FISCAL DECENTRALIZATION AND ECONOMIC GROWTH IN OECD

COUNTRIES MATCHING SPENDING WITH REVENUE DECENTRALIZATION

Autores Norman Gemmell Richard Kneller

Ismael Sanz

P T No 609

NB Las opiniones expresadas en este trabajo son de la exclusiva responsabilidad de los autores pudiendo no coincidir con las del Instituto de Estudios Fiscales Desde el antildeo 1998 la coleccioacuten de Papeles de Trabajo del Instituto de Estudios Fiscales estaacute disponible en versioacuten electroacutenica en la direccioacuten gthttpwwwminhacesiefprincipalhtm

Edita Instituto de Estudios Fiscales NIPO 602-09-006-9 ISSN 1578-0252 Depoacutesito Legal M-23772-2001

4 4 4 4

5 5

6 6 6

INDEX

1 INTRODUCTION

2 ARGUMENTS IN FAVOUR AND AGAINST FISCAL DECENTRALIZATION

3 EMPIRICAL EVIDENCE ON FD AND ECONOMIC GROWTH

4 DECENTRALIZATION MEASURES DATA AND ECONOMETRIC METHODS 41 Introduction 42 The measure of polarization 43 Empirical strategy

5 RESULTS 51 PMG results 52 Instrumental variables

6 ROBUSTNESS CHECKS 61 Adding control variables 62 Using ldquoautonomous revenuerdquo definitions 63 Government spendingrevenue composition by levels of administration

7 CONCLUSIONS APPENDIX

REFERENCES

SIacuteNTESIS Principales implicaciones de poliacutetica econoacutemica

mdash 3 mdash

ABSTRACT

This paper examines whether the efficiency gains that allegedly accompany fiscal decentralization (FD) generate higher growth in more decentralised economies Previous research on this relationship has failed to generate a consensus We examine a sample of 23 OECD countries over 1972-2005 applying pooled mean group and instrumental variable techniques to a dynamic panel dataset We find that spending decentralization decreases while revenue decentralization increases economic growth Since OECD countries are substantially more spending than revenue decentralized this evidence provides strong support for Oates (1972) hypothesis that maximum FD efficiency gains require a close match between spending and revenue decentralization Some recent studies have concluded that increasing subnational autonomous revenue increases growth Our conclusion is rather that convergence between spending and revenue decentralization is growth-enhancing Our results are robust to various FD definitions and demonstrate the importance of testing simultaneously for these two FD-growth effects

Keywords fiscal decentralization economic growth pooled mean group government accountability

JEL Codes E62 H71 H72

mdash 5 mdash

Instituto de Estudios Fiscales

1 INTRODUCTION

Fiscal decentralization (hereafter FD) is a political economy trend in both developing and developed countries According to World Bank (1999) some 95 percent of democracies now have elected subnational governments and countries everywhere are devolving political fiscal and administrative powers to subnational tiers of government below the national level Dillinger (1994) reported that of the 75 developing countries with populations greater than 5 million all but 12 claim to have initiated measures to transfer some power to local government units In developed countries the United States the United Kingdom and Canada have revived debates on fiscal decentralization or devolution (Xie et al 1999) In recent years the US Congress has been contemplating how to devolve more expenditure responsibility to State and local governments FD has also become a key issue in Japan since the law for the promotion of fiscal decentralization was enacted in 1995 These efforts at devolution in a number of OECD countries are accompanied by the emergence of a new top layer of government in the European Union

The movement towards FD is often justified by the widespread belief that it is an effective tool for increasing the efficiency of public expenditures and competition among subnational governments in delivering public services (Bird and Wallich 1993) This may also be a reaction to the failure of large centralized bureaucracies in developing and transitional countries (Martiacutenez-Vaacutezquez and McNab 2003) World Bank (1999) for example has argued that alongside globalization localization ndashthe increasing demand for local autonomyndash is the main force shaping the world in the first decade of the 21st century

In this paper we focus on a specific debate in the literature on FD ndash namely that it improves economic growth performance We summarise a number of the relevant arguments in section 2 and then review the existing empirical evidence on the FD-growth relationship in section 3 We argue that the existing literature is deficient in a number of respects for example by rarely testing simultaneously for revenue and expenditure decentralization Section 4 presents our data and empirical methodology and section 5 tests for an effect of FD on economic growth rates in OECD countries over the period 1972shy2005 Section 6 checks the robustness of our findings to alternative econometric techniques to deal with endogeneity and alternative measures of fiscal decentralization Section 7 summarises the main conclusions

mdash 7 mdash

2

2 ARGUMENTS IN FAVOUR AND AGAINST FISCAL DECENTRALIZATION

The basic argument in favour of fiscal decentralization is that it improves the efficiency of the public sector and promotes long-term economic development (Oates 1972) Decentralization enhances economic efficiency because local governments have better knowledge of local conditions and preferences in the provision of public goods than national governments due to their physical and institutional proximity These informational advantages allow local governments to deliver public goods and services that better match local preferences andor deliver the same public goods and services at lower cost1

In addition sub-national governments may be subject to closer scrutiny by their constituencies This greater accountability may also lead to greater producer efficiency by providing incentives to local governments to innovate in the production and supply of public goods and services (Martiacutenez-Vaacutezquez and McNab 2003) Over 30 years ago Oates (1972) argued that this allocative efficiency benefit becomes greater when there is a close match between revenue discretion and spending assignments at sub-national levels And such matching it is argued gives local government a stronger fiscal incentive to support local market development (Jin et al 2005) improves accountability of sub-national governments and reduces the distorting effects of intergovernmental transfers (Shah 1994)

Secondly Oates (1999) argues that by diversifying government output according to local preferences decentralization may attain higher levels of social welfare If preferences for public goods differ across regions uniform levels of public goods and services across jurisdictions will generally be inefficient The larger the variance in regional demands for public goods the larger the benefits of FD This diversification also allows residents to move to the community that best matches their demand for public goods and services and local tax rate Thus a lsquoTiebout sortingrsquo of individuals into demand-homogeneous jurisdictions further increases efficiency in resource allocation

Building on this Tiebout (1956) mechanism Brueckner (2006) proposes a model in which fiscal decentralization leads young and old consumers to live in separate jurisdictions according to their different demands for public services low and high This sorting increases after-tax income when young while reducing it when old increasing the incentive to save This stronger incentive in turn leads to an increase in investment in human capital and long-term economic growth However it is not necessary for individuals to have different

1 These arguments are reinforced where public good characteristics are local in nature (eg sharing economies or non-excludability aspects are geographically restricted)

mdash 8 mdash

Instituto de Estudios Fiscales

preferences for local public goods or be relatively mobile to obtain efficiency gains from FD Thiessen (2003) argues that as long as subnational governments better reflect the priorities of taxpayers this is sufficient for fiscal decentralization to offer efficiency advantages2

The theoretical effects of FD on economic growth are not unambiguously positive however Firstly FD may impact negatively on the distribution of public resources across jurisdictions since mobility of households and businesses can seriously constrain attempts to redistribute income Redistributional policies are likely to induce poor individuals to move into the jurisdiction while higher income individuals (who bear a greater tax burden) move out To the extent that income inequality retards economic growth (Persson and Tabellini 1994) FD might negatively affect growth by making redistribution more difficult Furthermore concentration of public goods with supra-local spillovers in a few geographical locations can also inhibit per capita growth because regional inequalities in infrastructure education healthcare and other public services may prevent full use of factors of production (Thiessen 2003) In this case more centralized public sectors might redistribute resources across jurisdictions leading to a more efficient distribution

Other economic arguments against FD include possible damage to macroeconomic stability via fiscal policy coordination problems (Tanzi 1996) inter-jurisdictional lsquoleakagesrsquo associated with local expenditures (Oates 1972)3 and failure to exploit economies of scale and scope (Prudrsquohomme 1995) In addition FD may lead local governments to engage in a lsquorace to the bottomrsquo on the taxation of mobile factors hence under-providing productive public expenditure (Brueckner 2004) or increase corruption because officials at the local level are closer to people and more susceptible to the demands of local interest groups (Prudrsquohomme 1995 Tanzi 1996)4 Finally Tanzi (1996)

2 A further argument in favour of FD is that it promotes competition among different levels of government resulting in a more efficient production of public goods under revenue constraints Such competition may prevent revenue maximisation by lsquomonopolyrsquo governments and the oversupply of public goods (Brennan and Buchanan 1980) 3 On the other hand Gramlich (1993) claims that if economic shocks are asymmetric then decentralised systems make it easier to achieve macroeconomic stability Shah (2006) also suggests that central bank independence is more likely attained under decentralized systems because the pressure of a unique central government diminishes leading to the presence of multiple governments with diverse and conflicting interests Finally Martiacutenez-Vaacutezquez and McNab (2003) maintain that a well designed fiscal decentralization system (preventing local governments to borrow without controls) avoids fiscal systems damaging macroeconomic stability 4 Martiacutenez-Vaacutezquez and McNab (2003) dispute this argument claiming that local officials are more visible to their constituents and thus corrupt behaviour is more visible than at the central level of government

mdash 9 mdash

suggests that the assumption that individuals freely move between municipalities may be unrealistic at least in the short term allowing local governments to be relatively unresponsive to local citizensrsquo preferences

In summary there are clearly argument for both positive and negative effects of fiscal decentralization on fiscal efficiency and economic growth rates It is perhaps not surprising then that the empirical literature discussed below has tended to find a variety of effects in different contexts

3 EMPIRICAL EVIDENCE ON FD AND ECONOMIC GROWTH

As a number of authors have noted there is surprisingly little research devoted to measuring the impact of fiscal decentralization on economic growth given that economic efficiency is the central argument used to support fiscal decentralization (Bardhan 2002 Martiacutenez-Vaacutezquez and McNab 2003) Among existing studies a mixed picture emerges of the effect of decentralization on growth rates Initial contributions summarised in table 1 tended to find that fiscal decentralization has a negative or negligible effect on economic growth (Davoodi and Zou 1998 Woller and Philips 1998 Zhang and Zou 1998 Xie et al 1999 and Jin and Zou 2005) These authors interpret their results as an indication that FD is already high such that further decentralization may be harmful for economic growth However many of these studies focus on developing or transition economies with China a specific focus of attention5

5 On China see also Lin and Liu (2000) and Jin et al (2005) who find some evidence of positive growth effects of FD Akai and Sakata (2002) also suggest that initial studies have a lsquocultural biasrsquo due to their use of cross-country data which fails to accommodate the various cultural historical and institutional differences between included countries

mdash 10 mdash

Tab

le 1

S U

MM

AR

Y O

F T

HE

EMP

IRIC

AL

LIT

ERA

TU

RE

Pap

ers

findi

ng a

neg

ativ

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Dav

oodi

amp

Zou

(1

998)

46 d

evel

opin

g amp

dev

elop

ed

coun

trie

s (U

nbal

ance

d pa

nel)

1970

shy19

89

5 an

d 10

ye

ar

aver

ages

of

grow

th in

re

al p

er

capi

ta o

utpu

t

Pane

l T

wo

way

fixe

d ef

fect

s

1 D

irect

spen

ding

by

subn

atio

nal

gove

rnm

ents

(net

of

inte

rgov

ernm

enta

l tr

ansfe

rs) a

s a sh

are

of

gene

ral g

over

nmen

t sp

endi

ng

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

tax

reve

nues

to G

DP

Ave

rage

gro

wth

rat

e of

pop

ulat

ion

initi

al

seco

ndar

y sc

hool

en

rolm

ent r

ate

initi

al

per c

apita

GD

P

inve

stm

ent s

hare

to

GD

P

In d

evel

oped

cou

ntrie

s

ther

e is

no r

elat

ions

hip

betw

een

FD a

nd g

row

th

whe

reas

this

asso

ciat

ion

is ne

gativ

e in

dev

elop

ing

coun

trie

s A

vera

ge ta

x ra

te

affe

cts

grow

th n

egat

ivel

y

Fisc

al p

olic

y gr

owth

ef

fect

s ar

e m

ore

rela

ted

to fu

nctio

nal

gove

rnm

ent s

pend

ing

com

posit

ion

Rev

enue

as

signm

ent a

mon

g le

vels

of g

over

nmen

t m

ay b

e lsquow

rong

rsquo

Wol

ler

and

Phill

ips

(199

8)

23 L

DC

s co

untr

ies

Perio

d 19

74shy

1991

Ann

ual

3 or

5

year

av

erag

es o

f pe

r cap

ita

grow

th r

ate

Pane

l O

ne

way

fixe

d ef

fect

s

1 L

ocal

gove

rnm

ent

shar

e in

tota

l go

vern

men

t rev

enue

s or

spen

ding

2

Loc

al go

vern

men

t sh

are

(exc

ludi

ng

gran

ts-in

-aid

) in

tota

l re

venu

es

3 L

ocal

gove

rnm

ent

shar

e in

tota

l spe

ndin

g (le

ss d

efen

ce amp

socia

l w

elfa

re)

mdash

Initi

al G

DP

in

vest

men

t se

cond

ary

scho

ol

enro

lmen

t and

po

pula

tion

grow

th

Robu

st o

penn

ess

in

flatio

n le

vel amp

va

rianc

e p

oliti

cal amp

fin

anci

al v

aria

bles

No

stro

ng a

ssoc

iatio

n be

twee

n FD

and

ec

onom

ic g

row

th in

LD

Cs

At b

est

wea

k in

vers

e re

latio

nshi

p be

twee

n re

venu

e FD

and

gr

owth

whe

n us

ing

five

year

s av

erag

es

FD d

oes

not a

ffect

ec

onom

ic g

row

th a

t na

tiona

l lev

el a

mon

g LD

Cs

It c

an a

ffect

ec

onom

ic

deve

lopm

ent a

t the

lo

cal l

evel

in L

DC

s

Zha

ng amp

Z

ou

(199

8)

28 C

hine

se

prov

ince

s

1986

-199

2

Real

gro

wth

ra

te o

f pr

ovin

cial

in

com

e

Pane

l O

ne

way

fixe

d ef

fect

s

1 R

atio

of p

er c

apita

co

nsol

idat

ed (o

r bu

dget

ary

prov

inci

al)

spen

ding

to p

er c

apita

co

nsol

idat

ed o

r

Cen

tral

and

pr

ovin

cial

re

venu

e to

na

tiona

l GD

P Fu

nctio

nal

Labo

r fo

rce

grow

th

rate

inv

estm

ent

rate

ope

nnes

s

infla

tion

rate

A hi

gher

deg

ree

of sp

endi

ng

fisca

l dec

entr

aliz

atio

n is

asso

ciat

ed w

ith lo

wer

pr

ovin

cial

eco

nom

ic

grow

th in

Chi

na C

entr

al

If lo

cal s

pend

ing

is al

read

y hi

gh f

urth

er

dece

ntra

lizat

ion

may

re

sult

in s

low

er

grow

th

(Sig

ue)

(Con

tinua

cioacuten

)

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Zha

ng amp

Z

ou

(199

8)

(Ext

ende

d ca

se 1

980-

9)

budg

etar

y ce

ntra

l sp

endi

ng

2 R

atio

of p

rovi

ncial

ex

tra-

budg

etar

y sp

endi

ng sh

are

in

inco

me

to c

entr

al ex

tra-

budg

etar

y sp

endi

ng sh

are

of

inco

me

com

posit

ion

of

cent

ral a

nd

prov

inci

al

budg

etar

y sp

endi

ng

and

prov

inci

al ta

x ra

te

have

neg

ativ

e ef

fect

s on

gr

owth

but

not

sig

nific

ant

Cen

tral

gov

ernm

ent

may

be

in a

bet

ter

posit

ion

to u

nder

take

pu

blic

inve

stm

ent w

ith

exte

rnal

ities

whe

n th

e co

untr

y is

deve

lopi

ng

Xie

et a

l (1

999)

U

S 19

48 shy

1994

Re

al p

er

capi

tal

outp

ut

grow

th r

ate

Tim

e se

ries

1 S

hare

of s

pend

ing

by e

ach

leve

l of

subn

atio

nal

gove

rnm

ent (

loca

l an

d st

ate)

in to

tal

gove

rnm

ent s

pend

ing

(exc

ludi

ng fe

dera

l gr

ants

to lo

wer

leve

ls of

gov

ernm

ent)

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

go

vern

men

t re

ceip

ts to

GD

P

Labo

ur fo

rce

adju

sted

for

educ

atio

n le

vels

in

vest

men

t en

ergy

pr

ices

ope

nnes

s

infla

tion

amp G

ini (

all

varia

bles

in g

row

th

rate

s)

Loca

l spe

ndin

g re

duce

s gr

owth

tho

ugh

low

sig

nific

ance

leve

ls S

tate

sp

endi

ng a

nd c

ombi

ned

stat

e an

d lo

cal s

pend

ing

are

high

ly in

signi

fican

t A

vera

ge ta

x ra

te n

egat

ive

but n

ot s

igni

fican

t

The

insig

nific

ant

coef

ficie

nts

on lo

cal

and

stat

e sp

endi

ng

shar

es m

ay im

ply

that

ex

istin

g FD

has

bee

n co

nsist

ent w

ith g

row

th

max

imiza

tion

Fur

ther

de

cent

raliz

atio

n in

pu

blic

spe

ndin

g m

ay b

e ha

rmfu

l for

gro

wth

Jin amp

Zou

(2

005)

30

Chi

nese

pr

ovin

ces

1979

-199

3 amp

1994

-199

9 (t

wo

diffe

rent

fis

cal

regi

mes

)

Real

GD

P gr

owth

rat

e Pa

nel

One

w

ay fi

xed

effe

cts

No

time

dum

mie

s

1 P

rovi

ncia

l sha

re i

n to

tal b

udge

tary

ex

pend

iture

or

reve

nue

2 P

rovi

ncia

l sh

are

in to

tal e

xtra

shybu

dget

ary

expe

nditu

re o

r re

venu

e

Cen

tral

and

pr

ovin

cial

tax

rate

m

easu

red

by th

e ra

tio o

f cen

tral

ta

x re

venu

es amp

pr

ovin

cial

tax

reve

nues

to G

DP

Prov

inci

al

inve

stm

ent

labo

ur

forc

e gr

owth

rat

e

open

ness

lag

ged

infla

tion

1979

-199

3 g

row

th is

ne

gativ

ely

asso

ciat

ed w

ith

expe

nditu

re F

D amp

po

sitiv

ely

with

rev

enue

FD

199

4-19

99 g

row

th

has

no s

igni

fican

t lin

k w

ith

prov

inci

al e

xpen

ditu

re

and

is ne

gativ

ely

affe

cted

by

pro

vinc

ial r

even

ue

Con

vent

iona

l wisd

om

(tha

t loc

al r

even

ue

shou

ld m

atch

ex

pend

iture

as

clos

e as

po

ssib

le a

t sub

-nat

iona

l le

vel t

o im

prov

e ef

ficie

ncy

and

prom

ote

grow

th) d

oes

not a

pply

to

Chi

na

Pap

ers

findi

ng a

pos

itiv

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Lin

and

Liu

(200

0)

28 C

hine

se

prov

ince

s 19

70-1

993

Gro

wth

rat

e of

rea

l per

ca

pita

GD

P

Tw

o w

ay

fixed

effe

cts

1 M

argi

nal r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

2 A

vera

ge r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

Fisc

al c

apac

ity

(pro

xy b

y m

ovin

g av

erag

e of

per

ca

pita

GD

P)

Popu

latio

n p

er

capi

ta in

vest

men

t gr

owth

rur

al

popu

latio

n sh

are

re

lativ

e fa

rm p

rices

im

plem

enta

tion

of

agric

ultu

ral r

efor

m

priv

ate

firm

s sh

are

in

indu

stria

l out

put

FD h

as a

pos

itive

effe

ct o

n gr

owth

Thi

s ef

fect

is

high

er w

hen

usin

g th

e m

argi

nal r

eten

tion

rate

Lo

ng-r

un e

ffect

s ar

e ca

ptur

ed b

y la

ggin

g FD

fin

ding

larg

er e

ffect

s on

gr

owth

than

with

cur

rent

FD

The

mar

gina

l ret

entio

n ra

te is

a b

ette

r m

easu

re

than

ave

rage

ret

entio

n ra

te F

D h

as in

crea

sed

grow

th in

Chi

na b

y im

prov

ing

effic

ienc

y of

re

sour

ce a

lloca

tion

rath

er th

an b

y in

duci

ng

mor

e in

vest

men

t

Aka

i amp

Saka

ta

(200

2)

50 U

S st

ates

19

92-1

996

(ave

rage

) Su

b pe

riods

19

92-1

994

amp

1994

-199

6

Ave

rage

G

row

th r

ate

of r

eal p

er

capi

ta g

ross

st

ate

prod

uct

Cro

ss

sect

ion(

One

w

ay fi

xed

effe

cts)

1 Lo

cal g

over

nmen

t re

venu

e or

spe

ndin

g sh

are

in s

tate

+ lo

cal

gove

rnm

ent r

even

ue

or s

pend

ing

2 R

atio

of l

ocal

go

vern

men

trsquos o

wn

reve

nue

to s

tate

+

loca

l rev

enue

3

Ave

rage

of r

even

ue

and

spen

ding

FD

of

indi

cato

r 1

Thi

s st

udy

do n

ot

cont

rol f

or p

ublic

se

ctor

siz

e

Popu

latio

n gr

owth

la

gged

gro

wth

rat

e

high

sch

ool

enro

lmen

t rat

io

pre-

tax

inco

me

Gin

i co

effic

ient

sou

ther

n st

ates

dum

my

st

atersquo

s sh

are

in U

S pa

tent

s o

penn

ess

de

moc

rats

sea

ts

Spen

ding

FD

and

the

aver

age

of s

pend

ing

and

reve

nue

FD (i

ndic

ator

3)

affe

ct g

row

th p

ositi

vely

Re

venu

e FD

and

fisc

al

auto

nom

y (in

dica

tor

2) d

o no

t sig

nific

antly

affe

ct

grow

th

Prio

r ne

gativ

e ef

fect

s w

ere

due

to th

e us

e of

da

ta fo

r co

untr

ies

that

w

ere

in e

arly

sta

ges

of

deve

lopm

ent a

nd w

ith

larg

e di

ffere

nces

in

hist

ory

and

cultu

re

Thi

esse

n (2

003)

A

vera

ges

for

21 O

ECD

(amp

4 m

iddl

e in

com

e)

coun

trie

s

Perio

d ov

er

the

perio

d 19

73-1

998

Ave

rage

gr

owth

of

inco

me

per

wor

king

-age

pe

rson

Cro

ss

coun

try

1 L

ocal

sh

are

in

cons

olid

ated

go

vern

men

t sp

endi

ng

or r

even

ue

and

the

aver

age

of

the

two

2 T

rans

form

atio

n of

m

easu

re 1

to

capt

ure

non-

linea

ritie

s

Publ

ic

cons

umpt

ion

to

GD

P an

d th

e fis

cal b

alan

ce a

re

incl

uded

as

robu

stne

ss

chec

ks (r

esul

ts

not r

epor

ted)

Initi

al in

com

e pe

r w

orke

r in

vest

men

t sc

hool

enr

olm

ent

sum

of w

orki

ng-a

ge

popu

latio

n gr

owth

te

chno

logy

gro

wth

de

prec

iatio

n ra

te

vola

tility

ope

nnes

s

Spen

ding

and

lsquoave

rage

rsquo FD

ha

ve a

pos

itive

sig

nific

ant

effe

ct o

n gr

owth

(but

not

ro

bust

) M

ore

robu

st

indi

cato

r 2

show

ing

a no

n-lin

ear

asso

ciat

ion

betw

een

FD a

nd g

row

th R

even

ue

FD a

nd se

lf-re

lianc

e

FD p

rom

otes

ec

onom

ic g

row

th

How

ever

ther

e is

a hu

mp

shap

ed

asso

ciat

ion

betw

een

FD a

nd g

row

th

indi

catin

g an

opt

imal

de

gree

of F

D th

at (Sig

ue)

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

4 4 4 4

5 5

6 6 6

INDEX

1 INTRODUCTION

2 ARGUMENTS IN FAVOUR AND AGAINST FISCAL DECENTRALIZATION

3 EMPIRICAL EVIDENCE ON FD AND ECONOMIC GROWTH

4 DECENTRALIZATION MEASURES DATA AND ECONOMETRIC METHODS 41 Introduction 42 The measure of polarization 43 Empirical strategy

5 RESULTS 51 PMG results 52 Instrumental variables

6 ROBUSTNESS CHECKS 61 Adding control variables 62 Using ldquoautonomous revenuerdquo definitions 63 Government spendingrevenue composition by levels of administration

7 CONCLUSIONS APPENDIX

REFERENCES

SIacuteNTESIS Principales implicaciones de poliacutetica econoacutemica

mdash 3 mdash

ABSTRACT

This paper examines whether the efficiency gains that allegedly accompany fiscal decentralization (FD) generate higher growth in more decentralised economies Previous research on this relationship has failed to generate a consensus We examine a sample of 23 OECD countries over 1972-2005 applying pooled mean group and instrumental variable techniques to a dynamic panel dataset We find that spending decentralization decreases while revenue decentralization increases economic growth Since OECD countries are substantially more spending than revenue decentralized this evidence provides strong support for Oates (1972) hypothesis that maximum FD efficiency gains require a close match between spending and revenue decentralization Some recent studies have concluded that increasing subnational autonomous revenue increases growth Our conclusion is rather that convergence between spending and revenue decentralization is growth-enhancing Our results are robust to various FD definitions and demonstrate the importance of testing simultaneously for these two FD-growth effects

Keywords fiscal decentralization economic growth pooled mean group government accountability

JEL Codes E62 H71 H72

mdash 5 mdash

Instituto de Estudios Fiscales

1 INTRODUCTION

Fiscal decentralization (hereafter FD) is a political economy trend in both developing and developed countries According to World Bank (1999) some 95 percent of democracies now have elected subnational governments and countries everywhere are devolving political fiscal and administrative powers to subnational tiers of government below the national level Dillinger (1994) reported that of the 75 developing countries with populations greater than 5 million all but 12 claim to have initiated measures to transfer some power to local government units In developed countries the United States the United Kingdom and Canada have revived debates on fiscal decentralization or devolution (Xie et al 1999) In recent years the US Congress has been contemplating how to devolve more expenditure responsibility to State and local governments FD has also become a key issue in Japan since the law for the promotion of fiscal decentralization was enacted in 1995 These efforts at devolution in a number of OECD countries are accompanied by the emergence of a new top layer of government in the European Union

The movement towards FD is often justified by the widespread belief that it is an effective tool for increasing the efficiency of public expenditures and competition among subnational governments in delivering public services (Bird and Wallich 1993) This may also be a reaction to the failure of large centralized bureaucracies in developing and transitional countries (Martiacutenez-Vaacutezquez and McNab 2003) World Bank (1999) for example has argued that alongside globalization localization ndashthe increasing demand for local autonomyndash is the main force shaping the world in the first decade of the 21st century

In this paper we focus on a specific debate in the literature on FD ndash namely that it improves economic growth performance We summarise a number of the relevant arguments in section 2 and then review the existing empirical evidence on the FD-growth relationship in section 3 We argue that the existing literature is deficient in a number of respects for example by rarely testing simultaneously for revenue and expenditure decentralization Section 4 presents our data and empirical methodology and section 5 tests for an effect of FD on economic growth rates in OECD countries over the period 1972shy2005 Section 6 checks the robustness of our findings to alternative econometric techniques to deal with endogeneity and alternative measures of fiscal decentralization Section 7 summarises the main conclusions

mdash 7 mdash

2

2 ARGUMENTS IN FAVOUR AND AGAINST FISCAL DECENTRALIZATION

The basic argument in favour of fiscal decentralization is that it improves the efficiency of the public sector and promotes long-term economic development (Oates 1972) Decentralization enhances economic efficiency because local governments have better knowledge of local conditions and preferences in the provision of public goods than national governments due to their physical and institutional proximity These informational advantages allow local governments to deliver public goods and services that better match local preferences andor deliver the same public goods and services at lower cost1

In addition sub-national governments may be subject to closer scrutiny by their constituencies This greater accountability may also lead to greater producer efficiency by providing incentives to local governments to innovate in the production and supply of public goods and services (Martiacutenez-Vaacutezquez and McNab 2003) Over 30 years ago Oates (1972) argued that this allocative efficiency benefit becomes greater when there is a close match between revenue discretion and spending assignments at sub-national levels And such matching it is argued gives local government a stronger fiscal incentive to support local market development (Jin et al 2005) improves accountability of sub-national governments and reduces the distorting effects of intergovernmental transfers (Shah 1994)

Secondly Oates (1999) argues that by diversifying government output according to local preferences decentralization may attain higher levels of social welfare If preferences for public goods differ across regions uniform levels of public goods and services across jurisdictions will generally be inefficient The larger the variance in regional demands for public goods the larger the benefits of FD This diversification also allows residents to move to the community that best matches their demand for public goods and services and local tax rate Thus a lsquoTiebout sortingrsquo of individuals into demand-homogeneous jurisdictions further increases efficiency in resource allocation

Building on this Tiebout (1956) mechanism Brueckner (2006) proposes a model in which fiscal decentralization leads young and old consumers to live in separate jurisdictions according to their different demands for public services low and high This sorting increases after-tax income when young while reducing it when old increasing the incentive to save This stronger incentive in turn leads to an increase in investment in human capital and long-term economic growth However it is not necessary for individuals to have different

1 These arguments are reinforced where public good characteristics are local in nature (eg sharing economies or non-excludability aspects are geographically restricted)

mdash 8 mdash

Instituto de Estudios Fiscales

preferences for local public goods or be relatively mobile to obtain efficiency gains from FD Thiessen (2003) argues that as long as subnational governments better reflect the priorities of taxpayers this is sufficient for fiscal decentralization to offer efficiency advantages2

The theoretical effects of FD on economic growth are not unambiguously positive however Firstly FD may impact negatively on the distribution of public resources across jurisdictions since mobility of households and businesses can seriously constrain attempts to redistribute income Redistributional policies are likely to induce poor individuals to move into the jurisdiction while higher income individuals (who bear a greater tax burden) move out To the extent that income inequality retards economic growth (Persson and Tabellini 1994) FD might negatively affect growth by making redistribution more difficult Furthermore concentration of public goods with supra-local spillovers in a few geographical locations can also inhibit per capita growth because regional inequalities in infrastructure education healthcare and other public services may prevent full use of factors of production (Thiessen 2003) In this case more centralized public sectors might redistribute resources across jurisdictions leading to a more efficient distribution

Other economic arguments against FD include possible damage to macroeconomic stability via fiscal policy coordination problems (Tanzi 1996) inter-jurisdictional lsquoleakagesrsquo associated with local expenditures (Oates 1972)3 and failure to exploit economies of scale and scope (Prudrsquohomme 1995) In addition FD may lead local governments to engage in a lsquorace to the bottomrsquo on the taxation of mobile factors hence under-providing productive public expenditure (Brueckner 2004) or increase corruption because officials at the local level are closer to people and more susceptible to the demands of local interest groups (Prudrsquohomme 1995 Tanzi 1996)4 Finally Tanzi (1996)

2 A further argument in favour of FD is that it promotes competition among different levels of government resulting in a more efficient production of public goods under revenue constraints Such competition may prevent revenue maximisation by lsquomonopolyrsquo governments and the oversupply of public goods (Brennan and Buchanan 1980) 3 On the other hand Gramlich (1993) claims that if economic shocks are asymmetric then decentralised systems make it easier to achieve macroeconomic stability Shah (2006) also suggests that central bank independence is more likely attained under decentralized systems because the pressure of a unique central government diminishes leading to the presence of multiple governments with diverse and conflicting interests Finally Martiacutenez-Vaacutezquez and McNab (2003) maintain that a well designed fiscal decentralization system (preventing local governments to borrow without controls) avoids fiscal systems damaging macroeconomic stability 4 Martiacutenez-Vaacutezquez and McNab (2003) dispute this argument claiming that local officials are more visible to their constituents and thus corrupt behaviour is more visible than at the central level of government

mdash 9 mdash

suggests that the assumption that individuals freely move between municipalities may be unrealistic at least in the short term allowing local governments to be relatively unresponsive to local citizensrsquo preferences

In summary there are clearly argument for both positive and negative effects of fiscal decentralization on fiscal efficiency and economic growth rates It is perhaps not surprising then that the empirical literature discussed below has tended to find a variety of effects in different contexts

3 EMPIRICAL EVIDENCE ON FD AND ECONOMIC GROWTH

As a number of authors have noted there is surprisingly little research devoted to measuring the impact of fiscal decentralization on economic growth given that economic efficiency is the central argument used to support fiscal decentralization (Bardhan 2002 Martiacutenez-Vaacutezquez and McNab 2003) Among existing studies a mixed picture emerges of the effect of decentralization on growth rates Initial contributions summarised in table 1 tended to find that fiscal decentralization has a negative or negligible effect on economic growth (Davoodi and Zou 1998 Woller and Philips 1998 Zhang and Zou 1998 Xie et al 1999 and Jin and Zou 2005) These authors interpret their results as an indication that FD is already high such that further decentralization may be harmful for economic growth However many of these studies focus on developing or transition economies with China a specific focus of attention5

5 On China see also Lin and Liu (2000) and Jin et al (2005) who find some evidence of positive growth effects of FD Akai and Sakata (2002) also suggest that initial studies have a lsquocultural biasrsquo due to their use of cross-country data which fails to accommodate the various cultural historical and institutional differences between included countries

mdash 10 mdash

Tab

le 1

S U

MM

AR

Y O

F T

HE

EMP

IRIC

AL

LIT

ERA

TU

RE

Pap

ers

findi

ng a

neg

ativ

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Dav

oodi

amp

Zou

(1

998)

46 d

evel

opin

g amp

dev

elop

ed

coun

trie

s (U

nbal

ance

d pa

nel)

1970

shy19

89

5 an

d 10

ye

ar

aver

ages

of

grow

th in

re

al p

er

capi

ta o

utpu

t

Pane

l T

wo

way

fixe

d ef

fect

s

1 D

irect

spen

ding

by

subn

atio

nal

gove

rnm

ents

(net

of

inte

rgov

ernm

enta

l tr

ansfe

rs) a

s a sh

are

of

gene

ral g

over

nmen

t sp

endi

ng

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

tax

reve

nues

to G

DP

Ave

rage

gro

wth

rat

e of

pop

ulat

ion

initi

al

seco

ndar

y sc

hool

en

rolm

ent r

ate

initi

al

per c

apita

GD

P

inve

stm

ent s

hare

to

GD

P

In d

evel

oped

cou

ntrie

s

ther

e is

no r

elat

ions

hip

betw

een

FD a

nd g

row

th

whe

reas

this

asso

ciat

ion

is ne

gativ

e in

dev

elop

ing

coun

trie

s A

vera

ge ta

x ra

te

affe

cts

grow

th n

egat

ivel

y

Fisc

al p

olic

y gr

owth

ef

fect

s ar

e m

ore

rela

ted

to fu

nctio

nal

gove

rnm

ent s

pend

ing

com

posit

ion

Rev

enue

as

signm

ent a

mon

g le

vels

of g

over

nmen

t m

ay b

e lsquow

rong

rsquo

Wol

ler

and

Phill

ips

(199

8)

23 L

DC

s co

untr

ies

Perio

d 19

74shy

1991

Ann

ual

3 or

5

year

av

erag

es o

f pe

r cap

ita

grow

th r

ate

Pane

l O

ne

way

fixe

d ef

fect

s

1 L

ocal

gove

rnm

ent

shar

e in

tota

l go

vern

men

t rev

enue

s or

spen

ding

2

Loc

al go

vern

men

t sh

are

(exc

ludi

ng

gran

ts-in

-aid

) in

tota

l re

venu

es

3 L

ocal

gove

rnm

ent

shar

e in

tota

l spe

ndin

g (le

ss d

efen

ce amp

socia

l w

elfa

re)

mdash

Initi

al G

DP

in

vest

men

t se

cond

ary

scho

ol

enro

lmen

t and

po

pula

tion

grow

th

Robu

st o

penn

ess

in

flatio

n le

vel amp

va

rianc

e p

oliti

cal amp

fin

anci

al v

aria

bles

No

stro

ng a

ssoc

iatio

n be

twee

n FD

and

ec

onom

ic g

row

th in

LD

Cs

At b

est

wea

k in

vers

e re

latio

nshi

p be

twee

n re

venu

e FD

and

gr

owth

whe

n us

ing

five

year

s av

erag

es

FD d

oes

not a

ffect

ec

onom

ic g

row

th a

t na

tiona

l lev

el a

mon

g LD

Cs

It c

an a

ffect

ec

onom

ic

deve

lopm

ent a

t the

lo

cal l

evel

in L

DC

s

Zha

ng amp

Z

ou

(199

8)

28 C

hine

se

prov

ince

s

1986

-199

2

Real

gro

wth

ra

te o

f pr

ovin

cial

in

com

e

Pane

l O

ne

way

fixe

d ef

fect

s

1 R

atio

of p

er c

apita

co

nsol

idat

ed (o

r bu

dget

ary

prov

inci

al)

spen

ding

to p

er c

apita

co

nsol

idat

ed o

r

Cen

tral

and

pr

ovin

cial

re

venu

e to

na

tiona

l GD

P Fu

nctio

nal

Labo

r fo

rce

grow

th

rate

inv

estm

ent

rate

ope

nnes

s

infla

tion

rate

A hi

gher

deg

ree

of sp

endi

ng

fisca

l dec

entr

aliz

atio

n is

asso

ciat

ed w

ith lo

wer

pr

ovin

cial

eco

nom

ic

grow

th in

Chi

na C

entr

al

If lo

cal s

pend

ing

is al

read

y hi

gh f

urth

er

dece

ntra

lizat

ion

may

re

sult

in s

low

er

grow

th

(Sig

ue)

(Con

tinua

cioacuten

)

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Zha

ng amp

Z

ou

(199

8)

(Ext

ende

d ca

se 1

980-

9)

budg

etar

y ce

ntra

l sp

endi

ng

2 R

atio

of p

rovi

ncial

ex

tra-

budg

etar

y sp

endi

ng sh

are

in

inco

me

to c

entr

al ex

tra-

budg

etar

y sp

endi

ng sh

are

of

inco

me

com

posit

ion

of

cent

ral a

nd

prov

inci

al

budg

etar

y sp

endi

ng

and

prov

inci

al ta

x ra

te

have

neg

ativ

e ef

fect

s on

gr

owth

but

not

sig

nific

ant

Cen

tral

gov

ernm

ent

may

be

in a

bet

ter

posit

ion

to u

nder

take

pu

blic

inve

stm

ent w

ith

exte

rnal

ities

whe

n th

e co

untr

y is

deve

lopi

ng

Xie

et a

l (1

999)

U

S 19

48 shy

1994

Re

al p

er

capi

tal

outp

ut

grow

th r

ate

Tim

e se

ries

1 S

hare

of s

pend

ing

by e

ach

leve

l of

subn

atio

nal

gove

rnm

ent (

loca

l an

d st

ate)

in to

tal

gove

rnm

ent s

pend

ing

(exc

ludi

ng fe

dera

l gr

ants

to lo

wer

leve

ls of

gov

ernm

ent)

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

go

vern

men

t re

ceip

ts to

GD

P

Labo

ur fo

rce

adju

sted

for

educ

atio

n le

vels

in

vest

men

t en

ergy

pr

ices

ope

nnes

s

infla

tion

amp G

ini (

all

varia

bles

in g

row

th

rate

s)

Loca

l spe

ndin

g re

duce

s gr

owth

tho

ugh

low

sig

nific

ance

leve

ls S

tate

sp

endi

ng a

nd c

ombi

ned

stat

e an

d lo

cal s

pend

ing

are

high

ly in

signi

fican

t A

vera

ge ta

x ra

te n

egat

ive

but n

ot s

igni

fican

t

The

insig

nific

ant

coef

ficie

nts

on lo

cal

and

stat

e sp

endi

ng

shar

es m

ay im

ply

that

ex

istin

g FD

has

bee

n co

nsist

ent w

ith g

row

th

max

imiza

tion

Fur

ther

de

cent

raliz

atio

n in

pu

blic

spe

ndin

g m

ay b

e ha

rmfu

l for

gro

wth

Jin amp

Zou

(2

005)

30

Chi

nese

pr

ovin

ces

1979

-199

3 amp

1994

-199

9 (t

wo

diffe

rent

fis

cal

regi

mes

)

Real

GD

P gr

owth

rat

e Pa

nel

One

w

ay fi

xed

effe

cts

No

time

dum

mie

s

1 P

rovi

ncia

l sha

re i

n to

tal b

udge

tary

ex

pend

iture

or

reve

nue

2 P

rovi

ncia

l sh

are

in to

tal e

xtra

shybu

dget

ary

expe

nditu

re o

r re

venu

e

Cen

tral

and

pr

ovin

cial

tax

rate

m

easu

red

by th

e ra

tio o

f cen

tral

ta

x re

venu

es amp

pr

ovin

cial

tax

reve

nues

to G

DP

Prov

inci

al

inve

stm

ent

labo

ur

forc

e gr

owth

rat

e

open

ness

lag

ged

infla

tion

1979

-199

3 g

row

th is

ne

gativ

ely

asso

ciat

ed w

ith

expe

nditu

re F

D amp

po

sitiv

ely

with

rev

enue

FD

199

4-19

99 g

row

th

has

no s

igni

fican

t lin

k w

ith

prov

inci

al e

xpen

ditu

re

and

is ne

gativ

ely

affe

cted

by

pro

vinc

ial r

even

ue

Con

vent

iona

l wisd

om

(tha

t loc

al r

even

ue

shou

ld m

atch

ex

pend

iture

as

clos

e as

po

ssib

le a

t sub

-nat

iona

l le

vel t

o im

prov

e ef

ficie

ncy

and

prom

ote

grow

th) d

oes

not a

pply

to

Chi

na

Pap

ers

findi

ng a

pos

itiv

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Lin

and

Liu

(200

0)

28 C

hine

se

prov

ince

s 19

70-1

993

Gro

wth

rat

e of

rea

l per

ca

pita

GD

P

Tw

o w

ay

fixed

effe

cts

1 M

argi

nal r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

2 A

vera

ge r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

Fisc

al c

apac

ity

(pro

xy b

y m

ovin

g av

erag

e of

per

ca

pita

GD

P)

Popu

latio

n p

er

capi

ta in

vest

men

t gr

owth

rur

al

popu

latio

n sh

are

re

lativ

e fa

rm p

rices

im

plem

enta

tion

of

agric

ultu

ral r

efor

m

priv

ate

firm

s sh

are

in

indu

stria

l out

put

FD h

as a

pos

itive

effe

ct o

n gr

owth

Thi

s ef

fect

is

high

er w

hen

usin

g th

e m

argi

nal r

eten

tion

rate

Lo

ng-r

un e

ffect

s ar

e ca

ptur

ed b

y la

ggin

g FD

fin

ding

larg

er e

ffect

s on

gr

owth

than

with

cur

rent

FD

The

mar

gina

l ret

entio

n ra

te is

a b

ette

r m

easu

re

than

ave

rage

ret

entio

n ra

te F

D h

as in

crea

sed

grow

th in

Chi

na b

y im

prov

ing

effic

ienc

y of

re

sour

ce a

lloca

tion

rath

er th

an b

y in

duci

ng

mor

e in

vest

men

t

Aka

i amp

Saka

ta

(200

2)

50 U

S st

ates

19

92-1

996

(ave

rage

) Su

b pe

riods

19

92-1

994

amp

1994

-199

6

Ave

rage

G

row

th r

ate

of r

eal p

er

capi

ta g

ross

st

ate

prod

uct

Cro

ss

sect

ion(

One

w

ay fi

xed

effe

cts)

1 Lo

cal g

over

nmen

t re

venu

e or

spe

ndin

g sh

are

in s

tate

+ lo

cal

gove

rnm

ent r

even

ue

or s

pend

ing

2 R

atio

of l

ocal

go

vern

men

trsquos o

wn

reve

nue

to s

tate

+

loca

l rev

enue

3

Ave

rage

of r

even

ue

and

spen

ding

FD

of

indi

cato

r 1

Thi

s st

udy

do n

ot

cont

rol f

or p

ublic

se

ctor

siz

e

Popu

latio

n gr

owth

la

gged

gro

wth

rat

e

high

sch

ool

enro

lmen

t rat

io

pre-

tax

inco

me

Gin

i co

effic

ient

sou

ther

n st

ates

dum

my

st

atersquo

s sh

are

in U

S pa

tent

s o

penn

ess

de

moc

rats

sea

ts

Spen

ding

FD

and

the

aver

age

of s

pend

ing

and

reve

nue

FD (i

ndic

ator

3)

affe

ct g

row

th p

ositi

vely

Re

venu

e FD

and

fisc

al

auto

nom

y (in

dica

tor

2) d

o no

t sig

nific

antly

affe

ct

grow

th

Prio

r ne

gativ

e ef

fect

s w

ere

due

to th

e us

e of

da

ta fo

r co

untr

ies

that

w

ere

in e

arly

sta

ges

of

deve

lopm

ent a

nd w

ith

larg

e di

ffere

nces

in

hist

ory

and

cultu

re

Thi

esse

n (2

003)

A

vera

ges

for

21 O

ECD

(amp

4 m

iddl

e in

com

e)

coun

trie

s

Perio

d ov

er

the

perio

d 19

73-1

998

Ave

rage

gr

owth

of

inco

me

per

wor

king

-age

pe

rson

Cro

ss

coun

try

1 L

ocal

sh

are

in

cons

olid

ated

go

vern

men

t sp

endi

ng

or r

even

ue

and

the

aver

age

of

the

two

2 T

rans

form

atio

n of

m

easu

re 1

to

capt

ure

non-

linea

ritie

s

Publ

ic

cons

umpt

ion

to

GD

P an

d th

e fis

cal b

alan

ce a

re

incl

uded

as

robu

stne

ss

chec

ks (r

esul

ts

not r

epor

ted)

Initi

al in

com

e pe

r w

orke

r in

vest

men

t sc

hool

enr

olm

ent

sum

of w

orki

ng-a

ge

popu

latio

n gr

owth

te

chno

logy

gro

wth

de

prec

iatio

n ra

te

vola

tility

ope

nnes

s

Spen

ding

and

lsquoave

rage

rsquo FD

ha

ve a

pos

itive

sig

nific

ant

effe

ct o

n gr

owth

(but

not

ro

bust

) M

ore

robu

st

indi

cato

r 2

show

ing

a no

n-lin

ear

asso

ciat

ion

betw

een

FD a

nd g

row

th R

even

ue

FD a

nd se

lf-re

lianc

e

FD p

rom

otes

ec

onom

ic g

row

th

How

ever

ther

e is

a hu

mp

shap

ed

asso

ciat

ion

betw

een

FD a

nd g

row

th

indi

catin

g an

opt

imal

de

gree

of F

D th

at (Sig

ue)

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

ABSTRACT

This paper examines whether the efficiency gains that allegedly accompany fiscal decentralization (FD) generate higher growth in more decentralised economies Previous research on this relationship has failed to generate a consensus We examine a sample of 23 OECD countries over 1972-2005 applying pooled mean group and instrumental variable techniques to a dynamic panel dataset We find that spending decentralization decreases while revenue decentralization increases economic growth Since OECD countries are substantially more spending than revenue decentralized this evidence provides strong support for Oates (1972) hypothesis that maximum FD efficiency gains require a close match between spending and revenue decentralization Some recent studies have concluded that increasing subnational autonomous revenue increases growth Our conclusion is rather that convergence between spending and revenue decentralization is growth-enhancing Our results are robust to various FD definitions and demonstrate the importance of testing simultaneously for these two FD-growth effects

Keywords fiscal decentralization economic growth pooled mean group government accountability

JEL Codes E62 H71 H72

mdash 5 mdash

Instituto de Estudios Fiscales

1 INTRODUCTION

Fiscal decentralization (hereafter FD) is a political economy trend in both developing and developed countries According to World Bank (1999) some 95 percent of democracies now have elected subnational governments and countries everywhere are devolving political fiscal and administrative powers to subnational tiers of government below the national level Dillinger (1994) reported that of the 75 developing countries with populations greater than 5 million all but 12 claim to have initiated measures to transfer some power to local government units In developed countries the United States the United Kingdom and Canada have revived debates on fiscal decentralization or devolution (Xie et al 1999) In recent years the US Congress has been contemplating how to devolve more expenditure responsibility to State and local governments FD has also become a key issue in Japan since the law for the promotion of fiscal decentralization was enacted in 1995 These efforts at devolution in a number of OECD countries are accompanied by the emergence of a new top layer of government in the European Union

The movement towards FD is often justified by the widespread belief that it is an effective tool for increasing the efficiency of public expenditures and competition among subnational governments in delivering public services (Bird and Wallich 1993) This may also be a reaction to the failure of large centralized bureaucracies in developing and transitional countries (Martiacutenez-Vaacutezquez and McNab 2003) World Bank (1999) for example has argued that alongside globalization localization ndashthe increasing demand for local autonomyndash is the main force shaping the world in the first decade of the 21st century

In this paper we focus on a specific debate in the literature on FD ndash namely that it improves economic growth performance We summarise a number of the relevant arguments in section 2 and then review the existing empirical evidence on the FD-growth relationship in section 3 We argue that the existing literature is deficient in a number of respects for example by rarely testing simultaneously for revenue and expenditure decentralization Section 4 presents our data and empirical methodology and section 5 tests for an effect of FD on economic growth rates in OECD countries over the period 1972shy2005 Section 6 checks the robustness of our findings to alternative econometric techniques to deal with endogeneity and alternative measures of fiscal decentralization Section 7 summarises the main conclusions

mdash 7 mdash

2

2 ARGUMENTS IN FAVOUR AND AGAINST FISCAL DECENTRALIZATION

The basic argument in favour of fiscal decentralization is that it improves the efficiency of the public sector and promotes long-term economic development (Oates 1972) Decentralization enhances economic efficiency because local governments have better knowledge of local conditions and preferences in the provision of public goods than national governments due to their physical and institutional proximity These informational advantages allow local governments to deliver public goods and services that better match local preferences andor deliver the same public goods and services at lower cost1

In addition sub-national governments may be subject to closer scrutiny by their constituencies This greater accountability may also lead to greater producer efficiency by providing incentives to local governments to innovate in the production and supply of public goods and services (Martiacutenez-Vaacutezquez and McNab 2003) Over 30 years ago Oates (1972) argued that this allocative efficiency benefit becomes greater when there is a close match between revenue discretion and spending assignments at sub-national levels And such matching it is argued gives local government a stronger fiscal incentive to support local market development (Jin et al 2005) improves accountability of sub-national governments and reduces the distorting effects of intergovernmental transfers (Shah 1994)

Secondly Oates (1999) argues that by diversifying government output according to local preferences decentralization may attain higher levels of social welfare If preferences for public goods differ across regions uniform levels of public goods and services across jurisdictions will generally be inefficient The larger the variance in regional demands for public goods the larger the benefits of FD This diversification also allows residents to move to the community that best matches their demand for public goods and services and local tax rate Thus a lsquoTiebout sortingrsquo of individuals into demand-homogeneous jurisdictions further increases efficiency in resource allocation

Building on this Tiebout (1956) mechanism Brueckner (2006) proposes a model in which fiscal decentralization leads young and old consumers to live in separate jurisdictions according to their different demands for public services low and high This sorting increases after-tax income when young while reducing it when old increasing the incentive to save This stronger incentive in turn leads to an increase in investment in human capital and long-term economic growth However it is not necessary for individuals to have different

1 These arguments are reinforced where public good characteristics are local in nature (eg sharing economies or non-excludability aspects are geographically restricted)

mdash 8 mdash

Instituto de Estudios Fiscales

preferences for local public goods or be relatively mobile to obtain efficiency gains from FD Thiessen (2003) argues that as long as subnational governments better reflect the priorities of taxpayers this is sufficient for fiscal decentralization to offer efficiency advantages2

The theoretical effects of FD on economic growth are not unambiguously positive however Firstly FD may impact negatively on the distribution of public resources across jurisdictions since mobility of households and businesses can seriously constrain attempts to redistribute income Redistributional policies are likely to induce poor individuals to move into the jurisdiction while higher income individuals (who bear a greater tax burden) move out To the extent that income inequality retards economic growth (Persson and Tabellini 1994) FD might negatively affect growth by making redistribution more difficult Furthermore concentration of public goods with supra-local spillovers in a few geographical locations can also inhibit per capita growth because regional inequalities in infrastructure education healthcare and other public services may prevent full use of factors of production (Thiessen 2003) In this case more centralized public sectors might redistribute resources across jurisdictions leading to a more efficient distribution

Other economic arguments against FD include possible damage to macroeconomic stability via fiscal policy coordination problems (Tanzi 1996) inter-jurisdictional lsquoleakagesrsquo associated with local expenditures (Oates 1972)3 and failure to exploit economies of scale and scope (Prudrsquohomme 1995) In addition FD may lead local governments to engage in a lsquorace to the bottomrsquo on the taxation of mobile factors hence under-providing productive public expenditure (Brueckner 2004) or increase corruption because officials at the local level are closer to people and more susceptible to the demands of local interest groups (Prudrsquohomme 1995 Tanzi 1996)4 Finally Tanzi (1996)

2 A further argument in favour of FD is that it promotes competition among different levels of government resulting in a more efficient production of public goods under revenue constraints Such competition may prevent revenue maximisation by lsquomonopolyrsquo governments and the oversupply of public goods (Brennan and Buchanan 1980) 3 On the other hand Gramlich (1993) claims that if economic shocks are asymmetric then decentralised systems make it easier to achieve macroeconomic stability Shah (2006) also suggests that central bank independence is more likely attained under decentralized systems because the pressure of a unique central government diminishes leading to the presence of multiple governments with diverse and conflicting interests Finally Martiacutenez-Vaacutezquez and McNab (2003) maintain that a well designed fiscal decentralization system (preventing local governments to borrow without controls) avoids fiscal systems damaging macroeconomic stability 4 Martiacutenez-Vaacutezquez and McNab (2003) dispute this argument claiming that local officials are more visible to their constituents and thus corrupt behaviour is more visible than at the central level of government

mdash 9 mdash

suggests that the assumption that individuals freely move between municipalities may be unrealistic at least in the short term allowing local governments to be relatively unresponsive to local citizensrsquo preferences

In summary there are clearly argument for both positive and negative effects of fiscal decentralization on fiscal efficiency and economic growth rates It is perhaps not surprising then that the empirical literature discussed below has tended to find a variety of effects in different contexts

3 EMPIRICAL EVIDENCE ON FD AND ECONOMIC GROWTH

As a number of authors have noted there is surprisingly little research devoted to measuring the impact of fiscal decentralization on economic growth given that economic efficiency is the central argument used to support fiscal decentralization (Bardhan 2002 Martiacutenez-Vaacutezquez and McNab 2003) Among existing studies a mixed picture emerges of the effect of decentralization on growth rates Initial contributions summarised in table 1 tended to find that fiscal decentralization has a negative or negligible effect on economic growth (Davoodi and Zou 1998 Woller and Philips 1998 Zhang and Zou 1998 Xie et al 1999 and Jin and Zou 2005) These authors interpret their results as an indication that FD is already high such that further decentralization may be harmful for economic growth However many of these studies focus on developing or transition economies with China a specific focus of attention5

5 On China see also Lin and Liu (2000) and Jin et al (2005) who find some evidence of positive growth effects of FD Akai and Sakata (2002) also suggest that initial studies have a lsquocultural biasrsquo due to their use of cross-country data which fails to accommodate the various cultural historical and institutional differences between included countries

mdash 10 mdash

Tab

le 1

S U

MM

AR

Y O

F T

HE

EMP

IRIC

AL

LIT

ERA

TU

RE

Pap

ers

findi

ng a

neg

ativ

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Dav

oodi

amp

Zou

(1

998)

46 d

evel

opin

g amp

dev

elop

ed

coun

trie

s (U

nbal

ance

d pa

nel)

1970

shy19

89

5 an

d 10

ye

ar

aver

ages

of

grow

th in

re

al p

er

capi

ta o

utpu

t

Pane

l T

wo

way

fixe

d ef

fect

s

1 D

irect

spen

ding

by

subn

atio

nal

gove

rnm

ents

(net

of

inte

rgov

ernm

enta

l tr

ansfe

rs) a

s a sh

are

of

gene

ral g

over

nmen

t sp

endi

ng

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

tax

reve

nues

to G

DP

Ave

rage

gro

wth

rat

e of

pop

ulat

ion

initi

al

seco

ndar

y sc

hool

en

rolm

ent r

ate

initi

al

per c

apita

GD

P

inve

stm

ent s

hare

to

GD

P

In d

evel

oped

cou

ntrie

s

ther

e is

no r

elat

ions

hip

betw

een

FD a

nd g

row

th

whe

reas

this

asso

ciat

ion

is ne

gativ

e in

dev

elop

ing

coun

trie

s A

vera

ge ta

x ra

te

affe

cts

grow

th n

egat

ivel

y

Fisc

al p

olic

y gr

owth

ef

fect

s ar

e m

ore

rela

ted

to fu

nctio

nal

gove

rnm

ent s

pend

ing

com

posit

ion

Rev

enue

as

signm

ent a

mon

g le

vels

of g

over

nmen

t m

ay b

e lsquow

rong

rsquo

Wol

ler

and

Phill

ips

(199

8)

23 L

DC

s co

untr

ies

Perio

d 19

74shy

1991

Ann

ual

3 or

5

year

av

erag

es o

f pe

r cap

ita

grow

th r

ate

Pane

l O

ne

way

fixe

d ef

fect

s

1 L

ocal

gove

rnm

ent

shar

e in

tota

l go

vern

men

t rev

enue

s or

spen

ding

2

Loc

al go

vern

men

t sh

are

(exc

ludi

ng

gran

ts-in

-aid

) in

tota

l re

venu

es

3 L

ocal

gove

rnm

ent

shar

e in

tota

l spe

ndin

g (le

ss d

efen

ce amp

socia

l w

elfa

re)

mdash

Initi

al G

DP

in

vest

men

t se

cond

ary

scho

ol

enro

lmen

t and

po

pula

tion

grow

th

Robu

st o

penn

ess

in

flatio

n le

vel amp

va

rianc

e p

oliti

cal amp

fin

anci

al v

aria

bles

No

stro

ng a

ssoc

iatio

n be

twee

n FD

and

ec

onom

ic g

row

th in

LD

Cs

At b

est

wea

k in

vers

e re

latio

nshi

p be

twee

n re

venu

e FD

and

gr

owth

whe

n us

ing

five

year

s av

erag

es

FD d

oes

not a

ffect

ec

onom

ic g

row

th a

t na

tiona

l lev

el a

mon

g LD

Cs

It c

an a

ffect

ec

onom

ic

deve

lopm

ent a

t the

lo

cal l

evel

in L

DC

s

Zha

ng amp

Z

ou

(199

8)

28 C

hine

se

prov

ince

s

1986

-199

2

Real

gro

wth

ra

te o

f pr

ovin

cial

in

com

e

Pane

l O

ne

way

fixe

d ef

fect

s

1 R

atio

of p

er c

apita

co

nsol

idat

ed (o

r bu

dget

ary

prov

inci

al)

spen

ding

to p

er c

apita

co

nsol

idat

ed o

r

Cen

tral

and

pr

ovin

cial

re

venu

e to

na

tiona

l GD

P Fu

nctio

nal

Labo

r fo

rce

grow

th

rate

inv

estm

ent

rate

ope

nnes

s

infla

tion

rate

A hi

gher

deg

ree

of sp

endi

ng

fisca

l dec

entr

aliz

atio

n is

asso

ciat

ed w

ith lo

wer

pr

ovin

cial

eco

nom

ic

grow

th in

Chi

na C

entr

al

If lo

cal s

pend

ing

is al

read

y hi

gh f

urth

er

dece

ntra

lizat

ion

may

re

sult

in s

low

er

grow

th

(Sig

ue)

(Con

tinua

cioacuten

)

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Zha

ng amp

Z

ou

(199

8)

(Ext

ende

d ca

se 1

980-

9)

budg

etar

y ce

ntra

l sp

endi

ng

2 R

atio

of p

rovi

ncial

ex

tra-

budg

etar

y sp

endi

ng sh

are

in

inco

me

to c

entr

al ex

tra-

budg

etar

y sp

endi

ng sh

are

of

inco

me

com

posit

ion

of

cent

ral a

nd

prov

inci

al

budg

etar

y sp

endi

ng

and

prov

inci

al ta

x ra

te

have

neg

ativ

e ef

fect

s on

gr

owth

but

not

sig

nific

ant

Cen

tral

gov

ernm

ent

may

be

in a

bet

ter

posit

ion

to u

nder

take

pu

blic

inve

stm

ent w

ith

exte

rnal

ities

whe

n th

e co

untr

y is

deve

lopi

ng

Xie

et a

l (1

999)

U

S 19

48 shy

1994

Re

al p

er

capi

tal

outp

ut

grow

th r

ate

Tim

e se

ries

1 S

hare

of s

pend

ing

by e

ach

leve

l of

subn

atio

nal

gove

rnm

ent (

loca

l an

d st

ate)

in to

tal

gove

rnm

ent s

pend

ing

(exc

ludi

ng fe

dera

l gr

ants

to lo

wer

leve

ls of

gov

ernm

ent)

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

go

vern

men

t re

ceip

ts to

GD

P

Labo

ur fo

rce

adju

sted

for

educ

atio

n le

vels

in

vest

men

t en

ergy

pr

ices

ope

nnes

s

infla

tion

amp G

ini (

all

varia

bles

in g

row

th

rate

s)

Loca

l spe

ndin

g re

duce

s gr

owth

tho

ugh

low

sig

nific

ance

leve

ls S

tate

sp

endi

ng a

nd c

ombi

ned

stat

e an

d lo

cal s

pend

ing

are

high

ly in

signi

fican

t A

vera

ge ta

x ra

te n

egat

ive

but n

ot s

igni

fican

t

The

insig

nific

ant

coef

ficie

nts

on lo

cal

and

stat

e sp

endi

ng

shar

es m

ay im

ply

that

ex

istin

g FD

has

bee

n co

nsist

ent w

ith g

row

th

max

imiza

tion

Fur

ther

de

cent

raliz

atio

n in

pu

blic

spe

ndin

g m

ay b

e ha

rmfu

l for

gro

wth

Jin amp

Zou

(2

005)

30

Chi

nese

pr

ovin

ces

1979

-199

3 amp

1994

-199

9 (t

wo

diffe

rent

fis

cal

regi

mes

)

Real

GD

P gr

owth

rat

e Pa

nel

One

w

ay fi

xed

effe

cts

No

time

dum

mie

s

1 P

rovi

ncia

l sha

re i

n to

tal b

udge

tary

ex

pend

iture

or

reve

nue

2 P

rovi

ncia

l sh

are

in to

tal e

xtra

shybu

dget

ary

expe

nditu

re o

r re

venu

e

Cen

tral

and

pr

ovin

cial

tax

rate

m

easu

red

by th

e ra

tio o

f cen

tral

ta

x re

venu

es amp

pr

ovin

cial

tax

reve

nues

to G

DP

Prov

inci

al

inve

stm

ent

labo

ur

forc

e gr

owth

rat

e

open

ness

lag

ged

infla

tion

1979

-199

3 g

row

th is

ne

gativ

ely

asso

ciat

ed w

ith

expe

nditu

re F

D amp

po

sitiv

ely

with

rev

enue

FD

199

4-19

99 g

row

th

has

no s

igni

fican

t lin

k w

ith

prov

inci

al e

xpen

ditu

re

and

is ne

gativ

ely

affe

cted

by

pro

vinc

ial r

even

ue

Con

vent

iona

l wisd

om

(tha

t loc

al r

even

ue

shou

ld m

atch

ex

pend

iture

as

clos

e as

po

ssib

le a

t sub

-nat

iona

l le

vel t

o im

prov

e ef

ficie

ncy

and

prom

ote

grow

th) d

oes

not a

pply

to

Chi

na

Pap

ers

findi

ng a

pos

itiv

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Lin

and

Liu

(200

0)

28 C

hine

se

prov

ince

s 19

70-1

993

Gro

wth

rat

e of

rea

l per

ca

pita

GD

P

Tw

o w

ay

fixed

effe

cts

1 M

argi

nal r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

2 A

vera

ge r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

Fisc

al c

apac

ity

(pro

xy b

y m

ovin

g av

erag

e of

per

ca

pita

GD

P)

Popu

latio

n p

er

capi

ta in

vest

men

t gr

owth

rur

al

popu

latio

n sh

are

re

lativ

e fa

rm p

rices

im

plem

enta

tion

of

agric

ultu

ral r

efor

m

priv

ate

firm

s sh

are

in

indu

stria

l out

put

FD h

as a

pos

itive

effe

ct o

n gr

owth

Thi

s ef

fect

is

high

er w

hen

usin

g th

e m

argi

nal r

eten

tion

rate

Lo

ng-r

un e

ffect

s ar

e ca

ptur

ed b

y la

ggin

g FD

fin

ding

larg

er e

ffect

s on

gr

owth

than

with

cur

rent

FD

The

mar

gina

l ret

entio

n ra

te is

a b

ette

r m

easu

re

than

ave

rage

ret

entio

n ra

te F

D h

as in

crea

sed

grow

th in

Chi

na b

y im

prov

ing

effic

ienc

y of

re

sour

ce a

lloca

tion

rath

er th

an b

y in

duci

ng

mor

e in

vest

men

t

Aka

i amp

Saka

ta

(200

2)

50 U

S st

ates

19

92-1

996

(ave

rage

) Su

b pe

riods

19

92-1

994

amp

1994

-199

6

Ave

rage

G

row

th r

ate

of r

eal p

er

capi

ta g

ross

st

ate

prod

uct

Cro

ss

sect

ion(

One

w

ay fi

xed

effe

cts)

1 Lo

cal g

over

nmen

t re

venu

e or

spe

ndin

g sh

are

in s

tate

+ lo

cal

gove

rnm

ent r

even

ue

or s

pend

ing

2 R

atio

of l

ocal

go

vern

men

trsquos o

wn

reve

nue

to s

tate

+

loca

l rev

enue

3

Ave

rage

of r

even

ue

and

spen

ding

FD

of

indi

cato

r 1

Thi

s st

udy

do n

ot

cont

rol f

or p

ublic

se

ctor

siz

e

Popu

latio

n gr

owth

la

gged

gro

wth

rat

e

high

sch

ool

enro

lmen

t rat

io

pre-

tax

inco

me

Gin

i co

effic

ient

sou

ther

n st

ates

dum

my

st

atersquo

s sh

are

in U

S pa

tent

s o

penn

ess

de

moc

rats

sea

ts

Spen

ding

FD

and

the

aver

age

of s

pend

ing

and

reve

nue

FD (i

ndic

ator

3)

affe

ct g

row

th p

ositi

vely

Re

venu

e FD

and

fisc

al

auto

nom

y (in

dica

tor

2) d

o no

t sig

nific

antly

affe

ct

grow

th

Prio

r ne

gativ

e ef

fect

s w

ere

due

to th

e us

e of

da

ta fo

r co

untr

ies

that

w

ere

in e

arly

sta

ges

of

deve

lopm

ent a

nd w

ith

larg

e di

ffere

nces

in

hist

ory

and

cultu

re

Thi

esse

n (2

003)

A

vera

ges

for

21 O

ECD

(amp

4 m

iddl

e in

com

e)

coun

trie

s

Perio

d ov

er

the

perio

d 19

73-1

998

Ave

rage

gr

owth

of

inco

me

per

wor

king

-age

pe

rson

Cro

ss

coun

try

1 L

ocal

sh

are

in

cons

olid

ated

go

vern

men

t sp

endi

ng

or r

even

ue

and

the

aver

age

of

the

two

2 T

rans

form

atio

n of

m

easu

re 1

to

capt

ure

non-

linea

ritie

s

Publ

ic

cons

umpt

ion

to

GD

P an

d th

e fis

cal b

alan

ce a

re

incl

uded

as

robu

stne

ss

chec

ks (r

esul

ts

not r

epor

ted)

Initi

al in

com

e pe

r w

orke

r in

vest

men

t sc

hool

enr

olm

ent

sum

of w

orki

ng-a

ge

popu

latio

n gr

owth

te

chno

logy

gro

wth

de

prec

iatio

n ra

te

vola

tility

ope

nnes

s

Spen

ding

and

lsquoave

rage

rsquo FD

ha

ve a

pos

itive

sig

nific

ant

effe

ct o

n gr

owth

(but

not

ro

bust

) M

ore

robu

st

indi

cato

r 2

show

ing

a no

n-lin

ear

asso

ciat

ion

betw

een

FD a

nd g

row

th R

even

ue

FD a

nd se

lf-re

lianc

e

FD p

rom

otes

ec

onom

ic g

row

th

How

ever

ther

e is

a hu

mp

shap

ed

asso

ciat

ion

betw

een

FD a

nd g

row

th

indi

catin

g an

opt

imal

de

gree

of F

D th

at (Sig

ue)

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

Instituto de Estudios Fiscales

1 INTRODUCTION

Fiscal decentralization (hereafter FD) is a political economy trend in both developing and developed countries According to World Bank (1999) some 95 percent of democracies now have elected subnational governments and countries everywhere are devolving political fiscal and administrative powers to subnational tiers of government below the national level Dillinger (1994) reported that of the 75 developing countries with populations greater than 5 million all but 12 claim to have initiated measures to transfer some power to local government units In developed countries the United States the United Kingdom and Canada have revived debates on fiscal decentralization or devolution (Xie et al 1999) In recent years the US Congress has been contemplating how to devolve more expenditure responsibility to State and local governments FD has also become a key issue in Japan since the law for the promotion of fiscal decentralization was enacted in 1995 These efforts at devolution in a number of OECD countries are accompanied by the emergence of a new top layer of government in the European Union

The movement towards FD is often justified by the widespread belief that it is an effective tool for increasing the efficiency of public expenditures and competition among subnational governments in delivering public services (Bird and Wallich 1993) This may also be a reaction to the failure of large centralized bureaucracies in developing and transitional countries (Martiacutenez-Vaacutezquez and McNab 2003) World Bank (1999) for example has argued that alongside globalization localization ndashthe increasing demand for local autonomyndash is the main force shaping the world in the first decade of the 21st century

In this paper we focus on a specific debate in the literature on FD ndash namely that it improves economic growth performance We summarise a number of the relevant arguments in section 2 and then review the existing empirical evidence on the FD-growth relationship in section 3 We argue that the existing literature is deficient in a number of respects for example by rarely testing simultaneously for revenue and expenditure decentralization Section 4 presents our data and empirical methodology and section 5 tests for an effect of FD on economic growth rates in OECD countries over the period 1972shy2005 Section 6 checks the robustness of our findings to alternative econometric techniques to deal with endogeneity and alternative measures of fiscal decentralization Section 7 summarises the main conclusions

mdash 7 mdash

2

2 ARGUMENTS IN FAVOUR AND AGAINST FISCAL DECENTRALIZATION

The basic argument in favour of fiscal decentralization is that it improves the efficiency of the public sector and promotes long-term economic development (Oates 1972) Decentralization enhances economic efficiency because local governments have better knowledge of local conditions and preferences in the provision of public goods than national governments due to their physical and institutional proximity These informational advantages allow local governments to deliver public goods and services that better match local preferences andor deliver the same public goods and services at lower cost1

In addition sub-national governments may be subject to closer scrutiny by their constituencies This greater accountability may also lead to greater producer efficiency by providing incentives to local governments to innovate in the production and supply of public goods and services (Martiacutenez-Vaacutezquez and McNab 2003) Over 30 years ago Oates (1972) argued that this allocative efficiency benefit becomes greater when there is a close match between revenue discretion and spending assignments at sub-national levels And such matching it is argued gives local government a stronger fiscal incentive to support local market development (Jin et al 2005) improves accountability of sub-national governments and reduces the distorting effects of intergovernmental transfers (Shah 1994)

Secondly Oates (1999) argues that by diversifying government output according to local preferences decentralization may attain higher levels of social welfare If preferences for public goods differ across regions uniform levels of public goods and services across jurisdictions will generally be inefficient The larger the variance in regional demands for public goods the larger the benefits of FD This diversification also allows residents to move to the community that best matches their demand for public goods and services and local tax rate Thus a lsquoTiebout sortingrsquo of individuals into demand-homogeneous jurisdictions further increases efficiency in resource allocation

Building on this Tiebout (1956) mechanism Brueckner (2006) proposes a model in which fiscal decentralization leads young and old consumers to live in separate jurisdictions according to their different demands for public services low and high This sorting increases after-tax income when young while reducing it when old increasing the incentive to save This stronger incentive in turn leads to an increase in investment in human capital and long-term economic growth However it is not necessary for individuals to have different

1 These arguments are reinforced where public good characteristics are local in nature (eg sharing economies or non-excludability aspects are geographically restricted)

mdash 8 mdash

Instituto de Estudios Fiscales

preferences for local public goods or be relatively mobile to obtain efficiency gains from FD Thiessen (2003) argues that as long as subnational governments better reflect the priorities of taxpayers this is sufficient for fiscal decentralization to offer efficiency advantages2

The theoretical effects of FD on economic growth are not unambiguously positive however Firstly FD may impact negatively on the distribution of public resources across jurisdictions since mobility of households and businesses can seriously constrain attempts to redistribute income Redistributional policies are likely to induce poor individuals to move into the jurisdiction while higher income individuals (who bear a greater tax burden) move out To the extent that income inequality retards economic growth (Persson and Tabellini 1994) FD might negatively affect growth by making redistribution more difficult Furthermore concentration of public goods with supra-local spillovers in a few geographical locations can also inhibit per capita growth because regional inequalities in infrastructure education healthcare and other public services may prevent full use of factors of production (Thiessen 2003) In this case more centralized public sectors might redistribute resources across jurisdictions leading to a more efficient distribution

Other economic arguments against FD include possible damage to macroeconomic stability via fiscal policy coordination problems (Tanzi 1996) inter-jurisdictional lsquoleakagesrsquo associated with local expenditures (Oates 1972)3 and failure to exploit economies of scale and scope (Prudrsquohomme 1995) In addition FD may lead local governments to engage in a lsquorace to the bottomrsquo on the taxation of mobile factors hence under-providing productive public expenditure (Brueckner 2004) or increase corruption because officials at the local level are closer to people and more susceptible to the demands of local interest groups (Prudrsquohomme 1995 Tanzi 1996)4 Finally Tanzi (1996)

2 A further argument in favour of FD is that it promotes competition among different levels of government resulting in a more efficient production of public goods under revenue constraints Such competition may prevent revenue maximisation by lsquomonopolyrsquo governments and the oversupply of public goods (Brennan and Buchanan 1980) 3 On the other hand Gramlich (1993) claims that if economic shocks are asymmetric then decentralised systems make it easier to achieve macroeconomic stability Shah (2006) also suggests that central bank independence is more likely attained under decentralized systems because the pressure of a unique central government diminishes leading to the presence of multiple governments with diverse and conflicting interests Finally Martiacutenez-Vaacutezquez and McNab (2003) maintain that a well designed fiscal decentralization system (preventing local governments to borrow without controls) avoids fiscal systems damaging macroeconomic stability 4 Martiacutenez-Vaacutezquez and McNab (2003) dispute this argument claiming that local officials are more visible to their constituents and thus corrupt behaviour is more visible than at the central level of government

mdash 9 mdash

suggests that the assumption that individuals freely move between municipalities may be unrealistic at least in the short term allowing local governments to be relatively unresponsive to local citizensrsquo preferences

In summary there are clearly argument for both positive and negative effects of fiscal decentralization on fiscal efficiency and economic growth rates It is perhaps not surprising then that the empirical literature discussed below has tended to find a variety of effects in different contexts

3 EMPIRICAL EVIDENCE ON FD AND ECONOMIC GROWTH

As a number of authors have noted there is surprisingly little research devoted to measuring the impact of fiscal decentralization on economic growth given that economic efficiency is the central argument used to support fiscal decentralization (Bardhan 2002 Martiacutenez-Vaacutezquez and McNab 2003) Among existing studies a mixed picture emerges of the effect of decentralization on growth rates Initial contributions summarised in table 1 tended to find that fiscal decentralization has a negative or negligible effect on economic growth (Davoodi and Zou 1998 Woller and Philips 1998 Zhang and Zou 1998 Xie et al 1999 and Jin and Zou 2005) These authors interpret their results as an indication that FD is already high such that further decentralization may be harmful for economic growth However many of these studies focus on developing or transition economies with China a specific focus of attention5

5 On China see also Lin and Liu (2000) and Jin et al (2005) who find some evidence of positive growth effects of FD Akai and Sakata (2002) also suggest that initial studies have a lsquocultural biasrsquo due to their use of cross-country data which fails to accommodate the various cultural historical and institutional differences between included countries

mdash 10 mdash

Tab

le 1

S U

MM

AR

Y O

F T

HE

EMP

IRIC

AL

LIT

ERA

TU

RE

Pap

ers

findi

ng a

neg

ativ

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Dav

oodi

amp

Zou

(1

998)

46 d

evel

opin

g amp

dev

elop

ed

coun

trie

s (U

nbal

ance

d pa

nel)

1970

shy19

89

5 an

d 10

ye

ar

aver

ages

of

grow

th in

re

al p

er

capi

ta o

utpu

t

Pane

l T

wo

way

fixe

d ef

fect

s

1 D

irect

spen

ding

by

subn

atio

nal

gove

rnm

ents

(net

of

inte

rgov

ernm

enta

l tr

ansfe

rs) a

s a sh

are

of

gene

ral g

over

nmen

t sp

endi

ng

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

tax

reve

nues

to G

DP

Ave

rage

gro

wth

rat

e of

pop

ulat

ion

initi

al

seco

ndar

y sc

hool

en

rolm

ent r

ate

initi

al

per c

apita

GD

P

inve

stm

ent s

hare

to

GD

P

In d

evel

oped

cou

ntrie

s

ther

e is

no r

elat

ions

hip

betw

een

FD a

nd g

row

th

whe

reas

this

asso

ciat

ion

is ne

gativ

e in

dev

elop

ing

coun

trie

s A

vera

ge ta

x ra

te

affe

cts

grow

th n

egat

ivel

y

Fisc

al p

olic

y gr

owth

ef

fect

s ar

e m

ore

rela

ted

to fu

nctio

nal

gove

rnm

ent s

pend

ing

com

posit

ion

Rev

enue

as

signm

ent a

mon

g le

vels

of g

over

nmen

t m

ay b

e lsquow

rong

rsquo

Wol

ler

and

Phill

ips

(199

8)

23 L

DC

s co

untr

ies

Perio

d 19

74shy

1991

Ann

ual

3 or

5

year

av

erag

es o

f pe

r cap

ita

grow

th r

ate

Pane

l O

ne

way

fixe

d ef

fect

s

1 L

ocal

gove

rnm

ent

shar

e in

tota

l go

vern

men

t rev

enue

s or

spen

ding

2

Loc

al go

vern

men

t sh

are

(exc

ludi

ng

gran

ts-in

-aid

) in

tota

l re

venu

es

3 L

ocal

gove

rnm

ent

shar

e in

tota

l spe

ndin

g (le

ss d

efen

ce amp

socia

l w

elfa

re)

mdash

Initi

al G

DP

in

vest

men

t se

cond

ary

scho

ol

enro

lmen

t and

po

pula

tion

grow

th

Robu

st o

penn

ess

in

flatio

n le

vel amp

va

rianc

e p

oliti

cal amp

fin

anci

al v

aria

bles

No

stro

ng a

ssoc

iatio

n be

twee

n FD

and

ec

onom

ic g

row

th in

LD

Cs

At b

est

wea

k in

vers

e re

latio

nshi

p be

twee

n re

venu

e FD

and

gr

owth

whe

n us

ing

five

year

s av

erag

es

FD d

oes

not a

ffect

ec

onom

ic g

row

th a

t na

tiona

l lev

el a

mon

g LD

Cs

It c

an a

ffect

ec

onom

ic

deve

lopm

ent a

t the

lo

cal l

evel

in L

DC

s

Zha

ng amp

Z

ou

(199

8)

28 C

hine

se

prov

ince

s

1986

-199

2

Real

gro

wth

ra

te o

f pr

ovin

cial

in

com

e

Pane

l O

ne

way

fixe

d ef

fect

s

1 R

atio

of p

er c

apita

co

nsol

idat

ed (o

r bu

dget

ary

prov

inci

al)

spen

ding

to p

er c

apita

co

nsol

idat

ed o

r

Cen

tral

and

pr

ovin

cial

re

venu

e to

na

tiona

l GD

P Fu

nctio

nal

Labo

r fo

rce

grow

th

rate

inv

estm

ent

rate

ope

nnes

s

infla

tion

rate

A hi

gher

deg

ree

of sp

endi

ng

fisca

l dec

entr

aliz

atio

n is

asso

ciat

ed w

ith lo

wer

pr

ovin

cial

eco

nom

ic

grow

th in

Chi

na C

entr

al

If lo

cal s

pend

ing

is al

read

y hi

gh f

urth

er

dece

ntra

lizat

ion

may

re

sult

in s

low

er

grow

th

(Sig

ue)

(Con

tinua

cioacuten

)

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Zha

ng amp

Z

ou

(199

8)

(Ext

ende

d ca

se 1

980-

9)

budg

etar

y ce

ntra

l sp

endi

ng

2 R

atio

of p

rovi

ncial

ex

tra-

budg

etar

y sp

endi

ng sh

are

in

inco

me

to c

entr

al ex

tra-

budg

etar

y sp

endi

ng sh

are

of

inco

me

com

posit

ion

of

cent

ral a

nd

prov

inci

al

budg

etar

y sp

endi

ng

and

prov

inci

al ta

x ra

te

have

neg

ativ

e ef

fect

s on

gr

owth

but

not

sig

nific

ant

Cen

tral

gov

ernm

ent

may

be

in a

bet

ter

posit

ion

to u

nder

take

pu

blic

inve

stm

ent w

ith

exte

rnal

ities

whe

n th

e co

untr

y is

deve

lopi

ng

Xie

et a

l (1

999)

U

S 19

48 shy

1994

Re

al p

er

capi

tal

outp

ut

grow

th r

ate

Tim

e se

ries

1 S

hare

of s

pend

ing

by e

ach

leve

l of

subn

atio

nal

gove

rnm

ent (

loca

l an

d st

ate)

in to

tal

gove

rnm

ent s

pend

ing

(exc

ludi

ng fe

dera

l gr

ants

to lo

wer

leve

ls of

gov

ernm

ent)

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

go

vern

men

t re

ceip

ts to

GD

P

Labo

ur fo

rce

adju

sted

for

educ

atio

n le

vels

in

vest

men

t en

ergy

pr

ices

ope

nnes

s

infla

tion

amp G

ini (

all

varia

bles

in g

row

th

rate

s)

Loca

l spe

ndin

g re

duce

s gr

owth

tho

ugh

low

sig

nific

ance

leve

ls S

tate

sp

endi

ng a

nd c

ombi

ned

stat

e an

d lo

cal s

pend

ing

are

high

ly in

signi

fican

t A

vera

ge ta

x ra

te n

egat

ive

but n

ot s

igni

fican

t

The

insig

nific

ant

coef

ficie

nts

on lo

cal

and

stat

e sp

endi

ng

shar

es m

ay im

ply

that

ex

istin

g FD

has

bee

n co

nsist

ent w

ith g

row

th

max

imiza

tion

Fur

ther

de

cent

raliz

atio

n in

pu

blic

spe

ndin

g m

ay b

e ha

rmfu

l for

gro

wth

Jin amp

Zou

(2

005)

30

Chi

nese

pr

ovin

ces

1979

-199

3 amp

1994

-199

9 (t

wo

diffe

rent

fis

cal

regi

mes

)

Real

GD

P gr

owth

rat

e Pa

nel

One

w

ay fi

xed

effe

cts

No

time

dum

mie

s

1 P

rovi

ncia

l sha

re i

n to

tal b

udge

tary

ex

pend

iture

or

reve

nue

2 P

rovi

ncia

l sh

are

in to

tal e

xtra

shybu

dget

ary

expe

nditu

re o

r re

venu

e

Cen

tral

and

pr

ovin

cial

tax

rate

m

easu

red

by th

e ra

tio o

f cen

tral

ta

x re

venu

es amp

pr

ovin

cial

tax

reve

nues

to G

DP

Prov

inci

al

inve

stm

ent

labo

ur

forc

e gr

owth

rat

e

open

ness

lag

ged

infla

tion

1979

-199

3 g

row

th is

ne

gativ

ely

asso

ciat

ed w

ith

expe

nditu

re F

D amp

po

sitiv

ely

with

rev

enue

FD

199

4-19

99 g

row

th

has

no s

igni

fican

t lin

k w

ith

prov

inci

al e

xpen

ditu

re

and

is ne

gativ

ely

affe

cted

by

pro

vinc

ial r

even

ue

Con

vent

iona

l wisd

om

(tha

t loc

al r

even

ue

shou

ld m

atch

ex

pend

iture

as

clos

e as

po

ssib

le a

t sub

-nat

iona

l le

vel t

o im

prov

e ef

ficie

ncy

and

prom

ote

grow

th) d

oes

not a

pply

to

Chi

na

Pap

ers

findi

ng a

pos

itiv

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Lin

and

Liu

(200

0)

28 C

hine

se

prov

ince

s 19

70-1

993

Gro

wth

rat

e of

rea

l per

ca

pita

GD

P

Tw

o w

ay

fixed

effe

cts

1 M

argi

nal r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

2 A

vera

ge r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

Fisc

al c

apac

ity

(pro

xy b

y m

ovin

g av

erag

e of

per

ca

pita

GD

P)

Popu

latio

n p

er

capi

ta in

vest

men

t gr

owth

rur

al

popu

latio

n sh

are

re

lativ

e fa

rm p

rices

im

plem

enta

tion

of

agric

ultu

ral r

efor

m

priv

ate

firm

s sh

are

in

indu

stria

l out

put

FD h

as a

pos

itive

effe

ct o

n gr

owth

Thi

s ef

fect

is

high

er w

hen

usin

g th

e m

argi

nal r

eten

tion

rate

Lo

ng-r

un e

ffect

s ar

e ca

ptur

ed b

y la

ggin

g FD

fin

ding

larg

er e

ffect

s on

gr

owth

than

with

cur

rent

FD

The

mar

gina

l ret

entio

n ra

te is

a b

ette

r m

easu

re

than

ave

rage

ret

entio

n ra

te F

D h

as in

crea

sed

grow

th in

Chi

na b

y im

prov

ing

effic

ienc

y of

re

sour

ce a

lloca

tion

rath

er th

an b

y in

duci

ng

mor

e in

vest

men

t

Aka

i amp

Saka

ta

(200

2)

50 U

S st

ates

19

92-1

996

(ave

rage

) Su

b pe

riods

19

92-1

994

amp

1994

-199

6

Ave

rage

G

row

th r

ate

of r

eal p

er

capi

ta g

ross

st

ate

prod

uct

Cro

ss

sect

ion(

One

w

ay fi

xed

effe

cts)

1 Lo

cal g

over

nmen

t re

venu

e or

spe

ndin

g sh

are

in s

tate

+ lo

cal

gove

rnm

ent r

even

ue

or s

pend

ing

2 R

atio

of l

ocal

go

vern

men

trsquos o

wn

reve

nue

to s

tate

+

loca

l rev

enue

3

Ave

rage

of r

even

ue

and

spen

ding

FD

of

indi

cato

r 1

Thi

s st

udy

do n

ot

cont

rol f

or p

ublic

se

ctor

siz

e

Popu

latio

n gr

owth

la

gged

gro

wth

rat

e

high

sch

ool

enro

lmen

t rat

io

pre-

tax

inco

me

Gin

i co

effic

ient

sou

ther

n st

ates

dum

my

st

atersquo

s sh

are

in U

S pa

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s o

penn

ess

de

moc

rats

sea

ts

Spen

ding

FD

and

the

aver

age

of s

pend

ing

and

reve

nue

FD (i

ndic

ator

3)

affe

ct g

row

th p

ositi

vely

Re

venu

e FD

and

fisc

al

auto

nom

y (in

dica

tor

2) d

o no

t sig

nific

antly

affe

ct

grow

th

Prio

r ne

gativ

e ef

fect

s w

ere

due

to th

e us

e of

da

ta fo

r co

untr

ies

that

w

ere

in e

arly

sta

ges

of

deve

lopm

ent a

nd w

ith

larg

e di

ffere

nces

in

hist

ory

and

cultu

re

Thi

esse

n (2

003)

A

vera

ges

for

21 O

ECD

(amp

4 m

iddl

e in

com

e)

coun

trie

s

Perio

d ov

er

the

perio

d 19

73-1

998

Ave

rage

gr

owth

of

inco

me

per

wor

king

-age

pe

rson

Cro

ss

coun

try

1 L

ocal

sh

are

in

cons

olid

ated

go

vern

men

t sp

endi

ng

or r

even

ue

and

the

aver

age

of

the

two

2 T

rans

form

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n of

m

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re 1

to

capt

ure

non-

linea

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s

Publ

ic

cons

umpt

ion

to

GD

P an

d th

e fis

cal b

alan

ce a

re

incl

uded

as

robu

stne

ss

chec

ks (r

esul

ts

not r

epor

ted)

Initi

al in

com

e pe

r w

orke

r in

vest

men

t sc

hool

enr

olm

ent

sum

of w

orki

ng-a

ge

popu

latio

n gr

owth

te

chno

logy

gro

wth

de

prec

iatio

n ra

te

vola

tility

ope

nnes

s

Spen

ding

and

lsquoave

rage

rsquo FD

ha

ve a

pos

itive

sig

nific

ant

effe

ct o

n gr

owth

(but

not

ro

bust

) M

ore

robu

st

indi

cato

r 2

show

ing

a no

n-lin

ear

asso

ciat

ion

betw

een

FD a

nd g

row

th R

even

ue

FD a

nd se

lf-re

lianc

e

FD p

rom

otes

ec

onom

ic g

row

th

How

ever

ther

e is

a hu

mp

shap

ed

asso

ciat

ion

betw

een

FD a

nd g

row

th

indi

catin

g an

opt

imal

de

gree

of F

D th

at (Sig

ue)

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

2

2 ARGUMENTS IN FAVOUR AND AGAINST FISCAL DECENTRALIZATION

The basic argument in favour of fiscal decentralization is that it improves the efficiency of the public sector and promotes long-term economic development (Oates 1972) Decentralization enhances economic efficiency because local governments have better knowledge of local conditions and preferences in the provision of public goods than national governments due to their physical and institutional proximity These informational advantages allow local governments to deliver public goods and services that better match local preferences andor deliver the same public goods and services at lower cost1

In addition sub-national governments may be subject to closer scrutiny by their constituencies This greater accountability may also lead to greater producer efficiency by providing incentives to local governments to innovate in the production and supply of public goods and services (Martiacutenez-Vaacutezquez and McNab 2003) Over 30 years ago Oates (1972) argued that this allocative efficiency benefit becomes greater when there is a close match between revenue discretion and spending assignments at sub-national levels And such matching it is argued gives local government a stronger fiscal incentive to support local market development (Jin et al 2005) improves accountability of sub-national governments and reduces the distorting effects of intergovernmental transfers (Shah 1994)

Secondly Oates (1999) argues that by diversifying government output according to local preferences decentralization may attain higher levels of social welfare If preferences for public goods differ across regions uniform levels of public goods and services across jurisdictions will generally be inefficient The larger the variance in regional demands for public goods the larger the benefits of FD This diversification also allows residents to move to the community that best matches their demand for public goods and services and local tax rate Thus a lsquoTiebout sortingrsquo of individuals into demand-homogeneous jurisdictions further increases efficiency in resource allocation

Building on this Tiebout (1956) mechanism Brueckner (2006) proposes a model in which fiscal decentralization leads young and old consumers to live in separate jurisdictions according to their different demands for public services low and high This sorting increases after-tax income when young while reducing it when old increasing the incentive to save This stronger incentive in turn leads to an increase in investment in human capital and long-term economic growth However it is not necessary for individuals to have different

1 These arguments are reinforced where public good characteristics are local in nature (eg sharing economies or non-excludability aspects are geographically restricted)

mdash 8 mdash

Instituto de Estudios Fiscales

preferences for local public goods or be relatively mobile to obtain efficiency gains from FD Thiessen (2003) argues that as long as subnational governments better reflect the priorities of taxpayers this is sufficient for fiscal decentralization to offer efficiency advantages2

The theoretical effects of FD on economic growth are not unambiguously positive however Firstly FD may impact negatively on the distribution of public resources across jurisdictions since mobility of households and businesses can seriously constrain attempts to redistribute income Redistributional policies are likely to induce poor individuals to move into the jurisdiction while higher income individuals (who bear a greater tax burden) move out To the extent that income inequality retards economic growth (Persson and Tabellini 1994) FD might negatively affect growth by making redistribution more difficult Furthermore concentration of public goods with supra-local spillovers in a few geographical locations can also inhibit per capita growth because regional inequalities in infrastructure education healthcare and other public services may prevent full use of factors of production (Thiessen 2003) In this case more centralized public sectors might redistribute resources across jurisdictions leading to a more efficient distribution

Other economic arguments against FD include possible damage to macroeconomic stability via fiscal policy coordination problems (Tanzi 1996) inter-jurisdictional lsquoleakagesrsquo associated with local expenditures (Oates 1972)3 and failure to exploit economies of scale and scope (Prudrsquohomme 1995) In addition FD may lead local governments to engage in a lsquorace to the bottomrsquo on the taxation of mobile factors hence under-providing productive public expenditure (Brueckner 2004) or increase corruption because officials at the local level are closer to people and more susceptible to the demands of local interest groups (Prudrsquohomme 1995 Tanzi 1996)4 Finally Tanzi (1996)

2 A further argument in favour of FD is that it promotes competition among different levels of government resulting in a more efficient production of public goods under revenue constraints Such competition may prevent revenue maximisation by lsquomonopolyrsquo governments and the oversupply of public goods (Brennan and Buchanan 1980) 3 On the other hand Gramlich (1993) claims that if economic shocks are asymmetric then decentralised systems make it easier to achieve macroeconomic stability Shah (2006) also suggests that central bank independence is more likely attained under decentralized systems because the pressure of a unique central government diminishes leading to the presence of multiple governments with diverse and conflicting interests Finally Martiacutenez-Vaacutezquez and McNab (2003) maintain that a well designed fiscal decentralization system (preventing local governments to borrow without controls) avoids fiscal systems damaging macroeconomic stability 4 Martiacutenez-Vaacutezquez and McNab (2003) dispute this argument claiming that local officials are more visible to their constituents and thus corrupt behaviour is more visible than at the central level of government

mdash 9 mdash

suggests that the assumption that individuals freely move between municipalities may be unrealistic at least in the short term allowing local governments to be relatively unresponsive to local citizensrsquo preferences

In summary there are clearly argument for both positive and negative effects of fiscal decentralization on fiscal efficiency and economic growth rates It is perhaps not surprising then that the empirical literature discussed below has tended to find a variety of effects in different contexts

3 EMPIRICAL EVIDENCE ON FD AND ECONOMIC GROWTH

As a number of authors have noted there is surprisingly little research devoted to measuring the impact of fiscal decentralization on economic growth given that economic efficiency is the central argument used to support fiscal decentralization (Bardhan 2002 Martiacutenez-Vaacutezquez and McNab 2003) Among existing studies a mixed picture emerges of the effect of decentralization on growth rates Initial contributions summarised in table 1 tended to find that fiscal decentralization has a negative or negligible effect on economic growth (Davoodi and Zou 1998 Woller and Philips 1998 Zhang and Zou 1998 Xie et al 1999 and Jin and Zou 2005) These authors interpret their results as an indication that FD is already high such that further decentralization may be harmful for economic growth However many of these studies focus on developing or transition economies with China a specific focus of attention5

5 On China see also Lin and Liu (2000) and Jin et al (2005) who find some evidence of positive growth effects of FD Akai and Sakata (2002) also suggest that initial studies have a lsquocultural biasrsquo due to their use of cross-country data which fails to accommodate the various cultural historical and institutional differences between included countries

mdash 10 mdash

Tab

le 1

S U

MM

AR

Y O

F T

HE

EMP

IRIC

AL

LIT

ERA

TU

RE

Pap

ers

findi

ng a

neg

ativ

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Dav

oodi

amp

Zou

(1

998)

46 d

evel

opin

g amp

dev

elop

ed

coun

trie

s (U

nbal

ance

d pa

nel)

1970

shy19

89

5 an

d 10

ye

ar

aver

ages

of

grow

th in

re

al p

er

capi

ta o

utpu

t

Pane

l T

wo

way

fixe

d ef

fect

s

1 D

irect

spen

ding

by

subn

atio

nal

gove

rnm

ents

(net

of

inte

rgov

ernm

enta

l tr

ansfe

rs) a

s a sh

are

of

gene

ral g

over

nmen

t sp

endi

ng

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

tax

reve

nues

to G

DP

Ave

rage

gro

wth

rat

e of

pop

ulat

ion

initi

al

seco

ndar

y sc

hool

en

rolm

ent r

ate

initi

al

per c

apita

GD

P

inve

stm

ent s

hare

to

GD

P

In d

evel

oped

cou

ntrie

s

ther

e is

no r

elat

ions

hip

betw

een

FD a

nd g

row

th

whe

reas

this

asso

ciat

ion

is ne

gativ

e in

dev

elop

ing

coun

trie

s A

vera

ge ta

x ra

te

affe

cts

grow

th n

egat

ivel

y

Fisc

al p

olic

y gr

owth

ef

fect

s ar

e m

ore

rela

ted

to fu

nctio

nal

gove

rnm

ent s

pend

ing

com

posit

ion

Rev

enue

as

signm

ent a

mon

g le

vels

of g

over

nmen

t m

ay b

e lsquow

rong

rsquo

Wol

ler

and

Phill

ips

(199

8)

23 L

DC

s co

untr

ies

Perio

d 19

74shy

1991

Ann

ual

3 or

5

year

av

erag

es o

f pe

r cap

ita

grow

th r

ate

Pane

l O

ne

way

fixe

d ef

fect

s

1 L

ocal

gove

rnm

ent

shar

e in

tota

l go

vern

men

t rev

enue

s or

spen

ding

2

Loc

al go

vern

men

t sh

are

(exc

ludi

ng

gran

ts-in

-aid

) in

tota

l re

venu

es

3 L

ocal

gove

rnm

ent

shar

e in

tota

l spe

ndin

g (le

ss d

efen

ce amp

socia

l w

elfa

re)

mdash

Initi

al G

DP

in

vest

men

t se

cond

ary

scho

ol

enro

lmen

t and

po

pula

tion

grow

th

Robu

st o

penn

ess

in

flatio

n le

vel amp

va

rianc

e p

oliti

cal amp

fin

anci

al v

aria

bles

No

stro

ng a

ssoc

iatio

n be

twee

n FD

and

ec

onom

ic g

row

th in

LD

Cs

At b

est

wea

k in

vers

e re

latio

nshi

p be

twee

n re

venu

e FD

and

gr

owth

whe

n us

ing

five

year

s av

erag

es

FD d

oes

not a

ffect

ec

onom

ic g

row

th a

t na

tiona

l lev

el a

mon

g LD

Cs

It c

an a

ffect

ec

onom

ic

deve

lopm

ent a

t the

lo

cal l

evel

in L

DC

s

Zha

ng amp

Z

ou

(199

8)

28 C

hine

se

prov

ince

s

1986

-199

2

Real

gro

wth

ra

te o

f pr

ovin

cial

in

com

e

Pane

l O

ne

way

fixe

d ef

fect

s

1 R

atio

of p

er c

apita

co

nsol

idat

ed (o

r bu

dget

ary

prov

inci

al)

spen

ding

to p

er c

apita

co

nsol

idat

ed o

r

Cen

tral

and

pr

ovin

cial

re

venu

e to

na

tiona

l GD

P Fu

nctio

nal

Labo

r fo

rce

grow

th

rate

inv

estm

ent

rate

ope

nnes

s

infla

tion

rate

A hi

gher

deg

ree

of sp

endi

ng

fisca

l dec

entr

aliz

atio

n is

asso

ciat

ed w

ith lo

wer

pr

ovin

cial

eco

nom

ic

grow

th in

Chi

na C

entr

al

If lo

cal s

pend

ing

is al

read

y hi

gh f

urth

er

dece

ntra

lizat

ion

may

re

sult

in s

low

er

grow

th

(Sig

ue)

(Con

tinua

cioacuten

)

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Zha

ng amp

Z

ou

(199

8)

(Ext

ende

d ca

se 1

980-

9)

budg

etar

y ce

ntra

l sp

endi

ng

2 R

atio

of p

rovi

ncial

ex

tra-

budg

etar

y sp

endi

ng sh

are

in

inco

me

to c

entr

al ex

tra-

budg

etar

y sp

endi

ng sh

are

of

inco

me

com

posit

ion

of

cent

ral a

nd

prov

inci

al

budg

etar

y sp

endi

ng

and

prov

inci

al ta

x ra

te

have

neg

ativ

e ef

fect

s on

gr

owth

but

not

sig

nific

ant

Cen

tral

gov

ernm

ent

may

be

in a

bet

ter

posit

ion

to u

nder

take

pu

blic

inve

stm

ent w

ith

exte

rnal

ities

whe

n th

e co

untr

y is

deve

lopi

ng

Xie

et a

l (1

999)

U

S 19

48 shy

1994

Re

al p

er

capi

tal

outp

ut

grow

th r

ate

Tim

e se

ries

1 S

hare

of s

pend

ing

by e

ach

leve

l of

subn

atio

nal

gove

rnm

ent (

loca

l an

d st

ate)

in to

tal

gove

rnm

ent s

pend

ing

(exc

ludi

ng fe

dera

l gr

ants

to lo

wer

leve

ls of

gov

ernm

ent)

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

go

vern

men

t re

ceip

ts to

GD

P

Labo

ur fo

rce

adju

sted

for

educ

atio

n le

vels

in

vest

men

t en

ergy

pr

ices

ope

nnes

s

infla

tion

amp G

ini (

all

varia

bles

in g

row

th

rate

s)

Loca

l spe

ndin

g re

duce

s gr

owth

tho

ugh

low

sig

nific

ance

leve

ls S

tate

sp

endi

ng a

nd c

ombi

ned

stat

e an

d lo

cal s

pend

ing

are

high

ly in

signi

fican

t A

vera

ge ta

x ra

te n

egat

ive

but n

ot s

igni

fican

t

The

insig

nific

ant

coef

ficie

nts

on lo

cal

and

stat

e sp

endi

ng

shar

es m

ay im

ply

that

ex

istin

g FD

has

bee

n co

nsist

ent w

ith g

row

th

max

imiza

tion

Fur

ther

de

cent

raliz

atio

n in

pu

blic

spe

ndin

g m

ay b

e ha

rmfu

l for

gro

wth

Jin amp

Zou

(2

005)

30

Chi

nese

pr

ovin

ces

1979

-199

3 amp

1994

-199

9 (t

wo

diffe

rent

fis

cal

regi

mes

)

Real

GD

P gr

owth

rat

e Pa

nel

One

w

ay fi

xed

effe

cts

No

time

dum

mie

s

1 P

rovi

ncia

l sha

re i

n to

tal b

udge

tary

ex

pend

iture

or

reve

nue

2 P

rovi

ncia

l sh

are

in to

tal e

xtra

shybu

dget

ary

expe

nditu

re o

r re

venu

e

Cen

tral

and

pr

ovin

cial

tax

rate

m

easu

red

by th

e ra

tio o

f cen

tral

ta

x re

venu

es amp

pr

ovin

cial

tax

reve

nues

to G

DP

Prov

inci

al

inve

stm

ent

labo

ur

forc

e gr

owth

rat

e

open

ness

lag

ged

infla

tion

1979

-199

3 g

row

th is

ne

gativ

ely

asso

ciat

ed w

ith

expe

nditu

re F

D amp

po

sitiv

ely

with

rev

enue

FD

199

4-19

99 g

row

th

has

no s

igni

fican

t lin

k w

ith

prov

inci

al e

xpen

ditu

re

and

is ne

gativ

ely

affe

cted

by

pro

vinc

ial r

even

ue

Con

vent

iona

l wisd

om

(tha

t loc

al r

even

ue

shou

ld m

atch

ex

pend

iture

as

clos

e as

po

ssib

le a

t sub

-nat

iona

l le

vel t

o im

prov

e ef

ficie

ncy

and

prom

ote

grow

th) d

oes

not a

pply

to

Chi

na

Pap

ers

findi

ng a

pos

itiv

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Lin

and

Liu

(200

0)

28 C

hine

se

prov

ince

s 19

70-1

993

Gro

wth

rat

e of

rea

l per

ca

pita

GD

P

Tw

o w

ay

fixed

effe

cts

1 M

argi

nal r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

2 A

vera

ge r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

Fisc

al c

apac

ity

(pro

xy b

y m

ovin

g av

erag

e of

per

ca

pita

GD

P)

Popu

latio

n p

er

capi

ta in

vest

men

t gr

owth

rur

al

popu

latio

n sh

are

re

lativ

e fa

rm p

rices

im

plem

enta

tion

of

agric

ultu

ral r

efor

m

priv

ate

firm

s sh

are

in

indu

stria

l out

put

FD h

as a

pos

itive

effe

ct o

n gr

owth

Thi

s ef

fect

is

high

er w

hen

usin

g th

e m

argi

nal r

eten

tion

rate

Lo

ng-r

un e

ffect

s ar

e ca

ptur

ed b

y la

ggin

g FD

fin

ding

larg

er e

ffect

s on

gr

owth

than

with

cur

rent

FD

The

mar

gina

l ret

entio

n ra

te is

a b

ette

r m

easu

re

than

ave

rage

ret

entio

n ra

te F

D h

as in

crea

sed

grow

th in

Chi

na b

y im

prov

ing

effic

ienc

y of

re

sour

ce a

lloca

tion

rath

er th

an b

y in

duci

ng

mor

e in

vest

men

t

Aka

i amp

Saka

ta

(200

2)

50 U

S st

ates

19

92-1

996

(ave

rage

) Su

b pe

riods

19

92-1

994

amp

1994

-199

6

Ave

rage

G

row

th r

ate

of r

eal p

er

capi

ta g

ross

st

ate

prod

uct

Cro

ss

sect

ion(

One

w

ay fi

xed

effe

cts)

1 Lo

cal g

over

nmen

t re

venu

e or

spe

ndin

g sh

are

in s

tate

+ lo

cal

gove

rnm

ent r

even

ue

or s

pend

ing

2 R

atio

of l

ocal

go

vern

men

trsquos o

wn

reve

nue

to s

tate

+

loca

l rev

enue

3

Ave

rage

of r

even

ue

and

spen

ding

FD

of

indi

cato

r 1

Thi

s st

udy

do n

ot

cont

rol f

or p

ublic

se

ctor

siz

e

Popu

latio

n gr

owth

la

gged

gro

wth

rat

e

high

sch

ool

enro

lmen

t rat

io

pre-

tax

inco

me

Gin

i co

effic

ient

sou

ther

n st

ates

dum

my

st

atersquo

s sh

are

in U

S pa

tent

s o

penn

ess

de

moc

rats

sea

ts

Spen

ding

FD

and

the

aver

age

of s

pend

ing

and

reve

nue

FD (i

ndic

ator

3)

affe

ct g

row

th p

ositi

vely

Re

venu

e FD

and

fisc

al

auto

nom

y (in

dica

tor

2) d

o no

t sig

nific

antly

affe

ct

grow

th

Prio

r ne

gativ

e ef

fect

s w

ere

due

to th

e us

e of

da

ta fo

r co

untr

ies

that

w

ere

in e

arly

sta

ges

of

deve

lopm

ent a

nd w

ith

larg

e di

ffere

nces

in

hist

ory

and

cultu

re

Thi

esse

n (2

003)

A

vera

ges

for

21 O

ECD

(amp

4 m

iddl

e in

com

e)

coun

trie

s

Perio

d ov

er

the

perio

d 19

73-1

998

Ave

rage

gr

owth

of

inco

me

per

wor

king

-age

pe

rson

Cro

ss

coun

try

1 L

ocal

sh

are

in

cons

olid

ated

go

vern

men

t sp

endi

ng

or r

even

ue

and

the

aver

age

of

the

two

2 T

rans

form

atio

n of

m

easu

re 1

to

capt

ure

non-

linea

ritie

s

Publ

ic

cons

umpt

ion

to

GD

P an

d th

e fis

cal b

alan

ce a

re

incl

uded

as

robu

stne

ss

chec

ks (r

esul

ts

not r

epor

ted)

Initi

al in

com

e pe

r w

orke

r in

vest

men

t sc

hool

enr

olm

ent

sum

of w

orki

ng-a

ge

popu

latio

n gr

owth

te

chno

logy

gro

wth

de

prec

iatio

n ra

te

vola

tility

ope

nnes

s

Spen

ding

and

lsquoave

rage

rsquo FD

ha

ve a

pos

itive

sig

nific

ant

effe

ct o

n gr

owth

(but

not

ro

bust

) M

ore

robu

st

indi

cato

r 2

show

ing

a no

n-lin

ear

asso

ciat

ion

betw

een

FD a

nd g

row

th R

even

ue

FD a

nd se

lf-re

lianc

e

FD p

rom

otes

ec

onom

ic g

row

th

How

ever

ther

e is

a hu

mp

shap

ed

asso

ciat

ion

betw

een

FD a

nd g

row

th

indi

catin

g an

opt

imal

de

gree

of F

D th

at (Sig

ue)

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

Instituto de Estudios Fiscales

preferences for local public goods or be relatively mobile to obtain efficiency gains from FD Thiessen (2003) argues that as long as subnational governments better reflect the priorities of taxpayers this is sufficient for fiscal decentralization to offer efficiency advantages2

The theoretical effects of FD on economic growth are not unambiguously positive however Firstly FD may impact negatively on the distribution of public resources across jurisdictions since mobility of households and businesses can seriously constrain attempts to redistribute income Redistributional policies are likely to induce poor individuals to move into the jurisdiction while higher income individuals (who bear a greater tax burden) move out To the extent that income inequality retards economic growth (Persson and Tabellini 1994) FD might negatively affect growth by making redistribution more difficult Furthermore concentration of public goods with supra-local spillovers in a few geographical locations can also inhibit per capita growth because regional inequalities in infrastructure education healthcare and other public services may prevent full use of factors of production (Thiessen 2003) In this case more centralized public sectors might redistribute resources across jurisdictions leading to a more efficient distribution

Other economic arguments against FD include possible damage to macroeconomic stability via fiscal policy coordination problems (Tanzi 1996) inter-jurisdictional lsquoleakagesrsquo associated with local expenditures (Oates 1972)3 and failure to exploit economies of scale and scope (Prudrsquohomme 1995) In addition FD may lead local governments to engage in a lsquorace to the bottomrsquo on the taxation of mobile factors hence under-providing productive public expenditure (Brueckner 2004) or increase corruption because officials at the local level are closer to people and more susceptible to the demands of local interest groups (Prudrsquohomme 1995 Tanzi 1996)4 Finally Tanzi (1996)

2 A further argument in favour of FD is that it promotes competition among different levels of government resulting in a more efficient production of public goods under revenue constraints Such competition may prevent revenue maximisation by lsquomonopolyrsquo governments and the oversupply of public goods (Brennan and Buchanan 1980) 3 On the other hand Gramlich (1993) claims that if economic shocks are asymmetric then decentralised systems make it easier to achieve macroeconomic stability Shah (2006) also suggests that central bank independence is more likely attained under decentralized systems because the pressure of a unique central government diminishes leading to the presence of multiple governments with diverse and conflicting interests Finally Martiacutenez-Vaacutezquez and McNab (2003) maintain that a well designed fiscal decentralization system (preventing local governments to borrow without controls) avoids fiscal systems damaging macroeconomic stability 4 Martiacutenez-Vaacutezquez and McNab (2003) dispute this argument claiming that local officials are more visible to their constituents and thus corrupt behaviour is more visible than at the central level of government

mdash 9 mdash

suggests that the assumption that individuals freely move between municipalities may be unrealistic at least in the short term allowing local governments to be relatively unresponsive to local citizensrsquo preferences

In summary there are clearly argument for both positive and negative effects of fiscal decentralization on fiscal efficiency and economic growth rates It is perhaps not surprising then that the empirical literature discussed below has tended to find a variety of effects in different contexts

3 EMPIRICAL EVIDENCE ON FD AND ECONOMIC GROWTH

As a number of authors have noted there is surprisingly little research devoted to measuring the impact of fiscal decentralization on economic growth given that economic efficiency is the central argument used to support fiscal decentralization (Bardhan 2002 Martiacutenez-Vaacutezquez and McNab 2003) Among existing studies a mixed picture emerges of the effect of decentralization on growth rates Initial contributions summarised in table 1 tended to find that fiscal decentralization has a negative or negligible effect on economic growth (Davoodi and Zou 1998 Woller and Philips 1998 Zhang and Zou 1998 Xie et al 1999 and Jin and Zou 2005) These authors interpret their results as an indication that FD is already high such that further decentralization may be harmful for economic growth However many of these studies focus on developing or transition economies with China a specific focus of attention5

5 On China see also Lin and Liu (2000) and Jin et al (2005) who find some evidence of positive growth effects of FD Akai and Sakata (2002) also suggest that initial studies have a lsquocultural biasrsquo due to their use of cross-country data which fails to accommodate the various cultural historical and institutional differences between included countries

mdash 10 mdash

Tab

le 1

S U

MM

AR

Y O

F T

HE

EMP

IRIC

AL

LIT

ERA

TU

RE

Pap

ers

findi

ng a

neg

ativ

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Dav

oodi

amp

Zou

(1

998)

46 d

evel

opin

g amp

dev

elop

ed

coun

trie

s (U

nbal

ance

d pa

nel)

1970

shy19

89

5 an

d 10

ye

ar

aver

ages

of

grow

th in

re

al p

er

capi

ta o

utpu

t

Pane

l T

wo

way

fixe

d ef

fect

s

1 D

irect

spen

ding

by

subn

atio

nal

gove

rnm

ents

(net

of

inte

rgov

ernm

enta

l tr

ansfe

rs) a

s a sh

are

of

gene

ral g

over

nmen

t sp

endi

ng

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

tax

reve

nues

to G

DP

Ave

rage

gro

wth

rat

e of

pop

ulat

ion

initi

al

seco

ndar

y sc

hool

en

rolm

ent r

ate

initi

al

per c

apita

GD

P

inve

stm

ent s

hare

to

GD

P

In d

evel

oped

cou

ntrie

s

ther

e is

no r

elat

ions

hip

betw

een

FD a

nd g

row

th

whe

reas

this

asso

ciat

ion

is ne

gativ

e in

dev

elop

ing

coun

trie

s A

vera

ge ta

x ra

te

affe

cts

grow

th n

egat

ivel

y

Fisc

al p

olic

y gr

owth

ef

fect

s ar

e m

ore

rela

ted

to fu

nctio

nal

gove

rnm

ent s

pend

ing

com

posit

ion

Rev

enue

as

signm

ent a

mon

g le

vels

of g

over

nmen

t m

ay b

e lsquow

rong

rsquo

Wol

ler

and

Phill

ips

(199

8)

23 L

DC

s co

untr

ies

Perio

d 19

74shy

1991

Ann

ual

3 or

5

year

av

erag

es o

f pe

r cap

ita

grow

th r

ate

Pane

l O

ne

way

fixe

d ef

fect

s

1 L

ocal

gove

rnm

ent

shar

e in

tota

l go

vern

men

t rev

enue

s or

spen

ding

2

Loc

al go

vern

men

t sh

are

(exc

ludi

ng

gran

ts-in

-aid

) in

tota

l re

venu

es

3 L

ocal

gove

rnm

ent

shar

e in

tota

l spe

ndin

g (le

ss d

efen

ce amp

socia

l w

elfa

re)

mdash

Initi

al G

DP

in

vest

men

t se

cond

ary

scho

ol

enro

lmen

t and

po

pula

tion

grow

th

Robu

st o

penn

ess

in

flatio

n le

vel amp

va

rianc

e p

oliti

cal amp

fin

anci

al v

aria

bles

No

stro

ng a

ssoc

iatio

n be

twee

n FD

and

ec

onom

ic g

row

th in

LD

Cs

At b

est

wea

k in

vers

e re

latio

nshi

p be

twee

n re

venu

e FD

and

gr

owth

whe

n us

ing

five

year

s av

erag

es

FD d

oes

not a

ffect

ec

onom

ic g

row

th a

t na

tiona

l lev

el a

mon

g LD

Cs

It c

an a

ffect

ec

onom

ic

deve

lopm

ent a

t the

lo

cal l

evel

in L

DC

s

Zha

ng amp

Z

ou

(199

8)

28 C

hine

se

prov

ince

s

1986

-199

2

Real

gro

wth

ra

te o

f pr

ovin

cial

in

com

e

Pane

l O

ne

way

fixe

d ef

fect

s

1 R

atio

of p

er c

apita

co

nsol

idat

ed (o

r bu

dget

ary

prov

inci

al)

spen

ding

to p

er c

apita

co

nsol

idat

ed o

r

Cen

tral

and

pr

ovin

cial

re

venu

e to

na

tiona

l GD

P Fu

nctio

nal

Labo

r fo

rce

grow

th

rate

inv

estm

ent

rate

ope

nnes

s

infla

tion

rate

A hi

gher

deg

ree

of sp

endi

ng

fisca

l dec

entr

aliz

atio

n is

asso

ciat

ed w

ith lo

wer

pr

ovin

cial

eco

nom

ic

grow

th in

Chi

na C

entr

al

If lo

cal s

pend

ing

is al

read

y hi

gh f

urth

er

dece

ntra

lizat

ion

may

re

sult

in s

low

er

grow

th

(Sig

ue)

(Con

tinua

cioacuten

)

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Zha

ng amp

Z

ou

(199

8)

(Ext

ende

d ca

se 1

980-

9)

budg

etar

y ce

ntra

l sp

endi

ng

2 R

atio

of p

rovi

ncial

ex

tra-

budg

etar

y sp

endi

ng sh

are

in

inco

me

to c

entr

al ex

tra-

budg

etar

y sp

endi

ng sh

are

of

inco

me

com

posit

ion

of

cent

ral a

nd

prov

inci

al

budg

etar

y sp

endi

ng

and

prov

inci

al ta

x ra

te

have

neg

ativ

e ef

fect

s on

gr

owth

but

not

sig

nific

ant

Cen

tral

gov

ernm

ent

may

be

in a

bet

ter

posit

ion

to u

nder

take

pu

blic

inve

stm

ent w

ith

exte

rnal

ities

whe

n th

e co

untr

y is

deve

lopi

ng

Xie

et a

l (1

999)

U

S 19

48 shy

1994

Re

al p

er

capi

tal

outp

ut

grow

th r

ate

Tim

e se

ries

1 S

hare

of s

pend

ing

by e

ach

leve

l of

subn

atio

nal

gove

rnm

ent (

loca

l an

d st

ate)

in to

tal

gove

rnm

ent s

pend

ing

(exc

ludi

ng fe

dera

l gr

ants

to lo

wer

leve

ls of

gov

ernm

ent)

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

go

vern

men

t re

ceip

ts to

GD

P

Labo

ur fo

rce

adju

sted

for

educ

atio

n le

vels

in

vest

men

t en

ergy

pr

ices

ope

nnes

s

infla

tion

amp G

ini (

all

varia

bles

in g

row

th

rate

s)

Loca

l spe

ndin

g re

duce

s gr

owth

tho

ugh

low

sig

nific

ance

leve

ls S

tate

sp

endi

ng a

nd c

ombi

ned

stat

e an

d lo

cal s

pend

ing

are

high

ly in

signi

fican

t A

vera

ge ta

x ra

te n

egat

ive

but n

ot s

igni

fican

t

The

insig

nific

ant

coef

ficie

nts

on lo

cal

and

stat

e sp

endi

ng

shar

es m

ay im

ply

that

ex

istin

g FD

has

bee

n co

nsist

ent w

ith g

row

th

max

imiza

tion

Fur

ther

de

cent

raliz

atio

n in

pu

blic

spe

ndin

g m

ay b

e ha

rmfu

l for

gro

wth

Jin amp

Zou

(2

005)

30

Chi

nese

pr

ovin

ces

1979

-199

3 amp

1994

-199

9 (t

wo

diffe

rent

fis

cal

regi

mes

)

Real

GD

P gr

owth

rat

e Pa

nel

One

w

ay fi

xed

effe

cts

No

time

dum

mie

s

1 P

rovi

ncia

l sha

re i

n to

tal b

udge

tary

ex

pend

iture

or

reve

nue

2 P

rovi

ncia

l sh

are

in to

tal e

xtra

shybu

dget

ary

expe

nditu

re o

r re

venu

e

Cen

tral

and

pr

ovin

cial

tax

rate

m

easu

red

by th

e ra

tio o

f cen

tral

ta

x re

venu

es amp

pr

ovin

cial

tax

reve

nues

to G

DP

Prov

inci

al

inve

stm

ent

labo

ur

forc

e gr

owth

rat

e

open

ness

lag

ged

infla

tion

1979

-199

3 g

row

th is

ne

gativ

ely

asso

ciat

ed w

ith

expe

nditu

re F

D amp

po

sitiv

ely

with

rev

enue

FD

199

4-19

99 g

row

th

has

no s

igni

fican

t lin

k w

ith

prov

inci

al e

xpen

ditu

re

and

is ne

gativ

ely

affe

cted

by

pro

vinc

ial r

even

ue

Con

vent

iona

l wisd

om

(tha

t loc

al r

even

ue

shou

ld m

atch

ex

pend

iture

as

clos

e as

po

ssib

le a

t sub

-nat

iona

l le

vel t

o im

prov

e ef

ficie

ncy

and

prom

ote

grow

th) d

oes

not a

pply

to

Chi

na

Pap

ers

findi

ng a

pos

itiv

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Lin

and

Liu

(200

0)

28 C

hine

se

prov

ince

s 19

70-1

993

Gro

wth

rat

e of

rea

l per

ca

pita

GD

P

Tw

o w

ay

fixed

effe

cts

1 M

argi

nal r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

2 A

vera

ge r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

Fisc

al c

apac

ity

(pro

xy b

y m

ovin

g av

erag

e of

per

ca

pita

GD

P)

Popu

latio

n p

er

capi

ta in

vest

men

t gr

owth

rur

al

popu

latio

n sh

are

re

lativ

e fa

rm p

rices

im

plem

enta

tion

of

agric

ultu

ral r

efor

m

priv

ate

firm

s sh

are

in

indu

stria

l out

put

FD h

as a

pos

itive

effe

ct o

n gr

owth

Thi

s ef

fect

is

high

er w

hen

usin

g th

e m

argi

nal r

eten

tion

rate

Lo

ng-r

un e

ffect

s ar

e ca

ptur

ed b

y la

ggin

g FD

fin

ding

larg

er e

ffect

s on

gr

owth

than

with

cur

rent

FD

The

mar

gina

l ret

entio

n ra

te is

a b

ette

r m

easu

re

than

ave

rage

ret

entio

n ra

te F

D h

as in

crea

sed

grow

th in

Chi

na b

y im

prov

ing

effic

ienc

y of

re

sour

ce a

lloca

tion

rath

er th

an b

y in

duci

ng

mor

e in

vest

men

t

Aka

i amp

Saka

ta

(200

2)

50 U

S st

ates

19

92-1

996

(ave

rage

) Su

b pe

riods

19

92-1

994

amp

1994

-199

6

Ave

rage

G

row

th r

ate

of r

eal p

er

capi

ta g

ross

st

ate

prod

uct

Cro

ss

sect

ion(

One

w

ay fi

xed

effe

cts)

1 Lo

cal g

over

nmen

t re

venu

e or

spe

ndin

g sh

are

in s

tate

+ lo

cal

gove

rnm

ent r

even

ue

or s

pend

ing

2 R

atio

of l

ocal

go

vern

men

trsquos o

wn

reve

nue

to s

tate

+

loca

l rev

enue

3

Ave

rage

of r

even

ue

and

spen

ding

FD

of

indi

cato

r 1

Thi

s st

udy

do n

ot

cont

rol f

or p

ublic

se

ctor

siz

e

Popu

latio

n gr

owth

la

gged

gro

wth

rat

e

high

sch

ool

enro

lmen

t rat

io

pre-

tax

inco

me

Gin

i co

effic

ient

sou

ther

n st

ates

dum

my

st

atersquo

s sh

are

in U

S pa

tent

s o

penn

ess

de

moc

rats

sea

ts

Spen

ding

FD

and

the

aver

age

of s

pend

ing

and

reve

nue

FD (i

ndic

ator

3)

affe

ct g

row

th p

ositi

vely

Re

venu

e FD

and

fisc

al

auto

nom

y (in

dica

tor

2) d

o no

t sig

nific

antly

affe

ct

grow

th

Prio

r ne

gativ

e ef

fect

s w

ere

due

to th

e us

e of

da

ta fo

r co

untr

ies

that

w

ere

in e

arly

sta

ges

of

deve

lopm

ent a

nd w

ith

larg

e di

ffere

nces

in

hist

ory

and

cultu

re

Thi

esse

n (2

003)

A

vera

ges

for

21 O

ECD

(amp

4 m

iddl

e in

com

e)

coun

trie

s

Perio

d ov

er

the

perio

d 19

73-1

998

Ave

rage

gr

owth

of

inco

me

per

wor

king

-age

pe

rson

Cro

ss

coun

try

1 L

ocal

sh

are

in

cons

olid

ated

go

vern

men

t sp

endi

ng

or r

even

ue

and

the

aver

age

of

the

two

2 T

rans

form

atio

n of

m

easu

re 1

to

capt

ure

non-

linea

ritie

s

Publ

ic

cons

umpt

ion

to

GD

P an

d th

e fis

cal b

alan

ce a

re

incl

uded

as

robu

stne

ss

chec

ks (r

esul

ts

not r

epor

ted)

Initi

al in

com

e pe

r w

orke

r in

vest

men

t sc

hool

enr

olm

ent

sum

of w

orki

ng-a

ge

popu

latio

n gr

owth

te

chno

logy

gro

wth

de

prec

iatio

n ra

te

vola

tility

ope

nnes

s

Spen

ding

and

lsquoave

rage

rsquo FD

ha

ve a

pos

itive

sig

nific

ant

effe

ct o

n gr

owth

(but

not

ro

bust

) M

ore

robu

st

indi

cato

r 2

show

ing

a no

n-lin

ear

asso

ciat

ion

betw

een

FD a

nd g

row

th R

even

ue

FD a

nd se

lf-re

lianc

e

FD p

rom

otes

ec

onom

ic g

row

th

How

ever

ther

e is

a hu

mp

shap

ed

asso

ciat

ion

betw

een

FD a

nd g

row

th

indi

catin

g an

opt

imal

de

gree

of F

D th

at (Sig

ue)

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

suggests that the assumption that individuals freely move between municipalities may be unrealistic at least in the short term allowing local governments to be relatively unresponsive to local citizensrsquo preferences

In summary there are clearly argument for both positive and negative effects of fiscal decentralization on fiscal efficiency and economic growth rates It is perhaps not surprising then that the empirical literature discussed below has tended to find a variety of effects in different contexts

3 EMPIRICAL EVIDENCE ON FD AND ECONOMIC GROWTH

As a number of authors have noted there is surprisingly little research devoted to measuring the impact of fiscal decentralization on economic growth given that economic efficiency is the central argument used to support fiscal decentralization (Bardhan 2002 Martiacutenez-Vaacutezquez and McNab 2003) Among existing studies a mixed picture emerges of the effect of decentralization on growth rates Initial contributions summarised in table 1 tended to find that fiscal decentralization has a negative or negligible effect on economic growth (Davoodi and Zou 1998 Woller and Philips 1998 Zhang and Zou 1998 Xie et al 1999 and Jin and Zou 2005) These authors interpret their results as an indication that FD is already high such that further decentralization may be harmful for economic growth However many of these studies focus on developing or transition economies with China a specific focus of attention5

5 On China see also Lin and Liu (2000) and Jin et al (2005) who find some evidence of positive growth effects of FD Akai and Sakata (2002) also suggest that initial studies have a lsquocultural biasrsquo due to their use of cross-country data which fails to accommodate the various cultural historical and institutional differences between included countries

mdash 10 mdash

Tab

le 1

S U

MM

AR

Y O

F T

HE

EMP

IRIC

AL

LIT

ERA

TU

RE

Pap

ers

findi

ng a

neg

ativ

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Dav

oodi

amp

Zou

(1

998)

46 d

evel

opin

g amp

dev

elop

ed

coun

trie

s (U

nbal

ance

d pa

nel)

1970

shy19

89

5 an

d 10

ye

ar

aver

ages

of

grow

th in

re

al p

er

capi

ta o

utpu

t

Pane

l T

wo

way

fixe

d ef

fect

s

1 D

irect

spen

ding

by

subn

atio

nal

gove

rnm

ents

(net

of

inte

rgov

ernm

enta

l tr

ansfe

rs) a

s a sh

are

of

gene

ral g

over

nmen

t sp

endi

ng

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

tax

reve

nues

to G

DP

Ave

rage

gro

wth

rat

e of

pop

ulat

ion

initi

al

seco

ndar

y sc

hool

en

rolm

ent r

ate

initi

al

per c

apita

GD

P

inve

stm

ent s

hare

to

GD

P

In d

evel

oped

cou

ntrie

s

ther

e is

no r

elat

ions

hip

betw

een

FD a

nd g

row

th

whe

reas

this

asso

ciat

ion

is ne

gativ

e in

dev

elop

ing

coun

trie

s A

vera

ge ta

x ra

te

affe

cts

grow

th n

egat

ivel

y

Fisc

al p

olic

y gr

owth

ef

fect

s ar

e m

ore

rela

ted

to fu

nctio

nal

gove

rnm

ent s

pend

ing

com

posit

ion

Rev

enue

as

signm

ent a

mon

g le

vels

of g

over

nmen

t m

ay b

e lsquow

rong

rsquo

Wol

ler

and

Phill

ips

(199

8)

23 L

DC

s co

untr

ies

Perio

d 19

74shy

1991

Ann

ual

3 or

5

year

av

erag

es o

f pe

r cap

ita

grow

th r

ate

Pane

l O

ne

way

fixe

d ef

fect

s

1 L

ocal

gove

rnm

ent

shar

e in

tota

l go

vern

men

t rev

enue

s or

spen

ding

2

Loc

al go

vern

men

t sh

are

(exc

ludi

ng

gran

ts-in

-aid

) in

tota

l re

venu

es

3 L

ocal

gove

rnm

ent

shar

e in

tota

l spe

ndin

g (le

ss d

efen

ce amp

socia

l w

elfa

re)

mdash

Initi

al G

DP

in

vest

men

t se

cond

ary

scho

ol

enro

lmen

t and

po

pula

tion

grow

th

Robu

st o

penn

ess

in

flatio

n le

vel amp

va

rianc

e p

oliti

cal amp

fin

anci

al v

aria

bles

No

stro

ng a

ssoc

iatio

n be

twee

n FD

and

ec

onom

ic g

row

th in

LD

Cs

At b

est

wea

k in

vers

e re

latio

nshi

p be

twee

n re

venu

e FD

and

gr

owth

whe

n us

ing

five

year

s av

erag

es

FD d

oes

not a

ffect

ec

onom

ic g

row

th a

t na

tiona

l lev

el a

mon

g LD

Cs

It c

an a

ffect

ec

onom

ic

deve

lopm

ent a

t the

lo

cal l

evel

in L

DC

s

Zha

ng amp

Z

ou

(199

8)

28 C

hine

se

prov

ince

s

1986

-199

2

Real

gro

wth

ra

te o

f pr

ovin

cial

in

com

e

Pane

l O

ne

way

fixe

d ef

fect

s

1 R

atio

of p

er c

apita

co

nsol

idat

ed (o

r bu

dget

ary

prov

inci

al)

spen

ding

to p

er c

apita

co

nsol

idat

ed o

r

Cen

tral

and

pr

ovin

cial

re

venu

e to

na

tiona

l GD

P Fu

nctio

nal

Labo

r fo

rce

grow

th

rate

inv

estm

ent

rate

ope

nnes

s

infla

tion

rate

A hi

gher

deg

ree

of sp

endi

ng

fisca

l dec

entr

aliz

atio

n is

asso

ciat

ed w

ith lo

wer

pr

ovin

cial

eco

nom

ic

grow

th in

Chi

na C

entr

al

If lo

cal s

pend

ing

is al

read

y hi

gh f

urth

er

dece

ntra

lizat

ion

may

re

sult

in s

low

er

grow

th

(Sig

ue)

(Con

tinua

cioacuten

)

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Zha

ng amp

Z

ou

(199

8)

(Ext

ende

d ca

se 1

980-

9)

budg

etar

y ce

ntra

l sp

endi

ng

2 R

atio

of p

rovi

ncial

ex

tra-

budg

etar

y sp

endi

ng sh

are

in

inco

me

to c

entr

al ex

tra-

budg

etar

y sp

endi

ng sh

are

of

inco

me

com

posit

ion

of

cent

ral a

nd

prov

inci

al

budg

etar

y sp

endi

ng

and

prov

inci

al ta

x ra

te

have

neg

ativ

e ef

fect

s on

gr

owth

but

not

sig

nific

ant

Cen

tral

gov

ernm

ent

may

be

in a

bet

ter

posit

ion

to u

nder

take

pu

blic

inve

stm

ent w

ith

exte

rnal

ities

whe

n th

e co

untr

y is

deve

lopi

ng

Xie

et a

l (1

999)

U

S 19

48 shy

1994

Re

al p

er

capi

tal

outp

ut

grow

th r

ate

Tim

e se

ries

1 S

hare

of s

pend

ing

by e

ach

leve

l of

subn

atio

nal

gove

rnm

ent (

loca

l an

d st

ate)

in to

tal

gove

rnm

ent s

pend

ing

(exc

ludi

ng fe

dera

l gr

ants

to lo

wer

leve

ls of

gov

ernm

ent)

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

go

vern

men

t re

ceip

ts to

GD

P

Labo

ur fo

rce

adju

sted

for

educ

atio

n le

vels

in

vest

men

t en

ergy

pr

ices

ope

nnes

s

infla

tion

amp G

ini (

all

varia

bles

in g

row

th

rate

s)

Loca

l spe

ndin

g re

duce

s gr

owth

tho

ugh

low

sig

nific

ance

leve

ls S

tate

sp

endi

ng a

nd c

ombi

ned

stat

e an

d lo

cal s

pend

ing

are

high

ly in

signi

fican

t A

vera

ge ta

x ra

te n

egat

ive

but n

ot s

igni

fican

t

The

insig

nific

ant

coef

ficie

nts

on lo

cal

and

stat

e sp

endi

ng

shar

es m

ay im

ply

that

ex

istin

g FD

has

bee

n co

nsist

ent w

ith g

row

th

max

imiza

tion

Fur

ther

de

cent

raliz

atio

n in

pu

blic

spe

ndin

g m

ay b

e ha

rmfu

l for

gro

wth

Jin amp

Zou

(2

005)

30

Chi

nese

pr

ovin

ces

1979

-199

3 amp

1994

-199

9 (t

wo

diffe

rent

fis

cal

regi

mes

)

Real

GD

P gr

owth

rat

e Pa

nel

One

w

ay fi

xed

effe

cts

No

time

dum

mie

s

1 P

rovi

ncia

l sha

re i

n to

tal b

udge

tary

ex

pend

iture

or

reve

nue

2 P

rovi

ncia

l sh

are

in to

tal e

xtra

shybu

dget

ary

expe

nditu

re o

r re

venu

e

Cen

tral

and

pr

ovin

cial

tax

rate

m

easu

red

by th

e ra

tio o

f cen

tral

ta

x re

venu

es amp

pr

ovin

cial

tax

reve

nues

to G

DP

Prov

inci

al

inve

stm

ent

labo

ur

forc

e gr

owth

rat

e

open

ness

lag

ged

infla

tion

1979

-199

3 g

row

th is

ne

gativ

ely

asso

ciat

ed w

ith

expe

nditu

re F

D amp

po

sitiv

ely

with

rev

enue

FD

199

4-19

99 g

row

th

has

no s

igni

fican

t lin

k w

ith

prov

inci

al e

xpen

ditu

re

and

is ne

gativ

ely

affe

cted

by

pro

vinc

ial r

even

ue

Con

vent

iona

l wisd

om

(tha

t loc

al r

even

ue

shou

ld m

atch

ex

pend

iture

as

clos

e as

po

ssib

le a

t sub

-nat

iona

l le

vel t

o im

prov

e ef

ficie

ncy

and

prom

ote

grow

th) d

oes

not a

pply

to

Chi

na

Pap

ers

findi

ng a

pos

itiv

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Lin

and

Liu

(200

0)

28 C

hine

se

prov

ince

s 19

70-1

993

Gro

wth

rat

e of

rea

l per

ca

pita

GD

P

Tw

o w

ay

fixed

effe

cts

1 M

argi

nal r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

2 A

vera

ge r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

Fisc

al c

apac

ity

(pro

xy b

y m

ovin

g av

erag

e of

per

ca

pita

GD

P)

Popu

latio

n p

er

capi

ta in

vest

men

t gr

owth

rur

al

popu

latio

n sh

are

re

lativ

e fa

rm p

rices

im

plem

enta

tion

of

agric

ultu

ral r

efor

m

priv

ate

firm

s sh

are

in

indu

stria

l out

put

FD h

as a

pos

itive

effe

ct o

n gr

owth

Thi

s ef

fect

is

high

er w

hen

usin

g th

e m

argi

nal r

eten

tion

rate

Lo

ng-r

un e

ffect

s ar

e ca

ptur

ed b

y la

ggin

g FD

fin

ding

larg

er e

ffect

s on

gr

owth

than

with

cur

rent

FD

The

mar

gina

l ret

entio

n ra

te is

a b

ette

r m

easu

re

than

ave

rage

ret

entio

n ra

te F

D h

as in

crea

sed

grow

th in

Chi

na b

y im

prov

ing

effic

ienc

y of

re

sour

ce a

lloca

tion

rath

er th

an b

y in

duci

ng

mor

e in

vest

men

t

Aka

i amp

Saka

ta

(200

2)

50 U

S st

ates

19

92-1

996

(ave

rage

) Su

b pe

riods

19

92-1

994

amp

1994

-199

6

Ave

rage

G

row

th r

ate

of r

eal p

er

capi

ta g

ross

st

ate

prod

uct

Cro

ss

sect

ion(

One

w

ay fi

xed

effe

cts)

1 Lo

cal g

over

nmen

t re

venu

e or

spe

ndin

g sh

are

in s

tate

+ lo

cal

gove

rnm

ent r

even

ue

or s

pend

ing

2 R

atio

of l

ocal

go

vern

men

trsquos o

wn

reve

nue

to s

tate

+

loca

l rev

enue

3

Ave

rage

of r

even

ue

and

spen

ding

FD

of

indi

cato

r 1

Thi

s st

udy

do n

ot

cont

rol f

or p

ublic

se

ctor

siz

e

Popu

latio

n gr

owth

la

gged

gro

wth

rat

e

high

sch

ool

enro

lmen

t rat

io

pre-

tax

inco

me

Gin

i co

effic

ient

sou

ther

n st

ates

dum

my

st

atersquo

s sh

are

in U

S pa

tent

s o

penn

ess

de

moc

rats

sea

ts

Spen

ding

FD

and

the

aver

age

of s

pend

ing

and

reve

nue

FD (i

ndic

ator

3)

affe

ct g

row

th p

ositi

vely

Re

venu

e FD

and

fisc

al

auto

nom

y (in

dica

tor

2) d

o no

t sig

nific

antly

affe

ct

grow

th

Prio

r ne

gativ

e ef

fect

s w

ere

due

to th

e us

e of

da

ta fo

r co

untr

ies

that

w

ere

in e

arly

sta

ges

of

deve

lopm

ent a

nd w

ith

larg

e di

ffere

nces

in

hist

ory

and

cultu

re

Thi

esse

n (2

003)

A

vera

ges

for

21 O

ECD

(amp

4 m

iddl

e in

com

e)

coun

trie

s

Perio

d ov

er

the

perio

d 19

73-1

998

Ave

rage

gr

owth

of

inco

me

per

wor

king

-age

pe

rson

Cro

ss

coun

try

1 L

ocal

sh

are

in

cons

olid

ated

go

vern

men

t sp

endi

ng

or r

even

ue

and

the

aver

age

of

the

two

2 T

rans

form

atio

n of

m

easu

re 1

to

capt

ure

non-

linea

ritie

s

Publ

ic

cons

umpt

ion

to

GD

P an

d th

e fis

cal b

alan

ce a

re

incl

uded

as

robu

stne

ss

chec

ks (r

esul

ts

not r

epor

ted)

Initi

al in

com

e pe

r w

orke

r in

vest

men

t sc

hool

enr

olm

ent

sum

of w

orki

ng-a

ge

popu

latio

n gr

owth

te

chno

logy

gro

wth

de

prec

iatio

n ra

te

vola

tility

ope

nnes

s

Spen

ding

and

lsquoave

rage

rsquo FD

ha

ve a

pos

itive

sig

nific

ant

effe

ct o

n gr

owth

(but

not

ro

bust

) M

ore

robu

st

indi

cato

r 2

show

ing

a no

n-lin

ear

asso

ciat

ion

betw

een

FD a

nd g

row

th R

even

ue

FD a

nd se

lf-re

lianc

e

FD p

rom

otes

ec

onom

ic g

row

th

How

ever

ther

e is

a hu

mp

shap

ed

asso

ciat

ion

betw

een

FD a

nd g

row

th

indi

catin

g an

opt

imal

de

gree

of F

D th

at (Sig

ue)

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

Tab

le 1

S U

MM

AR

Y O

F T

HE

EMP

IRIC

AL

LIT

ERA

TU

RE

Pap

ers

findi

ng a

neg

ativ

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Dav

oodi

amp

Zou

(1

998)

46 d

evel

opin

g amp

dev

elop

ed

coun

trie

s (U

nbal

ance

d pa

nel)

1970

shy19

89

5 an

d 10

ye

ar

aver

ages

of

grow

th in

re

al p

er

capi

ta o

utpu

t

Pane

l T

wo

way

fixe

d ef

fect

s

1 D

irect

spen

ding

by

subn

atio

nal

gove

rnm

ents

(net

of

inte

rgov

ernm

enta

l tr

ansfe

rs) a

s a sh

are

of

gene

ral g

over

nmen

t sp

endi

ng

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

tax

reve

nues

to G

DP

Ave

rage

gro

wth

rat

e of

pop

ulat

ion

initi

al

seco

ndar

y sc

hool

en

rolm

ent r

ate

initi

al

per c

apita

GD

P

inve

stm

ent s

hare

to

GD

P

In d

evel

oped

cou

ntrie

s

ther

e is

no r

elat

ions

hip

betw

een

FD a

nd g

row

th

whe

reas

this

asso

ciat

ion

is ne

gativ

e in

dev

elop

ing

coun

trie

s A

vera

ge ta

x ra

te

affe

cts

grow

th n

egat

ivel

y

Fisc

al p

olic

y gr

owth

ef

fect

s ar

e m

ore

rela

ted

to fu

nctio

nal

gove

rnm

ent s

pend

ing

com

posit

ion

Rev

enue

as

signm

ent a

mon

g le

vels

of g

over

nmen

t m

ay b

e lsquow

rong

rsquo

Wol

ler

and

Phill

ips

(199

8)

23 L

DC

s co

untr

ies

Perio

d 19

74shy

1991

Ann

ual

3 or

5

year

av

erag

es o

f pe

r cap

ita

grow

th r

ate

Pane

l O

ne

way

fixe

d ef

fect

s

1 L

ocal

gove

rnm

ent

shar

e in

tota

l go

vern

men

t rev

enue

s or

spen

ding

2

Loc

al go

vern

men

t sh

are

(exc

ludi

ng

gran

ts-in

-aid

) in

tota

l re

venu

es

3 L

ocal

gove

rnm

ent

shar

e in

tota

l spe

ndin

g (le

ss d

efen

ce amp

socia

l w

elfa

re)

mdash

Initi

al G

DP

in

vest

men

t se

cond

ary

scho

ol

enro

lmen

t and

po

pula

tion

grow

th

Robu

st o

penn

ess

in

flatio

n le

vel amp

va

rianc

e p

oliti

cal amp

fin

anci

al v

aria

bles

No

stro

ng a

ssoc

iatio

n be

twee

n FD

and

ec

onom

ic g

row

th in

LD

Cs

At b

est

wea

k in

vers

e re

latio

nshi

p be

twee

n re

venu

e FD

and

gr

owth

whe

n us

ing

five

year

s av

erag

es

FD d

oes

not a

ffect

ec

onom

ic g

row

th a

t na

tiona

l lev

el a

mon

g LD

Cs

It c

an a

ffect

ec

onom

ic

deve

lopm

ent a

t the

lo

cal l

evel

in L

DC

s

Zha

ng amp

Z

ou

(199

8)

28 C

hine

se

prov

ince

s

1986

-199

2

Real

gro

wth

ra

te o

f pr

ovin

cial

in

com

e

Pane

l O

ne

way

fixe

d ef

fect

s

1 R

atio

of p

er c

apita

co

nsol

idat

ed (o

r bu

dget

ary

prov

inci

al)

spen

ding

to p

er c

apita

co

nsol

idat

ed o

r

Cen

tral

and

pr

ovin

cial

re

venu

e to

na

tiona

l GD

P Fu

nctio

nal

Labo

r fo

rce

grow

th

rate

inv

estm

ent

rate

ope

nnes

s

infla

tion

rate

A hi

gher

deg

ree

of sp

endi

ng

fisca

l dec

entr

aliz

atio

n is

asso

ciat

ed w

ith lo

wer

pr

ovin

cial

eco

nom

ic

grow

th in

Chi

na C

entr

al

If lo

cal s

pend

ing

is al

read

y hi

gh f

urth

er

dece

ntra

lizat

ion

may

re

sult

in s

low

er

grow

th

(Sig

ue)

(Con

tinua

cioacuten

)

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Zha

ng amp

Z

ou

(199

8)

(Ext

ende

d ca

se 1

980-

9)

budg

etar

y ce

ntra

l sp

endi

ng

2 R

atio

of p

rovi

ncial

ex

tra-

budg

etar

y sp

endi

ng sh

are

in

inco

me

to c

entr

al ex

tra-

budg

etar

y sp

endi

ng sh

are

of

inco

me

com

posit

ion

of

cent

ral a

nd

prov

inci

al

budg

etar

y sp

endi

ng

and

prov

inci

al ta

x ra

te

have

neg

ativ

e ef

fect

s on

gr

owth

but

not

sig

nific

ant

Cen

tral

gov

ernm

ent

may

be

in a

bet

ter

posit

ion

to u

nder

take

pu

blic

inve

stm

ent w

ith

exte

rnal

ities

whe

n th

e co

untr

y is

deve

lopi

ng

Xie

et a

l (1

999)

U

S 19

48 shy

1994

Re

al p

er

capi

tal

outp

ut

grow

th r

ate

Tim

e se

ries

1 S

hare

of s

pend

ing

by e

ach

leve

l of

subn

atio

nal

gove

rnm

ent (

loca

l an

d st

ate)

in to

tal

gove

rnm

ent s

pend

ing

(exc

ludi

ng fe

dera

l gr

ants

to lo

wer

leve

ls of

gov

ernm

ent)

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

go

vern

men

t re

ceip

ts to

GD

P

Labo

ur fo

rce

adju

sted

for

educ

atio

n le

vels

in

vest

men

t en

ergy

pr

ices

ope

nnes

s

infla

tion

amp G

ini (

all

varia

bles

in g

row

th

rate

s)

Loca

l spe

ndin

g re

duce

s gr

owth

tho

ugh

low

sig

nific

ance

leve

ls S

tate

sp

endi

ng a

nd c

ombi

ned

stat

e an

d lo

cal s

pend

ing

are

high

ly in

signi

fican

t A

vera

ge ta

x ra

te n

egat

ive

but n

ot s

igni

fican

t

The

insig

nific

ant

coef

ficie

nts

on lo

cal

and

stat

e sp

endi

ng

shar

es m

ay im

ply

that

ex

istin

g FD

has

bee

n co

nsist

ent w

ith g

row

th

max

imiza

tion

Fur

ther

de

cent

raliz

atio

n in

pu

blic

spe

ndin

g m

ay b

e ha

rmfu

l for

gro

wth

Jin amp

Zou

(2

005)

30

Chi

nese

pr

ovin

ces

1979

-199

3 amp

1994

-199

9 (t

wo

diffe

rent

fis

cal

regi

mes

)

Real

GD

P gr

owth

rat

e Pa

nel

One

w

ay fi

xed

effe

cts

No

time

dum

mie

s

1 P

rovi

ncia

l sha

re i

n to

tal b

udge

tary

ex

pend

iture

or

reve

nue

2 P

rovi

ncia

l sh

are

in to

tal e

xtra

shybu

dget

ary

expe

nditu

re o

r re

venu

e

Cen

tral

and

pr

ovin

cial

tax

rate

m

easu

red

by th

e ra

tio o

f cen

tral

ta

x re

venu

es amp

pr

ovin

cial

tax

reve

nues

to G

DP

Prov

inci

al

inve

stm

ent

labo

ur

forc

e gr

owth

rat

e

open

ness

lag

ged

infla

tion

1979

-199

3 g

row

th is

ne

gativ

ely

asso

ciat

ed w

ith

expe

nditu

re F

D amp

po

sitiv

ely

with

rev

enue

FD

199

4-19

99 g

row

th

has

no s

igni

fican

t lin

k w

ith

prov

inci

al e

xpen

ditu

re

and

is ne

gativ

ely

affe

cted

by

pro

vinc

ial r

even

ue

Con

vent

iona

l wisd

om

(tha

t loc

al r

even

ue

shou

ld m

atch

ex

pend

iture

as

clos

e as

po

ssib

le a

t sub

-nat

iona

l le

vel t

o im

prov

e ef

ficie

ncy

and

prom

ote

grow

th) d

oes

not a

pply

to

Chi

na

Pap

ers

findi

ng a

pos

itiv

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Lin

and

Liu

(200

0)

28 C

hine

se

prov

ince

s 19

70-1

993

Gro

wth

rat

e of

rea

l per

ca

pita

GD

P

Tw

o w

ay

fixed

effe

cts

1 M

argi

nal r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

2 A

vera

ge r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

Fisc

al c

apac

ity

(pro

xy b

y m

ovin

g av

erag

e of

per

ca

pita

GD

P)

Popu

latio

n p

er

capi

ta in

vest

men

t gr

owth

rur

al

popu

latio

n sh

are

re

lativ

e fa

rm p

rices

im

plem

enta

tion

of

agric

ultu

ral r

efor

m

priv

ate

firm

s sh

are

in

indu

stria

l out

put

FD h

as a

pos

itive

effe

ct o

n gr

owth

Thi

s ef

fect

is

high

er w

hen

usin

g th

e m

argi

nal r

eten

tion

rate

Lo

ng-r

un e

ffect

s ar

e ca

ptur

ed b

y la

ggin

g FD

fin

ding

larg

er e

ffect

s on

gr

owth

than

with

cur

rent

FD

The

mar

gina

l ret

entio

n ra

te is

a b

ette

r m

easu

re

than

ave

rage

ret

entio

n ra

te F

D h

as in

crea

sed

grow

th in

Chi

na b

y im

prov

ing

effic

ienc

y of

re

sour

ce a

lloca

tion

rath

er th

an b

y in

duci

ng

mor

e in

vest

men

t

Aka

i amp

Saka

ta

(200

2)

50 U

S st

ates

19

92-1

996

(ave

rage

) Su

b pe

riods

19

92-1

994

amp

1994

-199

6

Ave

rage

G

row

th r

ate

of r

eal p

er

capi

ta g

ross

st

ate

prod

uct

Cro

ss

sect

ion(

One

w

ay fi

xed

effe

cts)

1 Lo

cal g

over

nmen

t re

venu

e or

spe

ndin

g sh

are

in s

tate

+ lo

cal

gove

rnm

ent r

even

ue

or s

pend

ing

2 R

atio

of l

ocal

go

vern

men

trsquos o

wn

reve

nue

to s

tate

+

loca

l rev

enue

3

Ave

rage

of r

even

ue

and

spen

ding

FD

of

indi

cato

r 1

Thi

s st

udy

do n

ot

cont

rol f

or p

ublic

se

ctor

siz

e

Popu

latio

n gr

owth

la

gged

gro

wth

rat

e

high

sch

ool

enro

lmen

t rat

io

pre-

tax

inco

me

Gin

i co

effic

ient

sou

ther

n st

ates

dum

my

st

atersquo

s sh

are

in U

S pa

tent

s o

penn

ess

de

moc

rats

sea

ts

Spen

ding

FD

and

the

aver

age

of s

pend

ing

and

reve

nue

FD (i

ndic

ator

3)

affe

ct g

row

th p

ositi

vely

Re

venu

e FD

and

fisc

al

auto

nom

y (in

dica

tor

2) d

o no

t sig

nific

antly

affe

ct

grow

th

Prio

r ne

gativ

e ef

fect

s w

ere

due

to th

e us

e of

da

ta fo

r co

untr

ies

that

w

ere

in e

arly

sta

ges

of

deve

lopm

ent a

nd w

ith

larg

e di

ffere

nces

in

hist

ory

and

cultu

re

Thi

esse

n (2

003)

A

vera

ges

for

21 O

ECD

(amp

4 m

iddl

e in

com

e)

coun

trie

s

Perio

d ov

er

the

perio

d 19

73-1

998

Ave

rage

gr

owth

of

inco

me

per

wor

king

-age

pe

rson

Cro

ss

coun

try

1 L

ocal

sh

are

in

cons

olid

ated

go

vern

men

t sp

endi

ng

or r

even

ue

and

the

aver

age

of

the

two

2 T

rans

form

atio

n of

m

easu

re 1

to

capt

ure

non-

linea

ritie

s

Publ

ic

cons

umpt

ion

to

GD

P an

d th

e fis

cal b

alan

ce a

re

incl

uded

as

robu

stne

ss

chec

ks (r

esul

ts

not r

epor

ted)

Initi

al in

com

e pe

r w

orke

r in

vest

men

t sc

hool

enr

olm

ent

sum

of w

orki

ng-a

ge

popu

latio

n gr

owth

te

chno

logy

gro

wth

de

prec

iatio

n ra

te

vola

tility

ope

nnes

s

Spen

ding

and

lsquoave

rage

rsquo FD

ha

ve a

pos

itive

sig

nific

ant

effe

ct o

n gr

owth

(but

not

ro

bust

) M

ore

robu

st

indi

cato

r 2

show

ing

a no

n-lin

ear

asso

ciat

ion

betw

een

FD a

nd g

row

th R

even

ue

FD a

nd se

lf-re

lianc

e

FD p

rom

otes

ec

onom

ic g

row

th

How

ever

ther

e is

a hu

mp

shap

ed

asso

ciat

ion

betw

een

FD a

nd g

row

th

indi

catin

g an

opt

imal

de

gree

of F

D th

at (Sig

ue)

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

(Con

tinua

cioacuten

)

Stud

y D

atas

et

Dep

ende

nt

vari

able

M

etho

d D

ecen

tral

izat

ion

mea

sure

O

ther

fisc

al

vari

able

s C

ontr

ol v

aria

bles

G

row

th E

ffect

C

oncl

usio

ns

Zha

ng amp

Z

ou

(199

8)

(Ext

ende

d ca

se 1

980-

9)

budg

etar

y ce

ntra

l sp

endi

ng

2 R

atio

of p

rovi

ncial

ex

tra-

budg

etar

y sp

endi

ng sh

are

in

inco

me

to c

entr

al ex

tra-

budg

etar

y sp

endi

ng sh

are

of

inco

me

com

posit

ion

of

cent

ral a

nd

prov

inci

al

budg

etar

y sp

endi

ng

and

prov

inci

al ta

x ra

te

have

neg

ativ

e ef

fect

s on

gr

owth

but

not

sig

nific

ant

Cen

tral

gov

ernm

ent

may

be

in a

bet

ter

posit

ion

to u

nder

take

pu

blic

inve

stm

ent w

ith

exte

rnal

ities

whe

n th

e co

untr

y is

deve

lopi

ng

Xie

et a

l (1

999)

U

S 19

48 shy

1994

Re

al p

er

capi

tal

outp

ut

grow

th r

ate

Tim

e se

ries

1 S

hare

of s

pend

ing

by e

ach

leve

l of

subn

atio

nal

gove

rnm

ent (

loca

l an

d st

ate)

in to

tal

gove

rnm

ent s

pend

ing

(exc

ludi

ng fe

dera

l gr

ants

to lo

wer

leve

ls of

gov

ernm

ent)

Ave

rage

tax

rate

pr

oxie

d by

the

ratio

of t

otal

go

vern

men

t re

ceip

ts to

GD

P

Labo

ur fo

rce

adju

sted

for

educ

atio

n le

vels

in

vest

men

t en

ergy

pr

ices

ope

nnes

s

infla

tion

amp G

ini (

all

varia

bles

in g

row

th

rate

s)

Loca

l spe

ndin

g re

duce

s gr

owth

tho

ugh

low

sig

nific

ance

leve

ls S

tate

sp

endi

ng a

nd c

ombi

ned

stat

e an

d lo

cal s

pend

ing

are

high

ly in

signi

fican

t A

vera

ge ta

x ra

te n

egat

ive

but n

ot s

igni

fican

t

The

insig

nific

ant

coef

ficie

nts

on lo

cal

and

stat

e sp

endi

ng

shar

es m

ay im

ply

that

ex

istin

g FD

has

bee

n co

nsist

ent w

ith g

row

th

max

imiza

tion

Fur

ther

de

cent

raliz

atio

n in

pu

blic

spe

ndin

g m

ay b

e ha

rmfu

l for

gro

wth

Jin amp

Zou

(2

005)

30

Chi

nese

pr

ovin

ces

1979

-199

3 amp

1994

-199

9 (t

wo

diffe

rent

fis

cal

regi

mes

)

Real

GD

P gr

owth

rat

e Pa

nel

One

w

ay fi

xed

effe

cts

No

time

dum

mie

s

1 P

rovi

ncia

l sha

re i

n to

tal b

udge

tary

ex

pend

iture

or

reve

nue

2 P

rovi

ncia

l sh

are

in to

tal e

xtra

shybu

dget

ary

expe

nditu

re o

r re

venu

e

Cen

tral

and

pr

ovin

cial

tax

rate

m

easu

red

by th

e ra

tio o

f cen

tral

ta

x re

venu

es amp

pr

ovin

cial

tax

reve

nues

to G

DP

Prov

inci

al

inve

stm

ent

labo

ur

forc

e gr

owth

rat

e

open

ness

lag

ged

infla

tion

1979

-199

3 g

row

th is

ne

gativ

ely

asso

ciat

ed w

ith

expe

nditu

re F

D amp

po

sitiv

ely

with

rev

enue

FD

199

4-19

99 g

row

th

has

no s

igni

fican

t lin

k w

ith

prov

inci

al e

xpen

ditu

re

and

is ne

gativ

ely

affe

cted

by

pro

vinc

ial r

even

ue

Con

vent

iona

l wisd

om

(tha

t loc

al r

even

ue

shou

ld m

atch

ex

pend

iture

as

clos

e as

po

ssib

le a

t sub

-nat

iona

l le

vel t

o im

prov

e ef

ficie

ncy

and

prom

ote

grow

th) d

oes

not a

pply

to

Chi

na

Pap

ers

findi

ng a

pos

itiv

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Lin

and

Liu

(200

0)

28 C

hine

se

prov

ince

s 19

70-1

993

Gro

wth

rat

e of

rea

l per

ca

pita

GD

P

Tw

o w

ay

fixed

effe

cts

1 M

argi

nal r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

2 A

vera

ge r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

Fisc

al c

apac

ity

(pro

xy b

y m

ovin

g av

erag

e of

per

ca

pita

GD

P)

Popu

latio

n p

er

capi

ta in

vest

men

t gr

owth

rur

al

popu

latio

n sh

are

re

lativ

e fa

rm p

rices

im

plem

enta

tion

of

agric

ultu

ral r

efor

m

priv

ate

firm

s sh

are

in

indu

stria

l out

put

FD h

as a

pos

itive

effe

ct o

n gr

owth

Thi

s ef

fect

is

high

er w

hen

usin

g th

e m

argi

nal r

eten

tion

rate

Lo

ng-r

un e

ffect

s ar

e ca

ptur

ed b

y la

ggin

g FD

fin

ding

larg

er e

ffect

s on

gr

owth

than

with

cur

rent

FD

The

mar

gina

l ret

entio

n ra

te is

a b

ette

r m

easu

re

than

ave

rage

ret

entio

n ra

te F

D h

as in

crea

sed

grow

th in

Chi

na b

y im

prov

ing

effic

ienc

y of

re

sour

ce a

lloca

tion

rath

er th

an b

y in

duci

ng

mor

e in

vest

men

t

Aka

i amp

Saka

ta

(200

2)

50 U

S st

ates

19

92-1

996

(ave

rage

) Su

b pe

riods

19

92-1

994

amp

1994

-199

6

Ave

rage

G

row

th r

ate

of r

eal p

er

capi

ta g

ross

st

ate

prod

uct

Cro

ss

sect

ion(

One

w

ay fi

xed

effe

cts)

1 Lo

cal g

over

nmen

t re

venu

e or

spe

ndin

g sh

are

in s

tate

+ lo

cal

gove

rnm

ent r

even

ue

or s

pend

ing

2 R

atio

of l

ocal

go

vern

men

trsquos o

wn

reve

nue

to s

tate

+

loca

l rev

enue

3

Ave

rage

of r

even

ue

and

spen

ding

FD

of

indi

cato

r 1

Thi

s st

udy

do n

ot

cont

rol f

or p

ublic

se

ctor

siz

e

Popu

latio

n gr

owth

la

gged

gro

wth

rat

e

high

sch

ool

enro

lmen

t rat

io

pre-

tax

inco

me

Gin

i co

effic

ient

sou

ther

n st

ates

dum

my

st

atersquo

s sh

are

in U

S pa

tent

s o

penn

ess

de

moc

rats

sea

ts

Spen

ding

FD

and

the

aver

age

of s

pend

ing

and

reve

nue

FD (i

ndic

ator

3)

affe

ct g

row

th p

ositi

vely

Re

venu

e FD

and

fisc

al

auto

nom

y (in

dica

tor

2) d

o no

t sig

nific

antly

affe

ct

grow

th

Prio

r ne

gativ

e ef

fect

s w

ere

due

to th

e us

e of

da

ta fo

r co

untr

ies

that

w

ere

in e

arly

sta

ges

of

deve

lopm

ent a

nd w

ith

larg

e di

ffere

nces

in

hist

ory

and

cultu

re

Thi

esse

n (2

003)

A

vera

ges

for

21 O

ECD

(amp

4 m

iddl

e in

com

e)

coun

trie

s

Perio

d ov

er

the

perio

d 19

73-1

998

Ave

rage

gr

owth

of

inco

me

per

wor

king

-age

pe

rson

Cro

ss

coun

try

1 L

ocal

sh

are

in

cons

olid

ated

go

vern

men

t sp

endi

ng

or r

even

ue

and

the

aver

age

of

the

two

2 T

rans

form

atio

n of

m

easu

re 1

to

capt

ure

non-

linea

ritie

s

Publ

ic

cons

umpt

ion

to

GD

P an

d th

e fis

cal b

alan

ce a

re

incl

uded

as

robu

stne

ss

chec

ks (r

esul

ts

not r

epor

ted)

Initi

al in

com

e pe

r w

orke

r in

vest

men

t sc

hool

enr

olm

ent

sum

of w

orki

ng-a

ge

popu

latio

n gr

owth

te

chno

logy

gro

wth

de

prec

iatio

n ra

te

vola

tility

ope

nnes

s

Spen

ding

and

lsquoave

rage

rsquo FD

ha

ve a

pos

itive

sig

nific

ant

effe

ct o

n gr

owth

(but

not

ro

bust

) M

ore

robu

st

indi

cato

r 2

show

ing

a no

n-lin

ear

asso

ciat

ion

betw

een

FD a

nd g

row

th R

even

ue

FD a

nd se

lf-re

lianc

e

FD p

rom

otes

ec

onom

ic g

row

th

How

ever

ther

e is

a hu

mp

shap

ed

asso

ciat

ion

betw

een

FD a

nd g

row

th

indi

catin

g an

opt

imal

de

gree

of F

D th

at (Sig

ue)

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

Pap

ers

findi

ng a

pos

itiv

e ef

fect

of F

D o

n ec

onom

ic g

row

th

Lin

and

Liu

(200

0)

28 C

hine

se

prov

ince

s 19

70-1

993

Gro

wth

rat

e of

rea

l per

ca

pita

GD

P

Tw

o w

ay

fixed

effe

cts

1 M

argi

nal r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

2 A

vera

ge r

eten

tion

rate

of l

ocal

ly

colle

cted

bud

geta

ry

reve

nue

Fisc

al c

apac

ity

(pro

xy b

y m

ovin

g av

erag

e of

per

ca

pita

GD

P)

Popu

latio

n p

er

capi

ta in

vest

men

t gr

owth

rur

al

popu

latio

n sh

are

re

lativ

e fa

rm p

rices

im

plem

enta

tion

of

agric

ultu

ral r

efor

m

priv

ate

firm

s sh

are

in

indu

stria

l out

put

FD h

as a

pos

itive

effe

ct o

n gr

owth

Thi

s ef

fect

is

high

er w

hen

usin

g th

e m

argi

nal r

eten

tion

rate

Lo

ng-r

un e

ffect

s ar

e ca

ptur

ed b

y la

ggin

g FD

fin

ding

larg

er e

ffect

s on

gr

owth

than

with

cur

rent

FD

The

mar

gina

l ret

entio

n ra

te is

a b

ette

r m

easu

re

than

ave

rage

ret

entio

n ra

te F

D h

as in

crea

sed

grow

th in

Chi

na b

y im

prov

ing

effic

ienc

y of

re

sour

ce a

lloca

tion

rath

er th

an b

y in

duci

ng

mor

e in

vest

men

t

Aka

i amp

Saka

ta

(200

2)

50 U

S st

ates

19

92-1

996

(ave

rage

) Su

b pe

riods

19

92-1

994

amp

1994

-199

6

Ave

rage

G

row

th r

ate

of r

eal p

er

capi

ta g

ross

st

ate

prod

uct

Cro

ss

sect

ion(

One

w

ay fi

xed

effe

cts)

1 Lo

cal g

over

nmen

t re

venu

e or

spe

ndin

g sh

are

in s

tate

+ lo

cal

gove

rnm

ent r

even

ue

or s

pend

ing

2 R

atio

of l

ocal

go

vern

men

trsquos o

wn

reve

nue

to s

tate

+

loca

l rev

enue

3

Ave

rage

of r

even

ue

and

spen

ding

FD

of

indi

cato

r 1

Thi

s st

udy

do n

ot

cont

rol f

or p

ublic

se

ctor

siz

e

Popu

latio

n gr

owth

la

gged

gro

wth

rat

e

high

sch

ool

enro

lmen

t rat

io

pre-

tax

inco

me

Gin

i co

effic

ient

sou

ther

n st

ates

dum

my

st

atersquo

s sh

are

in U

S pa

tent

s o

penn

ess

de

moc

rats

sea

ts

Spen

ding

FD

and

the

aver

age

of s

pend

ing

and

reve

nue

FD (i

ndic

ator

3)

affe

ct g

row

th p

ositi

vely

Re

venu

e FD

and

fisc

al

auto

nom

y (in

dica

tor

2) d

o no

t sig

nific

antly

affe

ct

grow

th

Prio

r ne

gativ

e ef

fect

s w

ere

due

to th

e us

e of

da

ta fo

r co

untr

ies

that

w

ere

in e

arly

sta

ges

of

deve

lopm

ent a

nd w

ith

larg

e di

ffere

nces

in

hist

ory

and

cultu

re

Thi

esse

n (2

003)

A

vera

ges

for

21 O

ECD

(amp

4 m

iddl

e in

com

e)

coun

trie

s

Perio

d ov

er

the

perio

d 19

73-1

998

Ave

rage

gr

owth

of

inco

me

per

wor

king

-age

pe

rson

Cro

ss

coun

try

1 L

ocal

sh

are

in

cons

olid

ated

go

vern

men

t sp

endi

ng

or r

even

ue

and

the

aver

age

of

the

two

2 T

rans

form

atio

n of

m

easu

re 1

to

capt

ure

non-

linea

ritie

s

Publ

ic

cons

umpt

ion

to

GD

P an

d th

e fis

cal b

alan

ce a

re

incl

uded

as

robu

stne

ss

chec

ks (r

esul

ts

not r

epor

ted)

Initi

al in

com

e pe

r w

orke

r in

vest

men

t sc

hool

enr

olm

ent

sum

of w

orki

ng-a

ge

popu

latio

n gr

owth

te

chno

logy

gro

wth

de

prec

iatio

n ra

te

vola

tility

ope

nnes

s

Spen

ding

and

lsquoave

rage

rsquo FD

ha

ve a

pos

itive

sig

nific

ant

effe

ct o

n gr

owth

(but

not

ro

bust

) M

ore

robu

st

indi

cato

r 2

show

ing

a no

n-lin

ear

asso

ciat

ion

betw

een

FD a

nd g

row

th R

even

ue

FD a

nd se

lf-re

lianc

e

FD p

rom

otes

ec

onom

ic g

row

th

How

ever

ther

e is

a hu

mp

shap

ed

asso

ciat

ion

betw

een

FD a

nd g

row

th

indi

catin

g an

opt

imal

de

gree

of F

D th

at (Sig

ue)

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

(Con

tinua

cioacuten

)

Thi

esse

n (2

003

(qua

drat

ic te

rms

sp

line

func

tions

) 3

Ow

n re

venu

es

shar

e in

sub

natio

nal

reve

nues

Ro

bust

inf

latio

n ra

te f

eder

al s

yste

m

dum

my

fina

ncia

l

indi

cato

rs (3

) not

sign

ifica

nt m

axim

ises

grow

th F

D

prom

otes

gro

wth

by

incr

easin

g in

vest

men

t an

d to

tal f

acto

r pr

oduc

tivity

Ebel

and

Yi

lmaz

(2

004)

6 C

entr

al a

nd

East

ern

Euro

pean

co

untr

ies

Per c

apita

G

DP

grow

th Bi

varia

te

estim

atio

n 1

Tax

rev

enue

s on

w

hich

loca

l go

vern

men

ts r

ule

(a)

on w

hich

loca

l go

vern

men

ts d

o no

t ru

le (b

) to

tal i

nter

shygo

vern

men

tal

tran

sfer

s (c

) tr

ansf

ers

on w

hich

loca

l go

vern

men

t do

not

rule

(d)

loca

l non

-tax

re

venu

e (e

) A

ll in

sh

ares

of t

otal

loca

l go

vern

men

t rev

enue

mdash

mdash

Loca

l tax

(a) a

nd n

on-t

ax

reve

nue

auto

nom

y (e

) re

pres

ent o

wn-

sour

ce

reve

nue

for

loca

l go

vern

men

ts a

nd h

ave

posit

ive

impa

cts

on

grow

th F

iscal

dep

ende

ncy

varia

bles

(c amp

d) n

ot

signi

fican

t T

ax s

harin

g (b

) ha

s a

nega

tive

impa

ct

FD m

eans

that

loca

l go

vern

men

ts h

ave

auth

ority

to e

xerc

ise

own

sour

ce ta

xatio

n If

FD

is d

efin

ed a

s re

venu

e au

tono

my

inst

ead

of lo

cal s

hare

of

pub

lic s

pend

ing

the

asso

ciat

ion

with

gr

owth

bec

omes

po

sitiv

e

Mel

oche

et

al

(200

4)

10 C

entr

al

and

East

ern

Euro

pean

C

ount

ries

(3

obse

rvat

ions

pe

r co

untr

y

betw

een

1997

and

20

00)

Ann

ual p

er

capi

ta G

DP

grow

th r

ate

Tw

o w

ay

fixed

effe

cts

1 L

ocal

shar

e in

ag

greg

ate

gove

rnm

ent

spen

ding

(net

of g

rant

s)

2 I

ndic

ator

s use

d in

Eb

el a

nd Y

ilmaz

(2

002)

(a-

e)

3 R

atio

of o

wn

sour

ce re

venu

es in

to

tal lo

cal r

even

ues (

f)

tota

l gov

ernm

ent

reve

nue

(g)

mdash

Initi

al G

DP

per c

apita

s

econ

dary

sch

ool

enro

lmen

t rat

io

annu

al p

opul

atio

n gr

owth

and

in

vest

men

t

Non

-tax

aut

onom

y (e

) and

re

venu

e au

tono

my

(g)

has

a po

sitiv

e ef

fect

on

grow

th w

here

as fi

scal

de

pend

ency

has

a n

egat

ive

one

The

com

posit

ion

of

loca

l rev

enue

s r

athe

r th

an s

ize

is r

elev

ant

for

grow

th L

ocal

re

venu

e co

ntro

lled

by

loca

l gov

ernm

ents

in

crea

ses

grow

th

Loca

l rev

enue

co

ntro

lled

cent

rally

re

duce

s gr

owth

(Sig

ue)

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

(Con

tinua

cioacuten

)

Iimi

(200

5)

51 lo

w

mid

dle

and

high

inco

me

coun

trie

s 19

97-2

001

(ave

rage

)

Ave

rage

gr

owth

rat

e of

rea

l GD

P pe

r cap

ita

over

199

7shy20

01

Cro

ss

sect

ion

1 T

he s

hare

of l

ocal

ex

pend

iture

(e

xclu

ding

sta

te

spen

ding

) in

tota

l go

vern

men

t spe

ndin

g

Tot

al ta

x re

venu

es a

s a

shar

e of

GD

P

Polit

ical

free

dom

(a

lone

and

inte

ract

ed

with

FD

) po

pula

tion

grow

th i

nitia

l se

cond

ary

scho

ol

enro

lmen

t in

itial

per

ca

pita

GD

P in

com

e amp

reg

iona

l dum

mie

s

Fisc

al d

ecen

tral

izat

ion

signi

fican

tly in

crea

ses

econ

omic

gro

wth

(but

ef

fect

slig

ht)

Inte

ract

ion

betw

een

FD a

nd p

oliti

cal

free

dom

is n

ot s

igni

fican

t

It ta

kes

cons

ider

able

tim

e fo

r FD

to h

ave

a vi

sible

effe

ct o

n ec

onom

ic g

row

th

Acc

ount

s fo

r en

doge

neity

usin

g fif

th

lagg

ed v

alue

as

inst

rum

ents

for

all

inde

pend

ent v

aria

bles

Jin e

t al

(200

5)

29 C

hine

se

prov

ince

s 19

70 -

1999

Gro

wth

of

non-

stat

eshyno

nshyag

ricul

tura

l em

ploy

men

t

Pane

lTw

o w

ay fi

xed

effe

cts

1 R

atio

of l

ocal

ex

pend

iture

to

cent

ral e

xpen

ditu

re

in a

pro

vinc

e 2

Pro

vinc

ial m

argi

nal

reve

nue

rete

ntio

n ra

te

mdash

Lagg

ed p

er c

apita

G

DP

Reve

nue

FD (i

ndic

ator

1)

has

posit

ive

effe

cts

on

priv

ate

empl

oym

ent

How

ever

the

effe

ct o

f the

pr

ovin

cial

mar

gina

l re

tent

ion

rate

(ind

icat

or

2) o

n em

ploy

men

t is

muc

h hi

gher

than

the

aver

age

If lo

cal g

over

nmen

t is

able

to k

eep

a sig

nific

ant s

hare

of

incr

ease

d ta

x re

venu

e

then

ther

e ar

e in

cent

ives

to s

uppo

rt

mar

ket d

evel

opm

ent

Endo

gene

ity n

ot a

n iss

ue b

ecau

se o

f ne

gativ

e ef

fect

of

lagg

ed e

mpl

oym

ent o

n m

argi

nal r

eten

tion

rate

Stan

sel

(200

5)

314

US

met

ropo

litan

ar

eas

1960

- 19

90

Popu

latio

n gr

owth

and

re

al p

er

capi

ta

inco

me

grow

th

Cro

ss

sect

ion

1 I

nitia

l num

ber

of

coun

ty m

unic

ipal

and

to

wns

hip

gove

rnm

ents

per

10

000

0 re

siden

ts

2 I

nitia

l num

ber

of

publ

ic s

choo

l dist

ricts

pe

r 10

000

0 re

siden

ts

mdash

Prev

ious

pop

ulat

ion

grow

th i

nitia

l po

pula

tion

initi

al

real

per

cap

ita

inco

me

initi

al

unem

ploy

men

t in

itial

man

ufac

turin

g sh

are

wor

king

-age

The

num

ber

of c

ount

y an

d m

unic

ipal

gov

ernm

ents

fo

und

to h

ave

posit

ive

rela

tions

hip

with

bot

h po

pula

tion

grow

th a

nd p

er

capi

ta in

com

e gr

owth

No

stat

istic

ally

sig

nific

ant

effe

ct fo

und

for

tow

nshi

p

Thi

s au

thor

focu

s on

th

e de

cent

raliz

atio

n di

men

sion

base

d on

th

e ho

rizon

tal

disp

ersio

n of

pow

er

amon

g in

divi

dual

lo

wer

-leve

l go

vern

men

ts

(Sig

ue)

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

(Con

tinua

cioacuten

)

Stan

sel

(200

5)

3 I

nitia

l cen

tral

-city

sh

are

of m

etro

are

a po

pula

tion

(The

hig

her

is th

is ra

tio th

e lo

wer

is

dece

ntra

lizat

ion)

popu

latio

n w

ith 1

6+

year

s of

sch

oolin

g

and

scho

ol d

istric

ts

Cen

tral

-city

sha

re o

f m

etro

are

a po

pula

tion

has

a ne

gativ

e ef

fect

Exam

inin

g m

etro

are

as

in th

e sa

me

natio

n av

oids

usin

g da

ta fr

om

a se

t of w

idel

y di

spar

ate

coun

trie

s

Tho

rnto

n (2

007)

19

OEC

D

coun

trie

s

Ave

rage

s 19

80-2

000

Ave

rage

rea

l G

DP

grow

th

per c

apita

Cro

ss

sect

ion

1 A

vera

ge ta

x re

venu

es o

f sub

shyna

tiona

l gov

ernm

ents

st

emm

ing

from

the

tax

base

and

tax

rate

s ov

er w

hich

they

hav

e fu

ll di

scre

tion

2 T

he s

quar

e of

in

dica

tor

1

No

othe

r fis

cal

varia

bles

in

clud

ed

Initi

al in

com

e pe

r ca

pita

inv

estm

ent

seco

ndar

y sc

hool

en

rolm

ent

grow

th

of th

e w

orki

ng-a

ge

popu

latio

n d

umm

y va

riabl

e fo

r fe

dera

l sy

stem

s

Whe

n th

e m

easu

re o

f re

venu

e FD

is li

mite

d to

re

venu

es o

ver

whi

ch

subn

atio

nal g

over

nmen

t ha

s fu

ll au

tono

my

impa

ct

on e

cono

mic

gro

wth

is n

ot

signi

fican

t Q

uadr

atic

term

al

so n

ot s

igni

fican

t

Muc

h of

the

liter

atur

e ha

s no

t dist

ingu

ished

ap

prop

riate

ly b

etw

een

adm

inist

rativ

e an

d su

bsta

ntiv

e FD

Hig

h lo

cal g

over

nmen

t re

venu

e an

d ex

pend

iture

sha

res

do

not n

eces

saril

y in

dica

te

high

loca

l aut

onom

y

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash

Instituto de Estudios Fiscales

A number of factors may explain this negative effect Firstly as Davoodi and Zou (1998) and Zhang and Zou (1998) argue FD may be particularly harmful for economic growth in the early stages of development where the administrative capability of local governments is insufficient local officials may not be responsive to preferences of local residents and local governments in those countries may be constrained by the central government Secondly fiscal policy-growth effects may be more related to the functional composition of government spending or type of tax rather than to fiscal decentralization per se If sub-national governments spend more on items with low growth effects such as social welfare whereas national governments spend more in growth enhancing items such as infrastructure then we could expect to observe a negative endogenous relationship between FD and economic growth We examine these latter arguments with respect to our OECD context in section 4

More recent studies especially those examining the US or OECD countries find some evidence of a positive relationship between FD and growth see Akai and Sakata (2002) Thiessen (2003) Ebel and Yilmaz (2004) Meloche et al (2004) Iimi (2005) Jin et al (2005) and Thornton (2007) One source of difference in results between the early and recent studies may be the FD measure used Recognising that high sub-national spending and revenue shares do not necessarily reflect high local autonomy then if autonomy is the key growth-enhancing characteristic of FD early studies probably overstated the degree of effective decentralization since some local revenuesexpenditures are typically controlled or mandated by central governments6

By contrast recent studies have focused on a more restricted measure of FD local government spending net of conditional or discretionary transfers (Ebel and Yilmaz 2004 Meloche et al 2004) and local revenues over which sub-national governments have some degree of control over the tax rate the tax base or both (Akai and Sakata 2002 Ebel and Yilmaz 2004 Meloche et al 2004 Thornton 2007) In a similar vane Lin and Liu (2000) and Jin et al (2005) use the marginal retention rate of locally collected revenue to reflect the degree of FD arguing that this captures the fiscal incentives for local government to promote local business development Using these narrower FD measures a positive impact of FD on economic growth generally finds more support7

6 Furthermore Lin and Liu (2000) criticise the measure employed in Zhang and Zou (1998) - the ratio of provincial spending to total central spending - because a large province would appear to have a high degree of fiscal decentralization merely by being more populous 7 An exception to these fiscal decentralization measures is Stansel (2005) who focuses on the horizontal dispersion of power among lower tiers of government using the number of county

mdash 17 mdash

Nevertheless the recent literature provides limited guidance on the growth effects of FD in OECD countries Recent evidence including OECD countries has tended to focus on the US (Akain and Sakata 2002 Stansel 2005) or include OECD countries among more diverse developed-developing country samples (Iimi 2005) Thiessen (2003) and Thornton (2007) examine samples of OECD countries directly Both use cross-section methods Thornton (2007) argues that recognising the extent of local autonomy is important while Thiessen (2003) finds evidence of a growth-maximising degree of FD That is growth is enhanced by converging towards intermediate levels of decentralization - from either high or low initial levels

Using more extensive annual panel data and more flexible dynamic econometric methods we show below that for a variety of measures of local fiscal autonomy the important convergence appears to be towards the same levels of revenue and spending decentralization That is our evidence suggests raising revenue decentralization andor lowering spending decentralization would be growth-enhancing on average for OECD countries As far as we are aware our empirical evidence is the first to support Oates (1972) hypothesis that FD efficiency benefits become greater when there is a close match between revenue discretion and spending assignments at sub-national levels Jin and Zou (2005) also tested simultaneously for growth effects of expenditure and revenue decentralisation across Chinese provinces but they reject Oatesrsquo hypothesis We obtain our results after controlling for endogeneity we find some effects running from growth to fiscal decentralisation in line with the arguments of Bahl amp Linn (1992) and Martiacutenez-Vaacutezquez and McNab (2003) that efficiency gains from and demand for FD emerge as economies grow Most previous empirical FD studies have not control for endogeneity at least in a systematic way an exception being Iimi (2005) who instrumented for FD in his cross section study using fifth lagged values8 Using flexible dynamic panel methods and the PMG in particular recognises that efficiency gains may take some time to materialise and occur at different rates in different countries

municipal and township administrations per 100000 residents in 314 US metropolitan areas Using this measure Stansel (2005) finds a positive and significant effect of FD on the growth of both population and real per capital income 8 Zhang and Zou (1998) Xie et al (1999) Lin and Liu (2000) Thiessen (2003) and Jin et al (2005) acknowledge potential endogeneity bias but do not control for it - due to small sample sizes and the difficulty of finding good instruments Lin and Liu (2000) show that for their case the Hausman test of the potential endogeneity of the FD variable fails to reject the hypothesis that the marginal retention rate is exogenous Jin et al (2005) regress marginal retention rates on lagged growth rates and find a negative rather than positive coefficient rejecting a positive upward bias in their estimated FD growth effect for China

mdash 18 mdash

Instituto de Estudios Fiscales

4 DECENTRALIZATION MEASURES DATA AND 4 ECONOMETRIC METHODS

Decentralization Measures

The data used in our econometric analysis is based on OECD General Government Accounts (various editions) This source uses accrual accounting providing a better picture of commitments undertaken by governments than traditional cash accounting However the information available from this source starts in 1990 or 1995 for most of the countries We have extended this time-series using annual IMF Government Finance Statistics (GFS) data This source covers a longer period back to 1972 but is based on the cash criterion We follow Stegarescu (2005) and construct two measures of expenditure decentralization and three measures of revenue decentralization In all cases these decentralization measures are calculated as shares of consolidated general government spending or revenue For expenditures we calculate

Subnationa l spending minus Transfers from subnationa l to central governmentDirect spending = (1) Consolidat ed general government spending

Subnational spending minus Grants from other governmentsSelf minus financed spending = Consolidated general government spending (2)

Indicator (1) lsquoDirect spendingrsquo subtracts transfers paid to central government thus reporting amounts spent directly at each local administrative level9 Indicator (2) treats subnational expenditure net of grants received from central government as lsquoself-financed spendingrsquo reflecting spending from lsquoown resourcesrsquo (Stegarescu 2005) As a measure of locally-financed spending it may be regarded as a more appropriate indicator of local autonomy

On the revenue side a measure of lsquoown revenuersquo decentralization is Subnational revenue minus Grants from other governmentsOwn revenue =

Consolidated general government revenue (3) Indicator (3) subtracts grants received from other levels of government from

total subnational revenues to capture lsquoown resourcesrsquo10

9 These transfers refer to the category lsquoGrants to other general government unitsrsquo (Government Finance Statistics Manual 2001) They can be current or capital grants depending on purpose and they include the tax levied by one level of government but transferred to other levels of government Transfers from sub-national governments to central governments are only significant for Spain and especially for Greece For the rest of the sample it accounts for a small share of sub-national government spending (average 19) 10 Ebel and Yilmaz (2004) contend that unconditional transfers and transfers given under objective criteria could be included under revenue decentralization However we subtract all transfers to leave only those revenues generated by subnational governments and which are not discretionarily fixed by central government (Stegarescu 2005) The other indicator

mdash 19 mdash

However there are also locally collected taxes over which local governments have little or no control Arguably these taxes should also be subtracted to measure autonomous local resources appropriately Unfortunately there is no official OECD data distinguishing between locally-collected taxes controlled by local versus central governments for a broad sample of countries11 However following the methodology of OECD (1999 2001) for Central and Eastern European Countries Stegarescu (2005) provides data for 21 OECD countries from 1975 to 2000 on the locally collected taxes decomposed into the following categories

A Tax bases orand rates determined by subnational governments

B Tax revenues shared between subnational and central governments of which

B1 Shared taxes subnational level determines revenue split

B2 Shared taxes subnational level has to consent to revenue split

B3 Shared taxes central government unilaterally determines revenue split

C Tax bases orand rates determined by central governments

This allows two additional revenue decentralization measures to be calculated autonomous own revenue (indicator 4 below) and the autonomous plus shared own revenue (indicator 5 below)

Own tax revenue(A) + Nontax amp capital revenueAutonomous own revenue =Consolidated general government revenue (4)

Autonomous amp Shared own revenue =Own tax revenue (A) + Shared tax revenue (B1amp B2) + Nontax amp capital revenue

Consolidated general government revenue (5) Indicator (4) is the share of taxes for which subnational governments determine

the tax baserates (category A) plus local non-tax and capital revenue The autonomous-plus-shared own revenue (indicator (5)) is the share of taxes in indicator (4) plus shared taxes where the revenue split is determined or consented by subnational governments (categories B1 and B2) These two revenue decentralization measures provide a narrower definition of local autonomy in public revenues but are only available for a more limited sample of countries and years Thus for Indicators (1) (2) amp (3) above our sample is composed of 23 OECD countries from the early 1970s to 2005 For Indicators (4) amp (5) data are restricted to 18 countries from 1975 to the late 1990rsquos (see appendix I for details) We therefore use (4) and (5) as robustness checks on the other indicators

used in the literature the marginal retention rate is not directly observable calculation would require simulations for each type of revenue see Thiessen (2003) 11 It is available for some Central and Eastern European Countries for 1997-2000 see OECD (1999) and (2001)

mdash 20 mdash