Fiscal Decentralization

• Author: Lusine Lusinyan

Intergovernmental arrangements, including their fiscal dimension, are in general shaped by historical and political developments. Thus, although the key argument in favor of fiscal decentralization is improved efficiency in public service provision-related to the government’s allocation objective in the Musgravian taxonomy-it is not always the main motivation for decentralization processes where various political economy considerations come into play (Ahmad, Brosio, and Tanzi, 2008). Not surprisingly, traditional normative approaches based on the hypothesis of benevolent policymakers, which imply government models devoid of meaningful political institutions, have proven inadequate in explaining the wide range of existing intergovernmental arrangements.

The limitations of the normative approach to local public economics in general and fiscal federalism and fiscal decentralization, in particular, have long been recognized. In his contribution to the Handbook of Public Economics, Rubinfeld (1987) suggested that positive models and a more careful specification of the political process by which public goods are provided would be a way forward for the research in this interesting and increasingly relevant area of economics. Indeed, almost 20 years thereafter, the emphasis on more realistic approaches to analyzing intergovernmental fiscal relations was the unifying theme of the papers published in the Handbook of Fiscal Federalism (Ahmad and Brosio, 2006). In particular, the main contribution of the positive or political economy approach is argued to be its ability to explain key benefits-preference-matching and accountability-widely believed to arise from increased fiscal decentralization, and give more precise predictions about when such benefits might be achieved. The results, however, become less conclusive when further complexities, such as lobbying and elite capture, are introduced, leaving the support for decentralization a qualified one.

But is more decentralization associated with more efficient outcomes when looking at the data? The answer from the empirical literature does not appear much more conclusive than that from the theory, and is further complicated by important data limitations. While there is some support for the positive relationship between decentralization and production efficiency (mainly education and health outcomes), the literature on preference-matching and decentralization remains small, and there is relatively poor evidence to characterize effective changes over time using comparable administrative and household survey data (Ahmad, Brosio, and Tanzi, 2008). In addition, there are also no clear-cut conclusions concerning the practical existence and impact of fiscal competition among jurisdictions-a key building block in both normative and positive models (Ferreira, Varsano, and Afonso, 2005). Keen and Kotsogiannis (2004) argue that, within federal systems, horizontal (between the same level of government) and vertical (between different levels of government) tax externalities push tax rates in opposite directions, leaving the net outcome unclear. What seems unambiguous, however, is that the intensification of tax competition among state governments would lead to welfare-reducing...