Fiscal Decentralisation and efficiency of

government. A brief literature review

Francesco Porcelli

January 2009

Fiscal decentralisation can be defined as a two-dimensional policy insti-

tution that involves either decentralisation of a tax instrument, when local
governments have the power to raise taxes, or decentralisation of expendi-
tures when local governments bear the responsibility for implementing ex-
penditure functions.
The way in which fiscal decentralisation affects the "quality" of govern-
ment activity can be seen from different points of view and operates through
many mechanisms. On the other hand the huge amount of theoretical and
empirical literature that studies the relation between decentralisation and
government efficiency can be divided into two large areas:

the classical theory

the second generation theory.

Although the theoretical justification of this research is mainly supported by

the more recent literature, in this section I will provide a summary of both
areas.

1 The classical theory of fiscal decentralisation

The classical approach can be restricted to three main contributions.

Department of Economics - University of Warwick (UK)

1
Francesco Porcelli - Decentralisation and efficiency of government 2

Chronologically, we can cite Tiebouts model of local public good

provision [Tiebout, 1956], where decentralisation coupled with mobile house-
holds solves the problem of the efficient provision of public goods. Essentially
local governments compete in offering a mix of tax and public goods, and
citizens "choose by their feet", deciding where to live according to their
preferences about tax and public goods.
The second and maybe most influential contributions is Oates [1972] De-
centralisation Theorem that solves the trade-off between centralised and
decentralised provision of public goods in favour of the former (centralisa-
tion) if average preferences across citizens of different region are equal, and
the consumption of the public goods generates spill-over effects; whereas
a decentralised provision maximises social welfare when preferences differ
across regions and spill-over effects are absent. The theorem hinges on the
crucial assumptions that governments operate in order to maximise social
welfare and that in case of centralisation there is a uniform provision of
public goods.
Finally the most important contribution in the public-choice perspective
of fiscal federalism is Brennan and Buchanan [1980] Leviathan hypothesis,
according to which fiscal decentralisation is a mechanism for constraining the
expansionary tendencies of governments. Under this approach central gov-
ernments do not maximise social welfare and operate like monopolists (or
leviathans) in order to increase their control over the economys resources.
Therefore, on the crucial assumption that households and firms are mobile,
splitting the central government in many local governments and introducing
fiscal competition among them through a decentralised fiscal system should
produce the same effect of explicit fiscal constraints on the central govern-
mens taxing power.
Oates [1972] and Tiebout [1956] offer a theoretical framework in which
fiscal decentralisation can guarantee an efficient provision of public goods
simply because local preferences are better satisfied than in the case of cen-
tralisation. Both previous approaches assume a benevolent government, but
the Leviathan hypothesis is based on the the opposite assumption whereby
decentralisation is a means to reduce government size in order to stem its
inefficient behaviour.

1.1 Empirical models that relate decentralisation and public

expenditure: Leviathan Hypothesis test
Most of the early empirical works about the effects of decentralisation are
aimed at assessing the relation between the size of government, measured in
terms of general government revenues or expenditures, and some indicators of
local governments degree of power, trying to provide a test for the Leviathan
Francesco Porcelli - Decentralisation and efficiency of government 3

hypothesis1 .
The main finding of this part of the literature supports the hypothesis
that decentralisation can reduce the aggregate government expenditure (see
Nelson [1987], Marlow [1988], Grossman [1989], Grossman and West [1994],
Feld et al. [2003], and Fiva [2005]). Exceptions can be found in the earli-
est empirical analysis when the econometric techniques were less advanced
[Oates, 1972, 1985], and seldom in more recent works [Stein, 1999].
One of the last studies in this field is that of Rodden [2003], whose main
argument is that fiscal decentralisation might lead to a smaller or larger
public sector depending on how it is funded: when decentralisation is pro-
vided by grants from general to local governments the Leviathan hypothesis
may not hold and the expected outcome should be a larger public sector;
instead, when the general government decentralises fiscal revenues the effect
on total public sector might be negative. For the first time the hypothesis
that expenditure decentralisation without local tax power can hinder the tax
competition predicted by the Leviathan model was successfully tested.
In these models, however, public expenditure is used as a dependent
variable and it is implicitly considered as the output of government activity.
The problem is that even if we assume that smaller is better according to
the Leviathan hypothesis, it would be very difficult to assess the effect of the
decentralisation on the efficiency of the government in this models, because
expenditure is an input of public activity and allocative or technical efficiency
is not always achievable by a more parsimonious government. Therefore, if
our goal is to assess whether decentralisation affects the efficiency of the
government, we should estimate a different kind of empirical model.

2 More recent developments

In the last twenty years the classical approach evolved together with the
theory of fiscal federalism in what is sometimes called the second-generation
theory of fiscal federalism [Oates, 2005].
In this new (or second generation) literature the effect of fiscal decentral-
isation has been modelled to embody the political process and the possibility
of asymmetric information across political agents. Differently from the clas-
sical approach governments are assumed to maximise their own objective
function that does not imply the maximisation of social welfare.
In this new framework the basic issue of whether to centralise or de-
centralise provision and/or funding of some public activities appears in a
somewhat, but not completely, different light.
The first stream of this new literature reconsiders the decentralisa-
tion theorem in a political economy contest. Here the main argument
1
For a detailed list of them from 1972 to 2003 see Feld et al. [2003] pag. 5.
Francesco Porcelli - Decentralisation and efficiency of government 4

in favour of decentralisation hinges on the inefficient outcome of the cen-

tralised decision-making process rather than on the trade-off between prefer-
ence matching and externalities typical of the original version of the Oates
theorem.
The second stream studies the trade-off between centralised and decen-
tralised provision in principal agent models of electoral accountabil-
ity. Essentially the electorate are the principals and the politicians are the
agents and the presence of asymmetric information between them can be
seen as the main reason why the government performance is inefficient. In
this framework decentralisation can reduce the information asymmetry gen-
erating yardstick and/or tax competition among sub-national governments,
and in this way the electorate can increase their control over the politicians
to stimulate more electoral accountability that finally translates into a more
efficient government activity, because, for example, we can observe less rent
diversion and less influence by lobbies.
At the same time the recent empirical literature provides more direct
evidence for the accountability argument. Essentially it studies the relation
between decentralisation and different measures of the quality of governments
as well as the direct relation between decentralisation and efficiency.

2.1 Decentralisation Theorem with political economy

Lockwood [2007] reconsidered the decentralisation theorem (DT), replacing
the assumption of benevolent government with a political economy model
like direct democracy where the decision-making process is implemented via
majority voting over alternative levels of public good provision. In this case
it has been shown that DT continues to hold if preferences of the median
voter are equal to the average preferences, otherwise there could be cases
where, in spite of spill-over effects and uniform preferences, decentralisation
welfare-dominates centralisation; or there could be cases where centralisa-
tion welfare-dominates decentralisation even if there are no externalities and
preferences differ across regions.
Lockwood [2002] and Besley and Coate [2003] explicitly depart from both
main assumptions of the DT, studying the trade-off between centralisation
and decentralisation in a political economy setting. They consider a more
realistic environment where provision of public goods can be set at a different
level across regions in the case of centralisation also, and the level of the
public goods is determined by a bargaining process among regional delegates
ruling out the unrealistic assumption of benevolent government, in this way
legislative rules rather than behaviour are taken as primitive.
Lockwood [2002] focuses more on the details of the bargaining process
and proves that decentralisation welfare-dominates centralisation even in the
presence of spill-over effects and identical preferences across regions. The
main argument is that inefficiencies of centralisation are essentially because
Francesco Porcelli - Decentralisation and efficiency of government 5

of the outcome of the bargaining process that in equilibrium is driven by

cost-minimisation, implying that the cheapest provision of public goods has
more probability of being implemented than those with the highest surplus.
Therefore in equilibrium centralisation provides a level of public good below
the efficient level.
Besley and Coate [2003] paid more attention to the strategic choice of del-
egates by voters, assuming heterogeneity within regions. It has been proved
that decentralisation welfare-dominates centralisation also in the case of uni-
form preferences across regions and spill-over effects, essentially because the
median voter prefers a delegate with preferences for the public good higher
than himself; as a result the equilibrium outcome in case of centralisation is
a provision of public goods above the efficient level.
These two important contributions offer new arguments in favour of de-
centralised provision of public goods since they show that centralised pro-
vision can be welfare-dominated even if the assumptions of the DT fail. In
fact, when we take into account the political process, the main argument
hinges on the inefficient outcome of the centralised decision process rather
than on the trade-off between preference matching and externalities.

2.2 Decentralisation in principal agent model of electoral ac-

countability
The analysis of fiscal decentralisation under the political economy perspec-
tive tends to model the political process assuming imperfect or asymmetric
information between voters and elected officials. The typical approach is
to consider a principal-agent model where the electorate is taken to be the
principal(s) that cannot observe directly the effort of the government, and
the elected officials to be the agents who maximise their own utility that
does not coincide completely with the utility of the voters.
In Oates [2005] words, "a centralised system takes the form of a single
agent (elected public official) who serves the whole population, while decen-
tralisation consists of one agent in each jurisdiction". As a result, the choice
between centralised or decentralised provision of public goods collapses in the
design of the optimal contract involving a reward scheme for the agent in or-
der to persuade him to exert high effort, i.e. high efficiency in the provision
of public good. In this framework, when fiscal decentralisation stimulates
political accountability a positive effect on government efficiency can be ob-
served also in the case of perfect homogeneity of preferences across local
jurisdictions.
Seabright [1996] seminal paper gives to accountability the precise mean-
ing of electoral accountability since it is defined in terms of the proba-
bility that welfare levels of a given jurisdiction determine the election of the
government.
Lockwood [2005], however, remarks that if the concept of accountability
Francesco Porcelli - Decentralisation and efficiency of government 6

is defined broadly it will be difficult to distinguish from preference-matching,

therefore it has been proposed to characterise more precisely the concept of
accountability, either the degree to which institutions allow the government
to divert rents, or the degree to which institutions allow special interest
groups to distort government decision-making by lobbying.2
The crucial argument is that electoral accountability is the main force
through which fiscal decentralisation can stimulate a more efficient govern-
ment activity. In particular Besley and Smart [2007] noticed that elections
provide accountability through two different effects: a selection effect, since
voters can decide not to re-elect bad incumbents, and an incentive discipline
effect, since bad incumbents have the incentive to improve the quality of
government in order to increase the probability of re-election.
The crucial point is, however, that decentralisation can create the incen-
tive to reduce rent diversion (and/or to reduce the influence of lobbies) in
order to increase the probability of re-election through two main forms of
competition among regions.

Tax competition, where local governments compete over tax rates in

order to attract tax base, that in the spirit of the Leviathan hypoth-
esis should reduce local government taxing power, improving voters
welfare only if officials where rent-seeking, otherwise the "race to the
bottom"3 would have a high probability of reducing social welfare as
a consequence of undersupply of public goods.

Yardstick competition, instead, occurs when voters can compare

tax policies and levels of public good provision adopted by officials of
other regions with those offered in their own jurisdiction. Voters should
improve their welfare by voting on the performance of their incumbent
relative to the incumbents in other regions.
In particular Besley and Case [1995], Bordignon et al. [2004] and Besley
and Smart [2007] have shown that the possibility of policy comparison
requires positively correlated cost across regions.
Recently Hindriks and Lockwood [2008] addressed the question of what
effect fiscal decentralisation can produce on accountability, either in
terms of selection effects or in terms of incentive effects, in an environ-
ment where politicians are rent-seeking and voters have only imperfect
information about the fiscal policy of other regions so that yardstick
competitions are partially ruled out. Their conclusion confirms the
positive effect of decentralisation on the quality of government since
2
In the continuation we will consider accountability more in terms of rent diversion,
for the lobbing argument you can cosider Bardhan and Mookerjee [2000], Bordignon et al.
[2003], Redoano [2003] and Ruta [2006].
3
In terms of reduction of the tax rate.
Francesco Porcelli - Decentralisation and efficiency of government 7

centralisation give rise to a weaker selection effect, but only when costs
of provisions are perfectly correlated across regions.

It is important to report another argument usually considered by those

who advocate the virtues of fiscal decentralisation: local governments possess
a better knowledge of local preferences because they are closer to people than
central government. This argument recalls the subsidiarity principle, and it
is usually justified on the grounds of costs and the benefits of acquiring
information about local preferences. As observed by Seabright [1996], the
failure of central authorities to obtain such information must reflect its lesser
value to central, than to local, public authorities.
To sum up, we can say than either under the classic approach or under
the political economy perspective fiscal decentralisation is largely seen as a
powerful policy institution to boost efficiency in the public sector. In particu-
lar, when the political process is taken into consideration, the main channel
through which this positive effect takes place is the strengthening of the
electoral accountability of public agents rather than the classic preference-
matching argument.

2.3 Empirical models that directly relate to efficiency of gov-

ernment and decentralisation
In more recent literature the effect of decentralisation is estimated in models
that adopt, as a dependent variable, some measures of general government
efficiency like, for example, the perceived corruption or indicators of the
output (or quality of the service) in particular sectors like health care and
education in order to provide more direct evidence for the accountability and
preference-matching argument.
Treisman [2000] suggests two ways to assess the quality of government:
first indexes of the perceived corruption4 ; then indicators of effectiveness of
public service provisions like the percentage of infants under twelve months
who have been inoculated for diphtheria, tetanus and pertussis for the health
sector, and the adult illiteracy rate for the effectiveness of a basic educational
service.
Using a cross-sectional dataset of a wide rage of developed and developing
countries, Treisman [2000] concludes that decentralisation does not seem to
be a good way to boost efficiency. In particular, structural decentralisation is
associated with greater perceived corruption and there is weak evidence that
countries with more tiers of government offer a lower quality of health; then,
unexpectedly, resource decentralisation based on revenues and expenditure
that are collected or spent by sub-national government is not significant;
moreover the effect of decentralisation on education is rarely significant in
4
Like those compiled by Transparency International or by experts at the World Bank.
Francesco Porcelli - Decentralisation and efficiency of government 8

general, but in the case of federal countries the effect seems to be positive
and significant.
Relying on a similar dataset, Fisman and Gatti [2000] reached, instead,
the opposite conclusion, claiming that decentralisation, measured in terms
of local government expenditure, reduces the perceived corruption.
Faguet [2004] studied the decentralisation case of Bolivia, where it has
been found that investment in human capital and social services changed
significantly after fiscal decentralisation reform in 1994 and these changes
were strongly and positively related to objective indicators of need.
Barankay and Lockwood [2007] challenged some of the previous works
advocating the necessity to estimate the decentralisations effect in a model
that mimics the production function of government activity. To support their
criticisms a model of the education systems production function has been
estimated by means of panel data from Swiss cantons over the period 1982
to 2000. The ceteris paribus effect of decentralisation on educational out-
put has been estimated with the inputs of the educational service controlled
for. Decentralisation is measured in terms of education expenditure at local
levels (counties) in total education expenditure (counties and cantons), the
educational output is represented by the maturity rate, and education ex-
penditure per pupil plays an important role among the input variables. The
empirical result strongly supports a positive effect of decentralisation on the
output of the education system.
Recently Adam et al. [2008] identified the effect of fiscal decentralisation
using a "two-stage approach". In the first stage, data envelopment analysis
of a panel of 21 OECD countries over the period 1970 to 2000 is used to
compute country-specific efficiency indexes, assuming an underlying produc-
tion process where public spending is considered as input and two composite
measures of performance are assumed as outputs of the public sector. In the
second stage, country-specific efficiency indexes have been regressed on an
extensive set of alternative revenues and expenditures in fiscal decentralisa-
tion measures and some control variables like demographic variables, index of
government regulation and openness of the economy, measure of population
heterogeneity, and variables that refer to the structure of the government and
productivity measures. Finally to control country heterogeneity they intro-
duce country fix effects through country dummies. Their results strongly
support the evidence of a positive and significant effect of decentralisation
on government efficiency.

3 Dangers of fiscal decentralisation

It is important, however, to stress that fiscal decentralisation brings with it
potential dangers as well. For example, we have already seen, in relation to
the Leviathan hypothesis, how tax competition can reduce social welfare if
Francesco Porcelli - Decentralisation and efficiency of government 9

the assumption of rent-seeking governments does not hold.

As remarked by Oates [2005], there is now much literature that contends
that active fiscal competition among jurisdictions can produce many distor-
tionary effects that can jeopardise good functioning of the market economy
as well as the redistributive purposes of fiscal policy (Wilson [1999] and
Kothenburger [2002]).
Finally, the other, and maybe most important, danger in a decentralised
fiscal system is the possibility of local governments exploiting the "fiscal
commons" by shifting some of the costs of the provision of local public goods
from the local to the central government budget account. This problem
hinges on the presence of soft budget constraints (SBC), a phenomenon
mainly arising from the fact that central government is not able to rule out
(in a credible way) the possibility of any sort of bailout in case of local
default.
In the presence of SBC, local governments have the incentive to expand
their programmes beyond their means, which builds perverse fiscal behaviour
into the system and undermines the positive effect of decentralisation on
efficiency.
As summarised by Oates [2005], the main solution of this problem re-
quires the implementation of an effective and reliable local system of taxa-
tion and intergovernmental grants in order to provide the revenues needed
to finance local programmes. Therefore the solution is studied through an-
other important area of fiscal federalism: the design of fiscal relation in a
multi-level government structure.
According to Musgrave [1983], local public functions should be financed
by user charges and local taxes, especially by property taxes and consump-
tion taxes, leaving income taxes to the central government; however, this
division of revenues implies that lower levels of government are likely to end
up with greater expenditure responsibilities than can be financed from their
own revenues.
Therefore, intergovernmental grants are important to close the revenue
gap, and as a result the funding system of sub-national government should be
based on two main pillars: own tax revenues and intergovernmental grants.
Their correct mix is a big issue in the fiscal federalism literature: some argue
that grants are essential to ensure an efficient and equitable system, others
advocate that there is no place for this transfer.
Although most of the literature agrees, however, that grants can be jus-
tified only from the efficiency point of view to compensate sub-national gov-
ernment for benefit spill-overs, in practice most countries have a system of
grants intended to equalise some concept of fiscal capacity [Bird, 1986].
In fact, according to Oates [1999], grants have two main functions: the
internalisation of spill-over benefits to other jurisdictions, and fiscal equali-
sation across jurisdictions. Accordingly they can assume two general forms:
conditional grants in the form of matching grants whose magnitude should
Francesco Porcelli - Decentralisation and efficiency of government 10

reflect the extent of the spill-overs; and unconditional grants in the form
of revenue sharing that are the appropriate vehicle for fiscal equalisation
purposes.
In conclusion, Bordignon and Turati [2002] consider a simple model of
bailing out and in the light of the theoretical literature on the SBC they anal-
yse the evolution of regional spending, funding, and deficits during the 1990s
in the Italian National Health System. According to their empirical analy-
sis, regional spending and financing seem to be related to some of the SBC
proxies, suggesting that removal of these features may help to strengthen
regional budgets.

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