Costs Preferences and Institutions, An Empirical Analysis of the Determinants of Government Decentralization.

Die Discussion Papers dienen einer möglichst schnellen Verbreitung von neueren Forschungsarbeiten des ZEW. Die Beiträge liegen in alleiniger Verantwortung der Autoren und stellen nicht notwendigerweise die Meinung des ZEW dar. Discussion Papers are intended to make results of ZEW research promptly available to other economists in order to encourage discussion and suggestions for revisions. The authors are solely responsible for the contents which do not necessarily represent the opinion of the ZEW. Download this ZEW Discussion Paper from our ftp server: ftp://ftp.zew.de/pub/zew-docs/dp/dp0539.pdf Nontechnical Summary Many industrial, as well as developing and transition countries are increasingly reallocating government functions from central government to regional or local governments. Despite this worldwide tendency, large differences in fiscal design across levels of government still persist and are not likely to disappear in the near future. Apart from normative considerations, these issues therefore raise the question about the common factors which determine observed cross-country differences in the distribution of spending and taxing powers between levels of government. According to the "Decentralization Theorem", the efficient allocation of government functions between different layers of government is determined by the trade-off between the benefits of decentralized provision of public goods, which allows for differentiation according to local preferences and conditions, and the costs of missing coordination in case of inter-jurisdictional spillovers and potential economies of scale. Recent work on fiscal federalism shows that apart from these traditional cost-benefit aspects, political decisionmaking processes and the underlying institutional rules determine the choice between centralization and decentralization in democracies. The delegation of political decisionmaking to elected representatives is shown to create a common-pool problem, collusive behavior and vote-trading leading in the end to inefficiently high public spending and centralization. However, the empirical literature provides only limited cross-national evidence on the implications of collective decision-making for government decentralization, and particularly, on the role of specific institutional rules. This paper takes a comprehensive empirical approach which integrates costs, preferences, and institutions to verify the contribution of the fiscal federalism literature to the explanation of cross-country differences in the degree of decentralization. More specifically, we investigate the predictions of Lockwood For this purpose, a detailed analysis and quantification of decision-making institutions is carried out for a sample of 23 OECD countries from 1965 to the present. Based upon this, we investigate empirically the effect of specific institutions on the degree of fiscal decentralization, explicitly considering institutional changes over time, and controlling for preference heterogeneity, economies of scale and other determinants of the vertical government structure and of the demand for public services. The results of the cross-sectional time-series regression analysis indicate that apart from preference heterogeneity, economies of scale, and other demand side factors, institutions are significant in explaining cross-national differences in the degree of fiscal decentralization. With total subnational tax revenues or direct expenditures reported in public finance statistics as dependent variable, participation of sub-central governments in central decision-making leads to more decentralization. However, when using a new indicator of decentralization instead which accounts for tax-raising powers of sub-central government, it turns out that particularly participation of representatives delegated by sub-central governments and legislatures in central decision-making concerning both the assignment of spending and taxing powers and other issues of national legislation is associated with less subnational fiscal autonomy and more tax centralization. In contrast to this, direct involvement of the citizens through regional referendums leads to increased decentralization of taxing powers. On the other hand, contrary to previous analyses at the subnational level, direct democracy at the national level is mostly found to be associated with increased centralization. The new contribution of this analysis is therefore twofold. First, these estimates support the collusion hypothesis and recent theoretical contributions in fiscal federalism which emphasize the role of decision-making institutions. Bargaining at the national level provides sub-central governments with more financial resources from the common pool to spend, while at the same time independent tax-raising autonomy is restricted. And second, the analysis shows how important it is to use in empirical studies an indicator of decentralization which accounts for subnational decision-making autonomy instead of received expenditure and revenue shares. Costs, Preferences, and Institutions: An Empirical Analysis of the Determinants of Government Decentralization † Dan Stegarescu ‡ Abstract This paper examines the factors determining vertical government structures. An empirical analysis for a panel of OECD countries indicates that apart from preferences, economies of scale, and other factors, institutions explain cross-national differences in the degree of fiscal decentralization. Accounting for taxing powers of subnational governments, the evidence strongly supports the collusion hypothesis according to which delegation of decision-making concerning the assignment of powers and national legislation to subnational representatives leads to increased tax centralization, as compared to direct participation of the citizens of the subnational entities. On the other hand, direct democracy at the national level is associated with higher centralization