The Dilemma Between Fiscal Decentralization and Budget Balance.

• Author: Shon, Jongmin

1. Introduction

   State and local autonomy and responsibility under the U.S. federalism have traditionally been a primary issue in the study of governance. The heterogeneity in a federal system still motivates researchers to examine its effects on government organizational structure and fiscal condition. Fiscal decentralization, a widely known political term, arranges decision-making authority in legal contexts across governments. Although the federal government controls and stabilizes its state and local governments, it also authorizes them to exert their own authority in making fiscal decisions (Prud'Homme, 1995; Rodden, 2002; Rodden, Eskeland and Litvack, 2002; Treisman, 2000; Wibbels, 2000). The independent but mingled fiscal decisions across multiple levels may distort the original purposes of the decisions made by each level, and the distortions may result in unexpected effects on performance. The hierarchical structure of the U.S. government motivates this study to shift the focus from the national level to the state and local levels.

   To follow up the studies above, this study aims to explore the effects of fiscal decentralization on budget balance in the sense that the degree of decentralization is a fundamental determinant of the autonomy and responsibility across the layers of state and local governments. Decentralization enables a government to create and change fiscal institutions. However, the degree of decentralization is neither easily interpreted nor easily measured because accounting and financial information is embedded in all levels of government. The U.S. state and local governments establish their own fiscal institutions that influence government budgets such as tax, spending, deficits, and debts, and they have made efforts to promote and maintain their balanced budget (Smith and Hou, 2013). In spite of their efforts toward budget balance, many state and local governments still struggle.

   In this regard, this study employs multidimensional indicators of the degree of fiscal decentralization. Such indicators not only capture multiple aspects of fiscal autonomy but also serve as data to analyze the effects of decentralization on the budget balance. The results provide interesting evidence of different and/or contradictory effects on the budget balance. More specifically, state governments are more likely to balance their total and general budgets when fiscal authority over expenditure is more decentralized, while local governments are more likely to do so when the fiscal authority for revenue is more decentralized.

   This paper conducts empirical tests of the effects of fiscal decentralization on U.S. state and local budget balance in order to answer the question of whether fiscal decentralization helps governments to achieve their own balanced budget. The next three sections provide a review of the literature on fiscal decentralization, its effects on fiscal performance, and budget balance as a proxy for fiscal performance. The fifth section describes data and methodology including the measurement of the degree of decentralization with five indicators. The sixth section presents regression results along with a brief explanation, and the last section concludes with implications.

2. Fiscal decentralization

   Decentralization refers to the degree of autonomy and responsibility of each layer of government in a federal system. The degree of autonomy of a layer of government determines its provision of public services. The degree is not a black and white dichotomy, but a continuum; thus, the U.S. federal system has aimed to construct an outline that places appropriate political-economic functions and instruments at the proper level of government and has explored how to optimize the degree of decentralization for effective allocation of autonomy and responsibility. This function has motivated many researchers to test the degree of fiscal decentralization in various ways. Another reason for this line of research is the theoretical prediction that fiscal decentralization improves the efficiency of the provision of public services as well as enhances accountability and performance.

   The scholarly works on fiscal decentralization have been developed with an interest in the impacts of decentralization across layers of governments on their fiscal policy-making process as well as on government performance, which is an issue of growing significance in public administration (Barenstein and De Mello, 2001; Oates, 1972; Rodden, 2002; Rodden, Eskeland and Litvack, 2002; Shah, 2005; Winer, 1983). According to Bird and Vaillancourt (2008), the degree of decentralization determines the type of fiscal decentralization among (de)concentration, delegation and devolution (1). The virtue of American democracy has been its closeness to the people, and local autonomy has contributed to the development of this virtue by allocating responsibilities to and improving potentialities of the lower layers of governments (Brunori, 2007). Local governments have been key providers of public services and have recently enjoyed greater decision-making autonomy in their budget process (De Mello, 2001).

   However, fiscal autonomy still threatens the provision of public services because local governments are more vulnerable to changes in their environments, and spillover effects are observed in overlapping jurisdictions. The responsibilities of local governments go beyond their potentialities with the expansion of demands. These expansions cause fiscal crises at local levels and lead to financial crises (Inman, 2003; Rodden, 2002; Rodden, Eskeland and Litvack, 2002). The imbalance between autonomy, responsibilities, and potentialities in local governments raises fiscal threats across the entire government, especially at upper levels. In addition, the imbalance leads federal-state governments to spend extra dollars on protecting the local governments from fiscal threats. Therefore, the federal-state governments have to consider how to change the allocation of autonomy and responsibilities, and such changes in status and responsibility in local governments demand that all levels of governments transform their inter-relationships and organizational structures. The degree of fiscal decentralization determines how to arrange local governance and collaborate on institutional collective actions (Cigler, 1993; Feiock, 2004).

3. Fiscal decentralization and performance

   The allocation of autonomy and responsibility in local governments is determined by the federal and state budget constraints. The decentralization theorem asserts that a higher degree of fiscal decentralization reduces government expenditures due to competition between governments. Additionally, the Leviathan theory has pointed out that fiscal decentralization warns against a bureaucrat monopoly and prevents bureaucrats from maximizing their budgets; thus, their power to tax is curtailed by their competitors (Brennan and Buchanan, 1980; Grossman, 1989; Grossman and West, 1994; Marlow, 1988; Nelson, 1987; Oates, 1972). Shadbegian (1999) concluded that a higher degree of fiscal decentralization decreases government expenditures, while greater shares of federal grants increase expenditures. In this vein, reducing expenditures leads governments to balance their budgets by holding revenue constant.

   Stein's (1999) study, on the other hand, described how fiscal decentralization expands the expenditures rather than the revenues of sub-national governments, demonstrating that expenditures will be exceeded when governments have more borrowing autonomy. Ebel and Yilmaz (2003) considered revenue autonomy associated with fiscal decentralization in terms of government size and found negative associations. Ebdaje (1994) found out that simultaneous considerations on both revenue and expenditure reduce government size. Jin and Zou (2005) concluded that vertical imbalance is the only factor that expands the aggregate expenditures of governments.

   Indeed, some studies have warned that fiscal decentralization may cause too much expansion of expenditure by externalizing the costs (Rodden, 2002; Rodde, Eskeland and Litvack, 2002; Von Hagen et al., 2000). Rodden (2002) added grants to the studies on fiscal decentralization, and asserted that a greater dependence of sub-national governments on inter-governmental transfers leads to budget deficits. Inman (2003) reported that the transition costs of bailouts and transfers from local governments to federal budgets can prevent local governments from providing public services and goods efficiently, which results in inefficient resource allocation. Furthermore, Rodden (2003) added that the reduction of government expenditures depends on funding sources because an analysis of expenditures alone cannot capture the effects on budgets. Studies have found that the effects of fiscal decentralization on government budgets shown in previous research remain inconsistent, though results are somewhat contradictory. The results appear to depend not only on what factors are considered, but also on how fiscal decentralization is measured. Considering either revenue or expenditure alone may not provide sufficient evidence; thus, the vertical imbalance with grants should be discussed in further detail.

4. Budget balance as fiscal performance

   Fiscal performance depends on the rules of budgeting decisions. Among the various types of fiscal performance, this paper focuses on budget balance. U.S. state and local governments have established their own fiscal institutions (2) that have impacts on the reduction of budget deficits and public debts. For example, TELs and BBRs (3) have put limitations in place that prevent governments from having deficits and controlled revenue and expenditures in state and local governments in order to achieve balanced budgets. Because budget balance considers revenues and expenditures, it is an important indicator for fiscal performance and helps...