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When Is Fiscal Decentralization Good for Governance?
Author(s): Charles R. Hankla

Source: Publius, Vol. 39, No. 4 (Fall, 2009), pp. 632-650
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When is Fiscal Decentralization
Good for Governance?
Charles R. Hankla*
Many developing countries are seeking to improve governance with fiscal decentralization. It is
therefore worth revisiting what we know about political and economic institutions to understand
how and under what circumstances decentralization can be beneficial. In an effort to do that, I
review past research on the governance implications of devolving power to subnational author-
ities. Based on this review, I find that the gains from decentralization depend sensitively on how
subnational authorities and intergovernmental relations are structured. I therefore conclude the
paper by drawing nine lessons from theory and experience to help improve the design of decen-
tralized institutions.
Even a cursory examination of the world's states reveals a dizzying array of

relationships between central and subnational governments. In some states, the
central government is clearly dominant and subnational authorities are merely
agents of its will. In others, strong regional and local leaders influence the crafting
of virtually all domestic policies. Many systems fall somewhere between these two
extremes, with central governments setting the direction of national policies and
subnational authorities exercising power on the margins. In some states, the
strength of subnational governments lies in their influence over the national policy-
making process, while in others it rests in their competence over specific policy
arenas set aside for them by a federal constitution.
This already diverse mixture of systems has been further enriched by a recent
global trend toward decentralization, most strikingly in the developing world.
International Monetary Fund data on twenty-nine countries, for example, show
that the percent of total public expenditure undertaken by regional and local
governments has increased from around 20 percent in the late 1970s to between 30
percent and 40 percent in the mid-1990s (Rodden 2006). There is reason to believe
that this trend is continuing and even accelerating as decentralization gains support
within the international development community. It has therefore become urgent
to understand the impact of decentralization on governance quality, especially in
* Georgia State University; chankla@gsu.edu
Publius: The Journal of Federalism volume 39 number 4, pp. 632-650

doi:10.1093/publius/pjn034
Advance Access publication 6 November 2008
© The Author 2008. Published by Oxford University Press on behalf of CSF Associates: Publius, Inc.
All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.
Fiscal Decentralization and Governance 633
poor countries where institutional changes

or ill.
In this article, I draw lessons from theory and experience to shed light on the
consequences of empowering subnational governments, especially in the developing
country context. My focus, unless otherwise indicated, is on the "region,"
"province," or "state" standing at the highest level of subnational government,
although many of the principles discussed will apply to local institutions as well. I
begin by mining current research in economics and political science for insights
into the potential benefits and pitfalls of decentralization. I then attempt to draw
general lessons for designing the most efficient system of intergovernmental
relations. In doing so, I seek the political and fiscal institutions best suited for
maximizing the benefits of decentralization and avoiding the pitfalls, with the goal
of providing the best governance outcomes possible. For the purposes of this
article, decentralization provides quality governance when (i) it efficiently and
reliably provides citizens with the public goods and services that they desire, (ii) it
ameliorates (or at least avoids exacerbating) regional inequality and separatism, and
(iii) it protects macroeconomic stability. Throughout the article, I draw on the
experiences of a variety of states, centralized and decentralized, rich and poor, to
flesh out my broad points with real-world examples.
Is Decentralization Good for Developing Countries?

The State of the Debate
Do the benefits of decentralization for developing countries outweigh the potential

drawbacks? Most of the first-generation literature in economics views
decentralization in a very positive light, emphasizing, among other things, its
potential to improve efficiency (Oates 2005). More recently, a number of studies
have called into question the belief that decentralization is a uniformly good policy
choice. In this section, I will review the current state of the debate over
decentralization's impact on three policy outcomes: (i) the targeting and efficient
provision of public goods, (ii) inequality and regionalism, and (iii) macroeconomic
stability.
Decentralization, Targeting, and the Allocation of Public Goods

Tiebout (1956) pioneered the idea that decentralization, especially fiscal
decentralization, can improve the efficiency of public goods provision by making
it less uniform. His argument was that, in countries where taxation and spending
powers are delegated to subnational governments, citizens can sort themselves
geographically according to their preferred combination of government services.
Two decades later, Oates (1972) took Tiebout's simple but powerful idea as a
starting point in developing a more comprehensive theory about the optimal level
634 C. R. Hankla
of decentralizat
responsiveness
internalize ex
governments en
spend policies en
other hand, Oate
whose effects m
be underprovid
consider the ben
much to generat
level of decentra
drawbacks of non-internalization.
A possible implication of Oates's argument is that, in most cases, public services

should be provided at a subnational level. National governments should concern
themselves with macroeconomic stabilization and with equalizing the regions and
encouraging spending that generates positive externalities (Bird et al. 2003). Not all
scholars agree, however, that decentralization is a necessary precondition for the
targeting of public goods. For example, some critics, pointing out that moving
from region to region tends to be costly, argue that citizens are unlikely to sort
themselves geographically by tax and spending preference (Manor 1999; Bardhan
2002). This relative immobility of citizens should be especially true, they contend,
in developing countries.
A second reservation that many scholars have about the Tiebout and Oates models
is that they assume that central governments are unable to target different bundles of
public goods to different regions (Breton 2002; Treisman 2007). If central governments
can in fact accommodate the heterogeneous preferences of their citizens with targeted
fiscal policies, subnational governments become superfluous.
While there is probably some truth to these critiques, a number of points can be
adduced to defend the first-generation theories. First, political impediments may
make it difficult for central governments to tax different regions or groups
differently or to provide more public goods in one place than another. Clever
approaches may be found to do so (such as imposing excise duties only on
products made in regions that prefer more government), but it is unlikely that
central authorities will be as efficient in targeting their fiscal behavior as sub-
national governments. Moreover, central governments, which respond to the
aggregate national preferences of voters, may lack the incentives to provide such
targeted policies. Finally, even if they are willing to vary their taxation and spending,
such governments are unlikely to be the most effective judges of regional preferences.
While it may be true that citizens rarely sort themselves geographically by fiscal policy
preference, subnational governments in a decentralized system can at least provide the
policies preferred by most current residents of their constituency.
Targeting diverse regions with their pre

not the only important aspect of quality g
it is important that subnational governme
over particularistic goods in the first plac
ization encourages such positive incentives
ability of the state. The basic intuition her
when it is closer to the people. First, citiz
public officials when they live in the sam
from a distant national capital (see von
transparency results in better public serv
found that political participation tends to
1999; Crook 2003). Second, subnational
position to judge what citizens want if th
A number of empirical studies have e
decentralization and governance (and mo
Excellent summaries of this literature c
(1999), and Azfar et al. (2004). To take s
that, in Kenya, local water services are su
the central government. By contrast, Parr
improvement in educational services after
Davoodi and Zou (1998) conclude that
experience slower economic growth, bu
subnational expenditure percentages to me
the opposite relationship. Von Bra
decentralization reduces poverty.
There is currently a debate in the l
decentralization with promoting transpare
Gurgur and Shah 2002; Crook 2003; Huthe
it exacerbates, or at best has no impact on
Tanzi 2002). Experts in the first camp a
leaders at the regional level. Those in t
government provide more opportuniti
subnational government leaders may be le
A related argument is that decentralizati
hands of regional governments than they
2003). Even if subnational authorities have
possess the administrative resources nec
regional governments lack sufficient numb
their policies, and this problem is especial
Finally, some scholars have highlighted th
enhancing accountability, may simply s
636 C. R. Hankla
powers of regional
2001; von Braun an
especially local gov
democracy and ac
governments truly
Decentralization, Ine
A different strand o
example, Weingast 1
intergovernmenta
citizens, and especia
they prefer lower
authorities in direct
incentive to provide
(see Qian and Roland
governance may fin
slows. Decentralizat
government from
reasons, according t
decentralization sho
the growth of gover
Other scholars ques
circumstances, dece
nation. If regional
revenues, it is inevi
poorer regions, ex
Aznar et al. 2004).
availability of educ
since decentralizatio
on central transfer
Furthermore, som
carefully regulated b
the free flow of c
constitution provide
to prevent such an e
work to protect int
(such as India), reg
powers to interfere
A final concern i
contribute to the st
the development of separatist moveme

decentralization for national cohesiveness
Some scholars fear that decentralization
countries (i.e. Treisman 1999; von Braun an
opposite point, contending that decentr
disintegration (i.e. Haysom 2003; Lijphar
world have relied on decentralization to m
creation of federal systems in Belgium an
power in the United Kingdom to the c
example France and the Soviet Union, have
promote national unity. The specific impa
probably only an issue in highly divided so
case basis (Crook 2003).
Decentralization and Macroeconomic Stab

A final strand of the literature critiques d
pose to macroeconomic stability (i.e. Pr
Smoke 2006 and Wibbels 2000 for review
subnational governments may undermi
countries by engaging in profligate spend
Treisman (2000) and Wibbels (2000) have
with higher inflation.
Other scholars have emphasized that dece
challenges for the macroeconomy if central
of subnational authorities to borrow on pr
to a "no-bailout" policy (see Rodden 2006
beyond their capacity to pay and then tur
debt, they have no incentive to behave res
tools, however, central governments can i
responsible financial practices.
Nine Lessons for the Design of De

What are we to conclude from these contr
impact on governance? If there is an overa
the impact of strengthening subnational in
depends sensitively on case-specific deta
that decentralized institutions, when desig
and avoid most of the potential drawbacks
The consequences can be dire, however,
this section, I cull from theory and experie
638 C. R. Hankla
well-functioning
categories - those
that promote bett
that strengthen n
economy is by no
lessons are likely t
performance outco
Making Decentrali
I. Subnational gove
Only when centra
governments can t
et al. 1999). Wha
absolute rule her
population size, an
speaking, however
few cross-constitu
geographical differ
States constituti
regulating comm
coining money, a
authorities to unde
perhaps the develo
the constitution as
states, and still oth
from foreign affa
States, on the oth
agriculture, and
economic planning
Specific powers m
In a comparison o
Europe, for examp
responsibilities suc
trash, and librari
hospitals, and dis
shared among diff
national or region
and local authoriti
bring to bear the c
public policy issue
It is important to note, however, that ma

clear policy areas that are under the purvi
cooperative forms of intergovernmental r
argue, may avoid conflicts between levels o
voters to reward and punish politicians fo
the United States and India have rules that
national and subnational governments, alth
complicated. By contrast, France and Ge
countries where intergovernmental resp
France, the regions have responsibility fo
and transport, whereas the smaller departm
and roads, and the communes over pla
However, the precise responsibilities
government remain somewhat contested i
making frequently involves multiple level
decentralized case of Germany, states deri
representation in the upper house of the n
than from independent powers over spe
implementation (as well as taxation and sp
between the center and the states. Rodden
approach has impeded the ability of voter
and has contributed to cases of dangerous
2. Subnational governments should enjo
administrative capacity to perform their res
For reasons already noted, achieving the
depend on the creation of genuinely indepe
significant policy responsibility, the most im
is that they have control over their expend
adjust their behavior to the preferences of
approach is to provide subnational gover
creation of the national budget, generally
Of course, even responsive and fiscally in
will be unable to function properly if t
1999). A number of ideas have been floate
including an administrative sharing progr
India and South Africa) or among regional
2002). Private sector expertise can also be
subnational governance (Shah 2003).
administrative structures is vital for decen
3. Subnational governments should have the
unconditional transfers.
640 C. R. Hankla
Most experts em
governments. Su
decentralization b
government pol
maximized when
enjoy the benefit
circumstances, re
they would if the
generated outsi
Rodden 2002).
What resources s
the importance of
assets such as re
2003). Such a tax
will flee to the co
bottom.
In the absence of
central transfers
own budgetary p
structure these t
with the portion
equalization gran
governments en
responsibilities.
India and Canad
is currently stru
India's states are
of finance are r
percent of public
2003). This imbalance is corrected with sizable transfers from the central
government disbursed through the finance commission, the planning commission,
and the central ministries (see Hankla Forthcoming). The finance commission,
which is at least nominally independent, oversees tax sharing programs with the
states. Revenues are disbursed based on objective criteria, but the commission does
not use clear formulae, so some discretion is possible. Revenues from the planning
commission, which fund India's economic development plans, are determined by
bargaining among state and central officials. State officials are represented on a
powerful advisory board called the National Development Council, and there is
evidence that political considerations have entered into disbursement decisions, at
least in the past (see Hankla Forthcoming). Further, the fact that planning
commission funding dries up five years after a project begins poses serious
budgetary problems for a number of states

(McCarten 2003).
By contrast, Canada is characterized by
virtually complete revenue and borrowing
and Tassonyi 2003). The provinces have v
and indeed they generate fully 83 percent
own revenues (Simeon and Papillon
governments tap many of the same reven
rely on federal authorities to collect the
sources of provincial finance include large
distributes to correct the country's vertic
Ensuring that Subnational Institutions are

4. Subnational institutions should be democ
Most of the benefits that accrue from dec
the improved accountability and transpare
decentralization that eschew elections (such
tion of the central government) may ac
decision-makers closer to the citizenry. W
that come with election, however, subn
citizens with the quality and level of gove
Bird and Vaillancourt 1998). Bearing out
and Zhuravskaya (2007) have found no
decentralization alone and improved servic
On a related issue, there is substantial evidence that increased electoral
competitiveness encourages quality governance and especially fiscal responsibility.
The reason is likely that, when elections are more strongly contested, incumbents
must worry more about the consequences at the ballot box of poor governance.
Hallerberg (2004), for example, has linked electoral competitiveness with fiscal
solvency in Western Europe, while Wibbels (2003) has made a similar argument for
US states. In a close examination of Mexico, Hecock (2006) has found that greater
competitiveness in subnational elections was associated with increased education
spending. It should be noted, however, that a stable party system at the subnational
level is also an important component of governance quality. A significant body of
research points to the negative impact of rapid legislative turnover on budget
deficits, arguing that it reduces the time horizons of elected officials (Roubini and
Sachs 1989; Grilli, Masciandaro, and Tabellini 1991; Franzese 2002).
India provides a useful example. In the past, the partisan make-up of
governments at both the state and federal levels in India was highly stable. As a
result, strong chief ministers dominated budgetary decisions at the state level, with
642 C. R. Hankla
legislatures largely
however, have brou
cabinet instability a
chief ministers an
decisions. There is a
the fiscal proflig
influential party w
Furthermore, the u
(most notably the g
of the economy (s
5. Subnational politi
public goods.
An important factor that separates successful from unsuccessful examples of
decentralization is the quality of institutional design at the subnational level. The
literature provides us with a wide array of lessons for how to structure institutions
to maximize governance quality, most of which derive from research at the national
level. I will briefly summarize those lessons here; for a more in-depth discussion,
please see Hankla (2008).
Most researchers would agree on the value of combining a strong, unified
executive with robust legislative oversight to encourage the provision of public over
particularistic goods. Strong, unified executives, whether directly elected (as in
presidential systems) or chosen by the legislature (as in parliamentary systems), are
responsible to broader constituencies than any single legislator. Furthermore, they
are an easily identifiable focal point of responsibility for the consequences of policy
decisions. As a result, unified executives have a strong incentive to provide public
over particularistic goods and to ensure that government is run efficiently (e.g.
Mukherjee 2003; Blair 1991; Roubini and Sachs 1989; Baldez and Carey 1999;
Hallerberg and Marier 2004). To take an example, in Canada the strong provincial
premiers, who generally control legislative majorities in their provincial capitals, are
probably better able to resist the temptation to overspend than are weaker
executives in other systems. If a province gets embroiled in a debt crisis, voters
can easily blame the governing party and punish it in elections (Bird and
Tassonyi 2003).
Of course, the importance of legislative oversight of executive power cannot be
overstated, and regional legislatures must possess the physical and administrative
resources necessary to ensure quality government (see, for example, Nijzink et al.
2006). A strong committee system and access to policy expertise and advice are
usually necessary for legislatures to function well.
Some observers recommend non-partisan elections at the regional and especially
local levels as protection from the animosities of national politics. Many municipal
elections in the United States, for example, are like this. Much research in political
science, however, emphasizes the benefits

national party system is reproduced at
parties allows citizens to quickly identify
candidate and encourages issue driven
(Manor 1999). Furthermore, some scho
leaders belong to the same political partie
less likely to engage in profligate spen
governance (for example, Rodden 2006). T
to a career in national politics, they m
subnational level. It should be noted, howe
question the link between co-partisanship
reduces salutary fiscal competition among
Protecting National Priorities and Preserv

6. The central government should use tran
To promote national cohesion and pr
addition to more normative reasons), cen
transfer payments to ensure equality of
(Oates 1972; Bird et al. 2003). To take
Canada distributes equalization funds so t
are brought up to an average level base
special arrangement with Quebec has b
province, which is sensitive about its ind
receipts (Bird and Tassonyi 2003).
7. The central government should use targ
national objectives and to encourage th
spillovers at the subnational level.
Some observers are justifiably concerned
authorities could neglect to finance o
government (Bird et al. 2003). Central g
frequently mandate that regional and loc
services at specific minimum levels. Su
education in the United Kingdom (Dave
conditional or matching grants to encour
(Shah 2003). Medicaid, a medical insuran
States, works in this fashion. Likewise, t
matching grants to encourage the pro
authorities (Shah 2003). Among the m
matching grants is to encourage subnat
whose benefits spillover outside their cons
644 C. R. Hankla
include the cons

research and dev
central governm
8. Reformers sho
unity and protect
By carefully desi
way toward rea
minority protect
treatment). Two
system design a
design on protect
"consociationalis
advocate list pro
interests are rep
2003), by contras
for the incentive
By allowing voter
candidates who w
best approach
representation ge
of groups, (ii) th
than voters (see
literature for tra
States, the Unite
One useful app
political unity is
regional level (s
ways - by holdin
using the same e
at the regional le
agendas. The pa
regional parties w
politicians, when
follow the nation
when national pa
will be suppress
elections should serve as a corrective.
9. The central government should protect macroeconomic stability.

The central government, of course, is ultimately responsible for the stability of
the macroeconomy. Central governments must therefore use the policies under
their control to promote exchange rate stability, control inflation, and ensure a
common internal market. Most of the mac

however, can be overcome if central gove
subnational authorities or impose a credi
counterproductive for national leaders to
when the money is intended to finance inve
probably wise (see Shah 2003). An alternative
the central government to impose a credible
et al. 2003). With such a policy, all debt that
be solely their responsibility to pay down. A
incentive to borrow only as much as they ca
able to set interest rates according to th
governments. This approach maximizes the
while minimizing the threat of macroeconom
There is much debate about when central
policy of no-bailout, since it may be difficul
government embroiled in a debt crisis. T
governments will be less able to commit t
subnational authorities with transfers (Rodd
French and Canadian fiscal relations prov
no-bailout policy can work in practice. All th
in France have the freedom to borrow from
law stipulates that borrowed money should
Furthermore, subnational governments ar
annual balance, and may be audited by the ce
Guengant 2002). As a result, recent decen
increased the risk that subnational governm
only slightly. Continuing central over
macroeconomic problems, and the fiscal
governments in France is generally good (Gi
Like France, Canada imposes few central re
relying instead on an informal policy of no-ba
to some indebtedness during the tight 1990s, bu
good shape (Bird and Tassonyi 2003). As a res
capital markets are free to adjust their lending
individual provinces, providing an incentive f
By contrast, efforts to limit subnational bo
successful than the no-bailout approach
governments, under pressure to attract fore
the declining importance of central planning
attracted to borrowing as a means for finan
2003). They have been able to bypass cent
646 C. R. Hankla
including by float
public enterprises
Reserve Bank of
(including the fina
states, reducing any
to develop seriou
cautionary tale for
the state level. Sub
especially when cen
Some Final Tho

More and more, n
governance with d
and economic institutions to understand how and under what circumstances
decentralization has been beneficial. This paper has sought to do that by reviewing past
research on the governance implications of devolving power to subnational authorities
and by drawing lessons from theory and experience for designing better decentralized
institutions. The nine lessons presented here, while by no means set in stone, are
intended to synthesize what is known about structuring intergovernmental relations,
with a focus on deriving practical lessons for those policy-makers in the developing
world considering decentralization for their citizens.
Acknowledgments
I would like to thank Jorge Martinez- Vazquez and Rich Engstrom for their
invaluable advice. I have also benefited from financial support from the US Agency
for International Development for work under contract to Georgia State University.
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When Is Fiscal Decentralization Good for Governance?

Author(s): Charles R. Hankla

Even a cursory examination of the world's states reveals a dizzying array of

* Georgia State University; chankla@gsu.edu

Publius: The Journal of Federalism volume 39 number 4, pp. 632-650

poor countries where institutional changes

Is Decentralization Good for Developing Countries?

Do the benefits of decentralization for developing countries outweigh the potential

Decentralization, Targeting, and the Allocation of Public Goods

A possible implication of Oates's argument is that, in most cases, public services

Targeting diverse regions with their pre

the development of separatist moveme

Decentralization and Macroeconomic Stab

Nine Lessons for the Design of De

It is important to note, however, that ma

budgetary problems for a number of states

Ensuring that Subnational Institutions are

science, however, emphasizes the benefits

Protecting National Priorities and Preserv

include the cons

9. The central government should protect macroeconomic stability.

common internal market. Most of the mac

Some Final Tho

Bardhan, Pranab. 2002. Decentralization of governance and development. Journal of

Bird, Richard, Bernard Dafflon, Claude Jea

Bird, Richard M., and Almos Tassonyi. 2003. C

Enikolopov, Ruben, and Ekaterina Zhuravs

Filippov, Mikhail, Peter C. Ordeshook, and Ol

Franzese, Robert. 2002. Macroeconomic poli

Gilbert, Guy, and Alain Guengant. 2002. The p

Assessing the evidence. Working Paper, Georgia State Un

Haysom, Nicholas R. L. 2003. Constitution making and

Manor, James. 1999. The political economy of democratic decentralization. Washington,

Mukherjee, Bumba. 2003. Political parties a

Nijzink, Lia, Shaheen Mozaffar, and Elisabe

Public Finance 12 (4): 349-373.

Parry, Taryn. 1997. Achieving balance in decentralization

Prud'Homme, Rémy. 1995. The dangers of decentralization. W

Rajaraman, Indira. 2000. Fiscal features of local government in India. In Governanc

Rao, M. Govinda. 2002. Fiscal decentralization in Indian federalism. In Managing fiscal

the Challenge of Hard Budget Constraints, ed. Jonathan Rodden

Cambridge University Press.

Roubini, Nouriel, and Jeffrey Sachs. 1989. Governmen

Cambridge University Press.

Weingast, Barry R. 1995. The economic role of political institutions: Market-preserving

the early United States. Comparative Political Studies 36

Yilmaz, Serdar, Yakup Beris, and Rodrigo Serrano-Ber

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