well as to test for the sources of pro-cyclicality, and to evaluate the impact of intergovernmental transfers on both state and federal cyclicality. The evidence provided suggests the existence of pro-cyclical fiscal policy in Brazil at the state level, which is more pronounced during economic downturns. For the Brazilian states the main source of observed pro-cyclicality is found in the pro-cyclical behavior of tax revenues directly collected by state governments (ICMS). Intergovernmental transfers (federal transfers) are not associated with changes in gross state product, but they are associated (procyclically) with the national GDP, which could amplify the pro-cyclical behavior of subnational expenditures.

The structure of the rest of the paper is as follows. Section 2 presents a review of the literature on sub-national budget cyclicality. Section 3 describes the characteristics of fiscal federalism in Brazil. Section 4 provides evidence on the pro-cyclicality of subnational fiscal policy in Brazil. Section 5 provides evidence on the sources of procyclicality by exploring the information available on the different levels of pro-cyclicality observed across the Brazilian states. Finally, conclusions are offered in Section 6.

# **2. Review of the Literature**

As mentioned above, there is a significant amount of empirical literature on budget cyclicality at the central government level compared to the relatively scarce literature analyzing budget cyclicality at the sub-national level in multi-tiered systems. Important contributions to the sub-national level-analyses, including the Brazilian experience, are presented below.

Sturzenegger and Werneck (2006) provide an assessment of the relationship between procyclicality and fiscal federalism in the Argentine and Brazilian cases. The authors tackle the questions of how the degree of pro-cyclicality of federal fiscal policy has been affected by the behavior of sub-national governments, and what the sources of state procyclicality are. For the Argentine case, the authors use both time-series and crosssectional dimensions at the state level for the period 1992-2002. The authors argue that the pro-cyclicality in Argentine provinces’ expenditures are mostly related to the nature of the tax base of sub-national jurisdictions. For the Brazilian case, however, the authors use a monthly time-series of aggregated fiscal variables for states and municipalities as a whole for the period 1997-2002. Based on the correlation of the cyclical components of fiscal variables (revenues, expenditures, and transfers) and output, the authors conclude that the spending of sub-national governments has shown a marked degree of procyclicality, which is closely related to the behavior of the tax revenues directly collected by sub-national governments. In the study of the Brazilian case, there is no analysis of the sources of pro-cyclicality.

Wibbels and Rodden (2006) analyze the sensitivity of provincial government finances to regional business cycles in eight federal republics (The United States, Canada, Germany, Australia, Spain, India, Brazil, and Argentina). Using annual data (from 1986 to 2000 for Brazil) on revenues, expenditures, deficits, and gross state product for each state or provincial government, the authors perform panel estimations for each fiscal item. Their results show that Brazilian states’ expenditures are highly pro-cyclical both in good times 3