Impact of Decentralization on economic growth

This paper reviews the current knowledge on an issue of increasing policy interest: what impact fiscal decentralization has on economic growth. Fiscal decentralization may indeed have a direct impact on economic growth but the theoretical underpinnings for this relationship remain largely undeveloped. The absence of an adequate theoretical framework has undermined the validity of the empirical work on this subject. A fair summary of the empirical search for a direct relationship between fiscal decentralization and economic growth is that it remains an open question. Much less attention has been devoted in the literature to the indirect channels through which fiscal decentralization may affect economic growth, through the impact of fiscal decentralization on economic efficiency, the regional distribution of resources, and macroeconomic stability. This paper explorers the nature of these links and concludes with some thoughts and policy advice.

Recently, fiscal decentralization, which entails the devolution of government fiscal responsibilities to lower levels of government, has been implemented in many developed and developing countries. Among its many objectives are: to reduce the burden on central and provincial government of providing public goods and services; to increase popular participation in the planning and implementation of development programmes; to find a way out from central government failures to secure national objectives, from the trap of ineffective, inefficient governance, macroeconomic instability, and inadequate economic growth; to reorganize the government for the cost effective provision of public goods and services. However, most theoretical and empirical studies have focused on the effect of fiscal decentralization on economic growth. The results obtained in those studies are mixed. For example, some find that fiscal decentralization reduces provincial economic growth (see Zhang and Zou), some find a negative relationship between fiscal decentralization and economic growth for developing countries, but no relationship exists for developed countries (see Davoodi and Zou,; Zhang and Zou). However, there are also a few studies that have been successful in verifying the potential contribution of fiscal decentralization to economic growth. For example, Oates detects a significant and robust positive correlation between fiscal decentralization and economic growth. Woller and Phillips find a statistically significant, though trivial, inverse relationship between the levels of revenue decentralization and economic growth in a sample of developed countries, and they do not find any relationship between fiscal decentralization and economic growth in a sample of less developed countries [5 p.223].

Lin and Liu also find that fiscal decentralization has made a positive contribution to economic growth in China. Their result differs from Zhang and Zou, because they use the marginal retention rate of locally collected budgetary revenues by provincial governments as a measurement of fiscal decentralization. The empirical studies doing in cross-country analysis and in-country analysis show that the form of government (federal vs. unitary) plays an important role in the execution of fiscal decentralization policy. Several studies have looked into this: first, between/among countries generally (Cheema and Rondinelli, 1983; Oates, 1985; Sachs and Warner, 1995; Thiessen, 1998; and McNab, 2000); second, between/among Muslim countries; third, between/among developed and less developed countries (Davoodi and Zou, 2001; Adam and Bevan, 1999); fourth, single country (Jin et al., 2003; Lin and Liu, 2004); and fifth, province level (Glaeser et al., 1996; Zhang and Zou, 2000; and Akai et al., 2001) [1 p.102]. This paper, consequently, asks: What would be the effect of implementing fiscal decentralization in countries with transition economic? This countries with different levels of governance: provinces, regencies and municipalities. Each countries has a different size in terms of land area population. Under such conditions, can the implementation of fiscal decentralization attain its objective of bringing prosperity to people? Can each province with its particular local receipts generate and expand the economy? Are the other sources (such as counter balance budget and other legal local revenues) used to defray the routine expenditures or development expenditures? In this study, the effect of fiscal decentralization on economic growth in a sample of several provinces will be explored. A province study offers several advantages: Firstly, a bigger sample of data is available at provincial level. Secondly, even though, according to the argument of Akai and Sakata, using a cross-province approach may fail to capture local cultural, historical, and institutional differences between provinces. But, this panel data estimation is able to adjust for such differences and capture the local heterogeneities.

Although decentralization is often associated with increased degrees of policy innovation, greater transparency, and better capacity of governments to adapt policies to local needs, it can be difficult to connect these factors with increased economic performance. Especially in countries lacking the appropriate institutions, legal systems, and human capital, economic growth rates are unlikely to rise as a direct result of fiscal decentralization. Indeed the opposite case is more likely to happen with decentralization having a detrimental effect on the overall economy of a country [3 p.52]..

We know very little about the relationship between decentralization and growth. Empirical evidence for the way in which decentralization affects growth has been contradictory and is plagued by measurement, specification, and analytical problems. There is stronger evidence for a relationship in the other direction --from growth to decentralization-- but the interpretations of this correlation between high income and decentralization have varied.

In the absence of strong, unambiguous, empirical evidence, researchers have put forward the following three hypotheses concerning the relationship between decentralization and growth: In each of the hypotheses, growth has only a secondary relationship to decentralization and the nature of this connection -- growth enhancing, growth-impeding, or growth-requiring- depends on what one sees as the primary effects of decentralization. These primary effects, in turn, have much to do with the specific design of decentralization policy. In this study, the effect of fiscal decentralization on economic growth in a sample of several provinces will be explored. A province study offers several advantages: Firstly, a bigger sample of data is available at provincial level. Secondly, even though, according to the argument of Akai and Sakata, using a cross-province approach may fail to capture local cultural, historical, and institutional differences between provinces. But, this panel data estimation is able to adjust for such differences and capture the local heterogeneities.

While the rest of the KMS node discusses the methods for reaching certain primary effects --ideally more efficient, responsive delivery of services-- this section provides an outline of the ways in which the commonly discussed primary effects of decentralization can shape decentralization’s effect on growth and desirability in less developed countries [2 p.270].

Three Alternative Hypotheses for How Decentralization can Indirectly Impact Growth

Hypothesis 1: Decentralization increases economic efficiency in public spending, therefore its dynamic effects should be growth-enhancing.

Hypothesis 2: Decentralization can lead to macroeconomic instability which can, in turn, inhibit growth.

Hypothesis 3: Developing countries have significantly different institutional and economic environments than developed countries and will not reap the benefits or suffer the consequences of decentralization in the same ways.

Several policy implications can be derived . First, that local government should be able to increase their non-tax revenues. Second, that there is a need to create conducive conditions for capital inflows. The availability of good infrastructure, and assurance of security and political stability are among conditions that can be expected to support local economic activities. Third, there is also a need to develop a clear framework for fiscal decentralization assignment such as income redistribution and borrowing. Central government should carry the policy responsibility for stabilizing income redistribution. Fiscal decentralization can degrade central government expenditures and at the same time improve the expenditures of sub-national government, including the midewind governance like

provinces and local governance like municipalities and communes. As for borrowing, for local government with limited source of finance, there is no reason to expect that local government should escape from taking loans to fund their activities [4 p. 1130].

There is no clear, automatic, relationship between decentralization and growth. Direct empirical studies have not been satisfying and a return to the literature on decentralization’s primary effects may be a more useful way to think about the relationship between growth and decentralization. From this point of view, the design of decentralization becomes the key factor in determining whether policies will lead to the efficiency linked to higher growth, exacerbate the deficits and instability connected to lower growth, or simply become mired in institutional constraints.

References and other resources:

1. Anwar Shah A fiscal need approach to Equalization // Canadian Public Policy - Analyze de Politiqeus, XXII:2:99-115 1996.

2. Gray C., Lane T., Varoudakis A.// Fiscal Policy and Economic Growth. Lessons for Eastern Europe and Central Asia/ Washington - 2007. – 305 p.

3. Martinez-Vazque J. //The Impact of Fiscal Decentralization: Issues in Theory and Challenges in Practice/ Mandaluyong City, Philippines: Asian Development Bank - 2011. – 301 p.

4. Oates, W. Fiscal Federalism. New York: Harcourt Brace Jovanovich // An Essay on Fiscal Federalism / 1999 - . Journal of Economic Literature vol. 3 pp. 1120–1149.

5. Zhang, T. and H. Zou., //Fiscal Decentralization, Public Spending, and Economic Growth in China/ Journal of Public Economics, vol. 67 (2). pp. 221–240.