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Thursday, 5 August 2010

Fiscal decentralisation and economic growth, 2nd Edition

We have previously touched on the difficult relationship between fiscal decentralisation and economic growth. New empirical evidence looking at OECD countries appears to show again a negative relationship between the two. We must of course be wary of extrapolating results from different environment, but given the plethora of results showing this negative aspect - it becomes important that the rationale for decentralisation is always clearly spelt out, especially the evidence that underpins its likely benefits :
The results of the analysis highlight that, given the recent levels of fiscal decentralization of the countries of the OECD, fiscal decentralization seems to be causing more harm than good from a growth perspective. The connection between fiscal decentralization and economic performance is negative, significant and robust to the inclusion of measurements of political and administrative decentralization and of a number of control variables. It is also not affected by whether we are looking at the expenditure or the revenue side of decentralization or by preferences for specific types of expenditure by subnational governments. The association also seems to be linear, with little indication of an inverted U-shaped relationship: the negative impact of decentralization on economic growth rises as countries in the OECD intensify the fiscal decentralization process. And this negative relationship happens regardless of whether decentralized governments display preferences for capital or current expenditure or feel more inclined to promote health, education, welfare expenditure or choose expenditure in economic affairs. The only exception to this trend occurs in cases of preferences for current expenditure in relatively low levels of fiscal decentralization. In these cases there is some margin of manoeuvre for governments, as moderate increases in fiscal decentralization may have a positive impact on economic growth.
The negative association between fiscal decentralization and growth is more robust than that between other types of decentralization and growth. Administrative decentralization also tends to display a negative connection to economic performance, although this connection is weaker and less robust than that of fiscal decentralization. Political decentralization exhibits a relationship with economic growth that is highly sensitive to the choice of measurement of political decentralization. With some types of indicators political decentralization has a positive impact on economic growth, while, with others, the connection is negative. But these differences linked to the choice of indicators of political decentralization do not in any case affect the robustness of the negative association between fiscal decentralization and growth.

Overall, the analysis shows that, at least in the case of OECD countries, the potential economic benefits of fiscal decentralization in terms of economic performance are more than counterweighed by the potential economic pitfalls of transferring ever greater resources to subnational tiers of government. Any potential benefits of fiscal decentralization in the form of greater territorial cohesion (Rodríguez-Pose and Ezcurra, 2010) are thus counterbalanced by lower aggregate growth. And political and administrative measures of decentralization seem to be unable to offset this trend. working papers series. Hence, in the case of the OECD, while fiscal decentralization may still be an adequate way to preserve and promote regional identity and culture, the claim that it will also bring about some sort of economic dividend can be considered as questionable.

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