rather than a regional - independence referendum. This seems to be the path chosen by the central government in Madrid. A first disadvantage of this approach is, however, that it robs the inhabitants of minority regions as Catalonia of the capacity to credibly threaten with secession and, as such, constitutionally surrenders them to a tyranny of the majority in a certain sense. 3 2 Vanschoonbeek J. (2014) Schotse onafhankelijkheid? Een politiek-economische analyse (Scottish Independence: a political-economic analysis), VIVES briefing 2014/7, KU Leuven; Vanschoonbeek, J. (2016) Regionale (in)stabiliteit in Europa (Regional Stability and Instability in Europe), VIVES briefing 2016/11, KU Leuven. 3 Buchanan, J. and Faith, R. (1987) Secession and the Limits of Taxation: Toward a Theory of Internal Exit,

4 VIVES BRIEFING 2017/07 A second disadvantage is that stringent secession clauses can spur separatist movements to more violent strategies because they render an independence war the only viable option for regions with a persistent desire for independence. 4 In this sense, Article 2 of the Spanish Constitution, which describes Spain as a single and indivisible country, can potentially co-explain why the Basque separatist movement Euskadi Ta Askatasuna (ETA) retained a strategy of terrorist attacks even after the Franco era. 5 Therefore, this briefing discusses an alternative policy option, namely buying off the political loyalty of dissatisfied regions by so-called ideological transfers. To explain how such transfers function and to demonstrate their practical relevance, we will start by taking an excursion to the Russian Federation in its early days and the present-day United Kingdom (UK), both of which drew up special budgetary arrangements to the benefit of the most dissatisfied regions so as to increase the stability of their national borders. Next, we will explain how current intraregional transfers in Spain appear to reduce rather than increase the stability of the country s borders. This suggests that the implementation of ideological transfers, by lowering the Catalan contribution to the Spanish Treasury, could be a successful solution to prevent a costly Catalan secession. To conclude, we highlight a number of issues that could arise upon the implementation of such transfer schemes and discuss both the efficiency and feasibility of this redistribution principle within the Spanish context. IDEOLOGICAL TRANSFERS AS AN ELIXIR AGAINST SEPARATIST TENDENCIES According to the political-economy approach, politically divided countries face an increased risk of separatism. Minority regions with strongly distinct policy preferences must contribute in equal terms to a government policy that is comparatively further removed from their own policy preferences, rendering them susceptible to the temptation of secession. Various researchers 6 argue that politically divided countries can prevent inefficient secessions by financially compensating dissatisfied regions for the disadvantages they experience from a uniform government policy. The idea is to convince the residents of the regions concerned to voluntarily decide against secession by lowering their taxes in proportion to the dissatisfaction they experience from the nationally-determined government policy. More specifically, such transfers will convince dissatisfied regions to accept the existing national borders as long as the willingness to pay is sufficiently high among the donors (the most satisfied regions) by compensating them for the burdens they experience from an unsatisfactory national government policy. When the necessary solidarity contribution, however, has risen to such an extent that the American Economic Review, 77(5); Apolte, T. (1997) Secession Clauses: A Tool for the Taming of an Arising Leviathan in Brussels?, Constitutional Political Economy, 8. 4 Mancini, S. (2008) Rethinking the Boundaries of Democratic Secession: Liberalism, Nationalism, and the Right of Minorities to Self-Determination, International Journal of Constitutional Law, 6(3-4). 5 Barros, C. P. and Gil-Alana, L. A. (2011) Terrorism: the Case of ETA, Chapter 16 in Handbook on the Economics of Conflict, Cheltenham. 6 Le Breton, M. and Weber, S. (2003) The Art of Making Everybody Happy : How to Prevent a Secession, IMF Staff Papers, 50(3); Haimanko, O., Le Breton, M., and Weber, S. (2005) Transfers in a Polarized Country: Bridging the Gap Between Efficiency and Stability, Journal of Public Economics, 89(7).

5 VIVES BRIEFING 2017/07 donors would threaten secession themselves, the willingness to pay is not enough to keep the minority region within the union and this provides scope for an efficient secession that will increase overall welfare. The relevance of this mechanism is aptly illustrated by the budgetary accommodation policy developed by the first Russian president, Boris Yeltsin, who introduced selective tax exemptions for the most unstable regions in the country in the early 1990s. 7 This was necessary because the disintegration of the Soviet Union and the subsequent political-economic reforms triggered a storm of regional protests that seriously threatened the territorial integrity of the Russian Federation in its early days. A contemporary observer summarized the analogy with the Soviet Union in his warning that Yeltsin found himself facing the threat that the Russian Federation like the USSR before it, might fall apart. 8 That Russia survived its early days territorially intact can thus be primarily attributed to the strategic policy of the Russian government. Specifically, it applied a policy of budgetary accommodation in which it collected disproportionally high taxes from the least rebellious regions to subsequently redistribute these towards the most discontented regions. Figure 1 illustrates that there was indeed a remarkably positive relationship between the distinctness of the voting behavior of Russian regions, used here as a benchmark for the distinctness of their policy preferences, and the transfers these regions received from the central government during 1993-1994 period. Figure 1. Ideological transfers in Russia (1994-1995) Through this policy, Yeltsin may well have bought off political support from the most dissatisfied regions in Russia that may still keep the country together today. Analogously, the absence of such ideological transfer schemes potentially explains why the similar multi-ethnic and communist states of the Soviet Union, Czechoslovakia and Yugoslavia were not able to withstand the ravages of time. Closer to home, British government spending in Scotland, Wales and Northern Ireland played an important part in the Scottish independence debate. In the UK, regional governments finance the majority of their expenses by means of a fixed grant from Westminster, the level of which is determined according to the Barnett formula. Many believe that this formula is in fact responsible for an English over-subsidy of the rest of the country. It is partly because of this that more and more voices call for a reform of the system and for 7 Treisman, D. (1996) The Politics of Intergovernmental Transfers in Post-Soviet Russia, British Journal of Political Science, 26(3); Treisman, D. S. (1999) After the Deluge, The University of Michigan Press. 8 Teague, E. (1994) Center-Periphery Relations in the Russian Federation, Chapter 2 in National Identity and Ethnicity in Russia and the New States of Eurasia, M.E. Sharpe.

6 VIVES BRIEFING 2017/07 greater account to be taken of the actual needs of the regions. 9 Even Joel Barnett, who devised the system, recently admitted that he thought his own calculation was terribly unfair. 10 Nevertheless, the British government does not appear to be prepared to initiate reforms in this area. What s more, two days before the Scottish independence referendum the leaders of the key anti-independence parties solemnly vowed to retain the formula in the event of a no vote. 11 This should, however, not come as a surprise, particularly because of the fact that this formula has grown into a mechanism for compensating dissatisfied regions for the lower value [ ] of national public goods arising from the greater cultural and geographic distance [ ] from the centre. 12 In a certain sense, interregional transfers in the UK therefore not only act as a redistribution mechanism from rich to poor (based on the concern for a fair distribution of income), but also from satisfied to dissatisfied regions (based on the concern for a fair distribution of political burdens). Figure 2 shows that in the 2005-2006 period the central British government did allocate disproportionately high public expenditures per pound of tax money paid to the most politically distinct regions on its territory, and that this pattern can even be discerned in the English regions that are not subjected to the Barnett formula. This suggests that the British promise to retain the ideological transfers incarnated in the Barnett rule may have prevented an inefficient Scottish secession in 2014. Figure 2. Ideological transfers in the UK (2005-2006) INCOME-BASED TRANSFERS MAY ADD FUEL TO THE SEPARATIST FIRE Despite their stabilizing effect, ideological transfers still remain a rarity in the real world. Income-based transfers, on the other hand, remain a popular vehicle for redistributing income from the rich to the poor throughout the world. They owe their popularity not only to the fact that they are easy to implement, but also to the fact that a policy to reduce income inequality is easier to defend politically. A possible disadvantage to income-based transfers is that they usually do not contribute to stable national borders. A second principal result in political-economic thinking with regard to state formation is that such transfers increase the probability of secession because they give the richer regions - the net payers of these transfers - additional reasons to consider a declaration of independence. 13 9 The Times (2017) Extra $350m from Barnett 'Shows Benefits of Scotland Being in UK '; Financial Times (2017), Scottish Vote Fuels Row over Barnett Formula. 10 McLean, I. and McMillan, A. (2003), The Distribution of Public Expenditure Across the UK Regions. Fiscal Studies, 24(1). 11 BBC (2014), What Now for The Vow'?. 12 Christie, A. and Swales, J. K. (2009), The Barnett Allocation Mechanism: Formula Plus Influence?, Regional Studies, 44(6). 13 Buchanan, J. and Faith, R. (1987), ibid; Bolton, P. and Roland, G. (1997) The Breakup of Nations: a Political

7 VIVES BRIEFING 2017/07 In Spain, for instance, growing dissatisfaction about financial flows between regions recently led to increasing support for an independent Catalan state. Apart from the Basque Country and the neighboring region of Navarra, which were able to negotiate favorable budgetary regulations of their own, the primary financing sources for Spanish regions entail a mix of own tax revenues and transfers. 14 The central government determines the level of these transfers such that regions that deliver equal tax efforts will also receive the same per capita budget for fundamental services such as education and health care. In essence, these transfers comprise an interregional solidarity mechanism in which richer regions partly finance government expenditures in poorer regions in order to meet the fundamental needs of all Spanish citizens, regardless of the taxpaying capacity of their home region. Figure 2. Income transfers in Spain (2005) Figure 3 shows how richer regions such as Madrid, Valencia and Catalonia see part of their tax money flow to regions such as Andalusia and Extremadura as a result of this system. It is estimated that the central government expenditures for Catalonia in 2005 amounted to only 72% of Catalan tax money paid. Out of dissatisfaction with this arrangement, the Catalan government proposed an amendment to its autonomy status in 2005 with the aim of reducing income transfers to the rest of Spain and acquiring additional tax competencies. 15 Although the Catalan government was able to obtain the approval of the Catalan and Spanish parliaments for this amendment and had it ratified in a referendum, the Constitutional Court declared the new financing terms unconstitutional in 2009. This decision triggered heated response in Catalonia and hardened the position of the new Catalan President, Artur Mas, to negotiate a more far-reaching pacte fiscal with the Spanish government. 16 When Spanish Prime Minister Rajoy firmly rejected this demand in September 2012, Mas promised, after a round of early elections, to organize an independence referendum. 17 Following an unsuccessful attempt in 2014, current president Puigdemont decided to hold a binding referendum in September 2017 - with or without the approval of Madrid. Rather than enhancing the internal stability of Spain, the Spanish income transfers thus appear to be the direct cause for the recent escalation in Catalan separatism. UNDESIRABLE SIDE EFFECTS OF IDEOLOGICAL TRANSFERS Economy Analysis, Quarterly Journal of Economics, 112(4). 14 Zabalza, A. and López-Laborda, J. (2011) The New Spanish System of Intergovernmental Transfers, International Tax and Public Finance, 18(6). 15 Guibernau, M. (2012) From Devolution to Secession: The Case of Catalonia, Chapter 7 in Multinational Federalism - Problems and Prospects, Palgrave Macmillan. 16 Martí, D. (2013) The 2012 Catalan Election: The First Step Towards Independence?, Regional & Federal Studies, 23(4). 17 Cuadras-Morató, X. (2016) Introduction: Catalonia, a New State in Europe?, Chapter 1 in Catalonia: A New Independent State in Europe? A Debate on Secession within the European Union, Routledge.

8 VIVES BRIEFING 2017/07 These examples suggest that interregional income transfers only enhance the stability of national borders if they flow to the regions with the greatest willingness to secede, rather than merely to the poorest regions. This is why a policy in which income is redistributed from richer to poorer regions usually is a source of instability, particularly if there are significant income differences between the various regions of a country. This observation is not restricted to Catalonia: in countries such as Belgium and Italy the elimination of north-south transfers equally appears to be an important reason for some inhabitants of the rich northern regions to plead for secession from the rest of the country. All of this illustrates how Madrid may have missed a historical window of opportunity when it refused Catalonia s demand for greater budgetary autonomy and a reduction in the transfers to the rest of Spain. Indeed, at that moment the central government may have refused to pay an acceptably low price for stable national borders. What is remarkable is that the current Catalan President indicated in an interview that this third option would undoubtedly enjoy widespread support in Catalonia. 18 Additionally, the example of the Basque Country, which has enjoyed an favorable budgetary exemption status since 1978 and which is remarkably quiet in the Catalan independence debate, suggests that such ideological transfers could effectively put the Spanish separatist genie back in the bottle. Nevertheless, various researchers have noted that the implementation of such a system could run into to various problems in the real world, which potentially explains the reluctance of the central Spanish government. First of all, administrative complexity makes such redistribution systems rather costly in terms of their implementation, partly due to the periodical measurements of regional political dissatisfaction that are necessary to determine the ideological transfers for each region. 19 Secondly, these transfer systems may struggle with issues of political credibility because the central government in Madrid can always renege on its promise of a favorable tax regime after the immediate threat of Catalan independence has subsided. 20 Thirdly, ideological transfers may be politically untenable because they may clash with other socio-economic objectives: indeed, in the case of Catalonia, they would redistribute income from poor to rich. 21 Lastly, there is a concern that such transfers may trigger strategic reactions, in which other Spanish regions could exaggerate their dissatisfaction with current government policy in order to draw more ideological transfers from the rest of the country to their own region. 22 Despite these potential problems, the favorable budgetary status enjoyed by the Basque Country today appears to be an efficient strategy for suppressing the long and often violent tradition of Basque separatism. Only time will tell whether the present Madrilenian 18 Torres, D. (2017) The Puigdemont Factor, Politico. 19 Spolaore, E. (2010) Federalism, Regional Redistribution, and Country Stability, Chapter 13 in The Political Economy of Inter-Regional Fiscal Flows: Measurement, Determinants and Effects on Country Stability, Edward Elgar Publishing. 20 Spolaore, E. (2009) Efficiency and Stability of National Borders, Review of Business and Economic Literature, 54(1). 21 Spolaore (2009), ibid. 22 Alesina, A. and Spolaore, E. (2003) The Size of Nations, MIT Press, Cambridge.

9 VIVES BRIEFING 2017/07 answer to the Catalan separatist threat will be equally effective and whether it will also be efficient from a welfare perspective. The latter will not be the case if Catalan separatism takes on a more violent course, or if it leads to the political suppression of the Catalan population.

10 VIVES BRIEFING 2017/07 RESEARCH CENTRE FOR REGIONAL ECONOMICS WAAISTRAAT 6 - BOX 3550 3000 LEUVEN, BELGIUM Jakob Vanschoonbeek University of Leuven PhD fellow of the Research Foundation - Flanders jakob.vanschoonbeek@kuleuven.be +32 (0)16 37 90 59 The objective of the VIVES Briefings is to provide input for the debate on the economic and social development of regions. They do this by means of brief contributions from VIVES own and affiliated researchers. These briefings are largely based on current fundamental research. Digital versions of these briefings can be consulted on the VIVES website: https://feb.kuleuven.be/vives