A Brief Literature Review
Fiscal decentralization involves a redefinition of the roles and responsibilities of the various levels of government in the conduct of fiscal policy. Traditional theories of public finance provide a normative framework for assigning the government’s three fiscal functions—stabilization, redistribution, and resource allocation—across government levels (Musgrave, 1959; Tiebout, 1956; Oates, 1972).1 While the center should be assigned the first two functions (Table 1.1 briefly reviews the main rationale), there is scope to improve resource allocation in the public sector through decentralization. The basic tenet of these theories is that governments and politicians behave like benevolent welfare maximizers; when preferences differ, welfare gains are possible through diversification of local public outputs.2 Two reasons underpin the possibility of gains: first, local politicians know consumers’ preferences in their jurisdictions better than does the central government, and therefore can better align the provision of local outputs to those preferences (allocative efficiency);3 and second, consumers can move to jurisdictions that better satisfy their preferences (Tiebout’s [1956] argument of “voting with one’s feet”). Therefore, subnational governments face competitive pressures to attract consumers of their outputs, resulting in more efficient (and possibly more innovative) provision of public services (productive efficiency).4
The Policy Rationale for Fiscal Decentralization
The Policy Rationale for Fiscal Decentralization
| Objectives of fiscal policy | Rationale in favor of centralized government | Rationale in favor of decentralized government |
|---|---|---|
| Stabilization (stability considerations) |
• Stabilization policies could be undermined if a large share of taxes or spending is undertaken by subnational governments, or if policies across government levels differ. • Centralizing stabilization policies: -allows better, easier policy coordination, -exploits scale economies (access to larger tax base and better borrowing conditions), and provides risk-sharing opportunities. |
• None |
| Redistribution (equity considerations) |
• In a decentralized framework, there may be insufficient federal or central funds for proper equalization to mitigate interregional inequalities. • If redistributive policies are decentralized, adverse selection may arise (net contributors move to areas with low tax and transfers, and net beneficiaries concentrate in areas with high tax and transfers). |
• Better targeting of decentralized social services |
| Allocation (efficiency considerations) |
Decentralizing allocative functions may be detrimental when • Preferences are fairly homogeneous and basic, so the “informational advantage” argument may not apply; • Externalities arise (subnationals do not take into account the effects of their decisions on other jurisdictions, leading to inefficiencies); • Excessive competition among local jurisdictions becomes damaging; and • Corruption may prevail when decision making is removed from the center (elite capture). |
• Local jurisdictions enjoy an informational advantage: politicians know consumers’ and voters’ preferences better, leading to optimal resource allocation (allocative efficiency). • Decentralization improves efficiency of public service delivery (productive efficiency), because local politicians respond to incentives to perform better (more accountability and less corruption) and compete to attract mobile labor and capital. |
The Policy Rationale for Fiscal Decentralization
| Objectives of fiscal policy | Rationale in favor of centralized government | Rationale in favor of decentralized government |
|---|---|---|
| Stabilization (stability considerations) |
• Stabilization policies could be undermined if a large share of taxes or spending is undertaken by subnational governments, or if policies across government levels differ. • Centralizing stabilization policies: -allows better, easier policy coordination, -exploits scale economies (access to larger tax base and better borrowing conditions), and provides risk-sharing opportunities. |
• None |
| Redistribution (equity considerations) |
• In a decentralized framework, there may be insufficient federal or central funds for proper equalization to mitigate interregional inequalities. • If redistributive policies are decentralized, adverse selection may arise (net contributors move to areas with low tax and transfers, and net beneficiaries concentrate in areas with high tax and transfers). |
• Better targeting of decentralized social services |
| Allocation (efficiency considerations) |
Decentralizing allocative functions may be detrimental when • Preferences are fairly homogeneous and basic, so the “informational advantage” argument may not apply; • Externalities arise (subnationals do not take into account the effects of their decisions on other jurisdictions, leading to inefficiencies); • Excessive competition among local jurisdictions becomes damaging; and • Corruption may prevail when decision making is removed from the center (elite capture). |
• Local jurisdictions enjoy an informational advantage: politicians know consumers’ and voters’ preferences better, leading to optimal resource allocation (allocative efficiency). • Decentralization improves efficiency of public service delivery (productive efficiency), because local politicians respond to incentives to perform better (more accountability and less corruption) and compete to attract mobile labor and capital. |
These issues are further developed in the next section of this chapter.
In practice, normative considerations seldom drive the assignment of functions. Experiences with fiscal decentralization lend little support to the welfare-maximizing predictions of these theories. In fact, fiscal decentralization is largely driven by political motives, and also reflects historical and cultural legacies. Fiscal decentralization has also shown a “dark side” in countries where subnational fiscal policies have played a large role in macroeconomic disruptions and debt crises—as, for example, in some Latin American countries during the 1980s. Fiscal decentralization can also enhance opportunities for corruption and abuse (Brennan and Buchanan, 1980; Prud’homme, 1995; Tanzi, 2001). The realization of the potential dangers of decentralization has called into question the relevance of traditional normative models, and has given way to a positive strand of literature, which attempts to understand the political and institutional conditions under which greater fiscal decentralization may enhance or undermine efficiency, when politicians behave as self-interested individuals with their own objective functions.5
Two main sources of distortions might hinder the effectiveness of fiscal decentralization. First, local policymakers can fail to internalize fully the cost of local spending when they can finance their marginal expenditure with central transfers or shared revenue funded by taxpayers in other jurisdictions (that is, the marginal benefits of additional spending exceed their marginal costs). This “common pool” problem often results in overspending and deficit bias. Second, local politicians may expect the central government to bail them out whenever necessary, thus undermining their incentives to behave in a fiscally responsible manner. This “soft budget constraint” problem arises when the central government cannot credibly commit to enforcing budget constraints for subnational governments consistently over time.6 A crucial issue is how to design and manage policies and institutions to mitigate the distortions created by the common pool and soft budget constraint problems. This issue will be covered in more detail in the following sections.
Macrofiscal Implications of Decentralization
Empirical evidence on the impact of fiscal decentralization on macroeconomic performance is mixed. Empirical studies seeking to quantify the relationship between measures of fiscal decentralization and macroeconomic variables, such as growth and inflation, have yielded contradictory results. This situation can be attributed to difficulties in compiling comparable measures of fiscal decentralization across countries because available data suffer from a number of shortcomings (Box 1.1), and difficulties in controlling for other possible factors (beyond decentralization) affecting macroeconomic performance. Finally, the design of intergovernmental fiscal relations, more than the degree of decentralization, affects efficiency and growth, as well as macroeconomic stabilization.7 As discussed in the previous section, decentralization can enhance or reduce efficiency, depending on the ability of subnational governments to carry out their increased responsibilities effectively. Similarly, decentralization can, in certain circumstances, negatively affect the conduct of short-term fiscal stabilization, or medium-term fiscal sustainability. This section briefly discusses interactions between various aspects of intergovernmental fiscal arrangements and macroeconomic management.
Measures of Fiscal Decentralization
Measures of fiscal decentralization abound in the literature. Empirical studies on various dimensions of fiscal decentralization use both quantitative (typically, subnational shares in total spending and revenue as well as measures of reliance on transfers) and qualitative indicators (capturing aspects of the institutional and regulatory framework for subnational government finances). For example, the World Bank identifies 18 indicators of fiscal decentralization. However, despite the seeming abundance of indicators, “measuring decentralization is both dif-f cult and controversial” (Treisman, 2006a, p. 2).
Data availability is relatively, sometimes severely, limited. The IMF’s Government Finance Statistics (GFS) database remains the best source of internationally comparable data on fiscal variables by government level. As of June 2009, the GFS database contained data for 152 countries, including local government data for 87 countries (see box table). The database includes a statement of government operations and detailed tables on revenue, expenses, and transactions in assets and liabilities. However, a general absence of standardized recording and reporting across government levels and even among jurisdictions at the same level hampers the collection of subnational fiscal statistics. Such limited coverage can lead to sample selection bias: countries reporting GFS data are more likely to have well-developed subnational governments with better-defined responsibilities, and may not be representative of the majority of decentralized countries.
Available data tend to overestimate the true degree of decentralization. Usually no distinction is made between autonomous versus mandated revenue and spending. For example, a large amount of expenditure undertaken by subnationals under mandate from the central government would not necessarily indicate that subnational governments are decentralized—they could merely operate as deconcentrated agents of the center. Similarly, subnational revenue would not adequately distinguish between own-source revenue (where subnationals have some degree of discretion over tax rates and tax bases) and shared revenue (with little or no subnational taxing autonomy). These are well-known limitations of GFS data.
Country Coverage of GFS Data
Country Coverage of GFS Data
| Total IMF members | 185 | |
| Countries reporting GFS statistics | 152 | |
| Reporting countries with published central | ||
| government data | 87 | |
| Reporting countries with published data on all | ||
| government levels | 60 | |
Country Coverage of GFS Data
| Total IMF members | 185 | |
| Countries reporting GFS statistics | 152 | |
| Reporting countries with published central | ||
| government data | 87 | |
| Reporting countries with published data on all | ||
| government levels | 60 | |
Data are typically aggregated by government level, possibly masking important differences within a level. Aggregation in GFS data masks information that could be useful in assessing differences and variation among subnational entities’ fiscal operations and capacities.
Quantitative data also omit important institutional dimensions. T ere is much more to fiscal decentralization than quantitative measures suggest. Qualitative information is also relevant, although not always available. The World Bank and the Organization for Economic Cooperation and Development (OECD; the latter under the Fiscal Federalism Network) have promoted efforts to collect information relating to the design and management of expenditure and revenue assignments, transfers, and borrowing arrangements. Coverage of indicators remains limited (for example, information on revenue assignment is available for 31 countries, of which 20 are OECD countries).
Sources: GFS database; and Ebel and Yilmaz, 2002.
When subnational governments hold the key to a large share of spending, the center is less able to conduct stabilization through fiscal policy. The center has limited room to carry out any needed fiscal adjustment when it only controls a small share of spending. Many countries, for instance, in Latin America, have experienced such difficulties. Even when the overall level of subnational spending is constrained by taxation and borrowing arrangements, a budget-neutral shift in the composition of such spending can in principle affect aggregate demand counter to the center’s stabilization policies. This contrary result may happen, for example, when the share of subnational spending with relatively larger multiplier effects increases. At the opposite end of the spectrum, central governments’ efforts to inject stimulus into the economy may be partly offset by subnational procyclical fiscal retrenchment during downturns—as happened in a number of countries during the 2008–09 financial crisis.
Similarly, when a significant share of revenue is managed by subnational governments, the center may not have sufficient resources for stabilization and redistribution purposes, or even to carry out its own spending responsibilities. A large pool of central resources provides risk-sharing opportunities, while smaller central government taxes inevitably limit insurance in the face of region-specific shocks. Central revenue may also prove insufficient to cover the center’s spending responsibilities, especially for entitlement programs (such as health care and pensions) whose costs are set to increase as a result of population aging. Some industrial countries are facing rapidly rising aging-related spending needs, but existing revenue-sharing formulas do not take into account differential dynamics in the spending responsibilities of the central and the subnational governments.
In certain circumstances, fiscal decentralization can contribute to a weakening of fiscal discipline. The more decentralized spending and taxing decisions are, the more difficult it is for the central government to ensure compliance with fiscal targets for the general government as a whole—its policy instruments, and its capacity to of set slippages at the subnational level, are more limited. The experience of European Union countries, for which the Stability and Growth Pact requires compliance with fiscal targets for the general government, but central and federal governments are directly responsible for meeting them, is illustrative in this respect (Balassone and Franco, 2001; Balassone, Franco, and Zotteri, 2004).
In such settings, nationally binding rules, or effective intergovernmental cooperation mechanisms, are needed to promote both short-term fiscal stabilization and medium-term fiscal sustainability.8 Some countries (e.g., Austria, Germany, Switzerland, and some Northern European countries) have used cooperative arrangements between the center and the subnational governments to formulate shared economic and fiscal objectives. In such cases, the incentive problem is addressed through moral suasion and peer pressure; although forging an agreement may be complex and time-consuming, greater ownership and flexibility often result from the process. In other countries, fiscal rules for subnational governments are being used; for example, in some European countries, Domestic Stability Pacts—the subnational counterpart to the Growth and Stability Pact for central governments—are increasingly being applied (Belgium, Italy, Spain).9 Fiscal rules offer the advantage of direct and immediate applicability; still, they may give rise to creative accounting and may not be politically sustainable if too rigid. Overall, fiscal rules may be a useful device to address coordination problems, but not necessarily to solve them. Box 1.2 reviews issues with regard to subnational fiscal rules.10
Lack of fiscal discipline at the subnational level—and related excessive borrowing—may result in unsustainable debt levels. Direct bailouts from the central government, which are financed through debt accumulation, can cause a protracted increase in debt, as can the creation of explicit or contingent liabilities at the subnational level that eventually add to government debt—as shown by the Latin American debt crises in the 1980s, and by Argentina’s crisis in the late 1990s. Subnational governments are generally less exposed to the financial repercussions of excessive public debt accumulation, such as higher expected inflation and interest rates, and therefore, again, may be less concerned about it.
Fiscal Rules for Subnational Governments
Fiscal rules at the subnational level act to modify the incentives faced by these governments. They offer a number of desirable features, such as transparency, reducing the level of uncertainty in the economic environment by increasing the predictability of governments’ behavior, and evenhandedness in promoting fiscal responsibility; to be effective, fiscal rules must be credible (that is, not set unrealistic targets) and be consistently enforced (to avoid expectations of bailouts from the central government).
Fiscal rules can be either procedural or numerical. Procedural rules aim to enhance transparency, accountability, and fiscal management. They typically require the government to commit up front to a monitorable fiscal policy strategy, usually for a multiyear period, and to routinely report and publish fiscal outcomes and strategy changes. New Zealand pioneered this approach, and applied procedural rules within the 1994 Fiscal Responsibility Act. Cross-country evidence suggests that, in countries with weak records of policy implementation, procedural rules may work better than numerical rules. At the same time, the successful implementation of procedural rules requires modern budget systems and a high degree of fiscal transparency, as well as a substantial constituency for fiscal discipline and responsibility.
Numerical fiscal rules refer to specific quantitative targets, and are intended to impose permanent constraints on fiscal policy, typically defined by an indicator of overall fiscal performance (such as the budget balance or the public debt). Examples of numerical rules abound at the central or general government level. For instance, in the European Union, ceilings are specified for deficit and debt ratios.
The United States implemented an expenditure cap mechanism (the Budget Enforcement Act) from 1991 to 2002. Canada resorted to both legislated spending caps (the Federal Spending Control Act, 1991–96) and unlegislated policy rules.
Numerical rules can help contain a deficit or expenditure bias, and address time-inconsistency problems. However, such rules also introduce policy inflexibility and may create incentives to resort to low-quality measures to meet numerical targets. For example, in some countries the application of numerical rules has led to creative accounting practices aimed at circumventing the rules, including reclassification of expenditures, accumulation of arrears, and the use of public entities off-budget to perform government operations. The existence of an effective public financial management system is a necessary condition for proper implementation of numerical fiscal rules.
Fiscal rules need to allow for flexibility over the cycle. A possible solution would be to define numerical fiscal rules in cyclically adjusted terms, although “local” cycles for subnational governments are difficult to assess. In the United States, “rainy day” funds have been used to introduce flexibility into fiscal policy implementation, as part of the fiscal rules in almost all states (Franco, Balassone, and Zotteri, 2007). In combination with rules calling for balanced budgets (exclusive of accumulation, or drawdown of the funds), rainy day funds have provided a transparent mechanism to save during good times, and have proved useful in smoothing the impact of cyclical revenue fluctuations on state expenditures. Experience indicates that rainy day funds cannot be relied upon for prolonged fiscal crises, as confirmed by financial difficulties of the U.S. states in the 2008–09 financial crisis.
Sources: Franco, Balassone, and Franzese, 2003; Ter-Minassian, 2005; Franco and Zotteri, 2008.For these reasons, IMF conditionality has focused on the general government fiscal balance. The IMF has advised countries to seek mechanisms, appropriate to their political and legal environments, to promote adherence by the subnational governments to national fiscal objectives (e.g., through the enactment of national or subnational fiscal responsibility laws). In some cases, however, the lack of timely and reliable data on subnational fiscal outturns has made the use of central government balances unavoidable as quantitative conditionality in IMF-supported programs.
Evidence also suggests that subnational fiscal policies tend to be procyclical, for various reasons (Wibbels and Rodden, 2006). First, subnationals may be heavily dependent on income-sensitive revenues. Second, the central government may play a limited role in stabilizing subnational fiscal positions through transfers over the cycle.11 In a normative world, a welfare-maximizing central government would strive to mitigate the procyclicality of subnational finances—as highlighted in Table 1.1, central or federal governments are typically better placed to conduct countercyclical policies and withstand the impact of cyclical shocks, relative to subnational governments, given their broader access to resources (larger tax base and better borrowing conditions) and their privileged role in policy coordination.12 However, the central government may face little incentive to do so; in fact, opportunistic central governments have an incentive to push the costs of adjustment onto subnationals, by cutting transfers in downturns—thus exacerbating procyclicality—or shifting spending (the so-called unfunded mandates). Indeed, in most federations, transfers are found to be procyclical, or at best acyclical.13 Finally, lack of access to borrowing may add to procyclicality, when subnationals cannot smooth spending through access to credit to of set lower revenue during downturns (and have not accumulated buffers as insurance for rainy days, as highlighted in Box 1.2).
Thus, not only the degree of fiscal decentralization, but also its design matter for macroeconomic management. The impact of subnational fiscal operations on fiscal discipline and procyclicality does not simply depend on the share of these operations in overall spending and revenue, but also on how they are financed. The discussion above has underlined the role that central transfers play in shaping incentives at the subnational level. This issue is relevant because in practically all countries, subnational spending shares are larger than revenue shares; thus, varying degrees of central transfers are required to cover the resulting vertical fiscal gaps (in Figure 1.1, all countries are located below the 45 degree line). In addition, these gaps appear to have been increasing over time, further highlighting the importance of establishing appropriate policies to deal with these issues (Figure 1.2).14
Subnational Revenues and Expenditures as Shares of General Government, 2006
Source: GFS data.The impact on fiscal discipline and the conduct of fiscal policy is the main macrofiscal issue confronting countries considering fiscal decentralization reforms. When the roles and responsibilities of government levels are modified, what expenditure and tax policies will appropriately ensure fiscal discipline and hard budget constraints? How should the transfer system be designed to provide appropriate funding for subnational operations, while ensuring an adequate level of equalization without blunting incentives to pursue sound policies? What supporting institutional mechanisms to ensure accountability for good results should be emplaced? Providing possible answers to these and related questions has been at the heart of the IMF’s work on fiscal decentralization, and in its policy dialogue with member countries, as explored in the next chapter.
Oates (2005) provides a summary of these traditional theories, also called “first-generation theories” of fiscal decentralization.
Local public outputs are goods and services whose consumption patterns are less than national in scope.
Oates (2005) notes that even in cases in which the central government is not affected by an asymmetry of information vis-à-vis subnationals, diversified provision of public services by the center may not be politically sustainable because the center cannot be seen as favoring some jurisdictions over others. This would still justify decentralized provision of some public services.
Even without the mobility assumption, subnational governments may engage in “yardstick competition” as citizens observe what neighboring jurisdictions offer and demand comparable treatment from their politicians (Besley and Case, 1995).
These are also called “second-generation theories” of fiscal decentralization (Qian and Weingast, 1997; Oates, 2005; Weingast, 2009). Ahmad and Brosio (2006) provide an extensive review of political economy theories.
For a review of the soft budget constraint literature, see Kornai, Maskin, and Roland (2003); and Rodden, Eskeland, and Litvak (2003).
Theoretical models in the literature seek to determine subnational budget shares that maximize output growth; for a comprehensive review, see Batbold, Mati, and Thornton (forthcoming). Some scholars have posited that fiscal decentralization may actually be neutral in its impact. For example, Treisman (2006b) presents a simple model implying that decentralization neither promotes nor inhibits growth, because any positive effect of decentralization on local governments will be of set by its negative effect on central government, and vice versa. One issue in these studies is related to identification problems, for example, the direction of causality is not clear.
For a review of these issues, see also Pisauro (2001).
The United States provides another example where fiscal rules are applied to the subnational (state) level; virtually all states apply some sort of balanced budget rule. However, these rules have been self-imposed by the states, and not by the federal government. It could still be said that their credibility is enhanced by an effective no-bailout policy on the part of the federal government.
These issues are further explored in “Identifying Mechanisms to Control Borrowing” in Chapter 2. In practice, solutions are not as clear cut as described here, and eclectic approaches are applied; for example, fiscal rules may be formulated in a cooperative framework (Franco and Zotteri, 2008).
A vast empirical literature finds that asymmetric shocks on regional incomes are managed through the tax-transfer system providing insurance mechanisms, as in Canada and the United States (Bayoumi and Masson, 1995); for Germany, von Hagen and Hepp (2001) find that the transfer system insures against revenue shocks, not shocks to regional incomes. Thus, the transfer system acts as a mechanism for insuring state budgets rather than regional economies. However, this literature has focused on the management of shocks, not the conduct of fiscal policy over the cycle.
Wibbels and Rodden (2006) suggest that an independent agency with an explicit countercyclical mandate would ensure that transfers are countercyclical. They also conclude that the trend toward increasing decentralization, especially in European Monetary Union countries, will complicate attempts to avoid procyclicality.
Stehn and Fedelino (2009) find that vertical transfers in Germany are procyclical.
Treisman (2006a) finds a strong positive relationship between economic development (measured as increases in GNP per capita) and expenditure decentralization, while the relationship with revenue decentralization does not appear to be significant. This could further explain why vertical fiscal gaps tend to widen over time.
