THE EFFECTS OF FISCAL DECENTRALIZATION ON GENERAL AND LOCAL GOVERNMENT SIZE: DOES COMPOSITE INDEX MATTER?

AuthorCanikalp, Ebru
  1. Introduction

    Fiscal decentralization is defined as the devolution of financial power and responsibilities from the central government to local governments (Neyapti, 2005). There are two main theoretical approaches to fiscal decentralization. First generation theories adopt the benevolent government assumption and explain the concept in a normative way (Oates, 1972; Rubinfeld, 1987). Second generation theories, on the other hand, draw attention to the problems of political institutions and government failure (Weingast, 2008), fiscal incentives (Weingast, 2009; Lockwood, 2015), market preserving fiscal federalism (Weingast, 1995, 2009) and the industrial organization structure (Oates, 2005; Garzarelli, 2004). Despite these differences, both approaches regard fiscal decentralization as a tool to control the government size and protect the private markets from destructive violations (Oates, 2005).

    There are two main arguments or motives for fiscal decentralization. First, fiscal decentralization would increase social welfare by ensuring the provision of more efficient public services and accountability due to better preference match and more engagement from voters. Second, fiscal decentralization would lead to a smaller government size. In the famous 'Leviathan' hypothesis developed by Brennan and Buchanan (1980), fiscal decentralization is proposed as a solution to limit the expansion of the public sector. According to this hypothesis, fiscal decentralization tends to constrain governments' Leviathan-type behavior by creating a 'race to bottom' effect. Additionally, Josselin (1995) and Craw (2008) suggest that fiscal decentralization would exert a positive impact on local government size, called Local Leviathan in the literature. This implies that the effects of fiscal decentralization on the size of general and local governments would markedly differ from each other. In other words, fiscal decentralization would be related to a smaller (larger) general (local) government size on theoretical grounds.

    Although fiscal decentralization has gained importance and popularity over time, its effects on government size are not clear-cut (Prud'homme, 1995; Tanzi, 2002; Rodden, 2003). Therefore, more empirical studies are deeply needed to shed light on the relationship between fiscal decentralization and government size at both general and local levels. There is no doubt that this issue has very important policy implications for designing and implementing fiscal policy.

    Investigating the relationship between fiscal decentralization and government size for 36 countries over the period 1972-2019, this study aims to contribute to the existing literature in three important dimensions. First, we employ alternative indexes to better capture the different sides or aspects of fiscal decentralization. Some early studies including Davoodi and Zou (1998), Ebel and Yilmaz (2002), Stegarescu (2005) employ basic indexes as a proxy for fiscal decentralization due to their simplicity and availability. However, using just basic indexes to measure such a multidimensional concept would be both misleading and unrealistic (OECD, 2013). Therefore, more recent studies, such as Akai and Sakata (2002), Vo (2008), Martinez-Vazquez and Timofeev (2010), develop some composite indexes to avoid the possible problems created by basic indexes. To capture the multidimensional aspects of fiscal decentralization, we follow the methodology of Vo (2008) and construct a composite index consisting of two components: fiscal importance and fiscal autonomy. In addition to Vo (2008)'s methodology, we also calculate basic indexes developed by Wallis and Oates (1988) and other composite indexes suggested by Akai and Sakata (2002) and Martinez-Vazquez and Timofeev (2010) to gain additional insights and check for the robustness of the results.

    Second, somewhat surprisingly, only a limited number of studies empirically examine the relationship between fiscal decentralization and local government size (Rodden, 2003; Kwon, 2003; Craw, 2008; Boetti, Piacenza and Turati, 2012; Liberati and Sacchi, 2013; Jia, Guo and Zhang, 2014). Therefore, we aim to fill this gap in the literature by investigating the impact of fiscal decentralization on the size of both general and local governments in the same framework. In doing so, we would directly test and compare whether the Leviathan or Local Leviathan is more successful in explaining the effects of fiscal decentralization. Third, due to possible inertia in government spending, we employ a dynamic panel method (Generalized Method of Moments, GMM), which is also well-suited to deal with some econometric problems such as autocorrelation, heteroscedasticity, and endogeneity.

    Our empirical results do not lend any evidence for the Leviathan hypothesis. On the other hand, we conclude that there exists a statistically positive relationship between the fiscal decentralization and local government size, supporting the existence of Local Leviathan. We should note that our main results are not sensitive to the choice of fiscal decentralization measure used in the empirical specifications.

    The rest of the article is organized as follows. The next section summarizes the empirical literature. In section 3, we present the model specification and the data set. Section 4 reports and discusses the empirical results. The last section contains the conclusions.

  2. Literature review

    As presented in the Annex, although many studies analyze the relationship between fiscal decentralization and general government size with different country groups, time intervals and econometric methods, there is no consensus on the issue whether fiscal decentralization is associated with a smaller government size or not. In other words, there is an ongoing debate as to whether fiscal decentralization would be helpful to limit the expansion of government size, as proposed by Brennan and Buchanan (1980). On the one hand, some studies such as Grossman (1989), Forbes and Zampelli (1989) or Joulfaian and Marlow (1991) found that fiscal decentralization has a negative effect on government size and hence confirm the Leviathan hypothesis. On the other hand, other studies like Oates (1972, 1985), Wallis and Oates (1988), Heil (1991) and Grossman (1992) firmly reject this finding.

    In the early studies, consistent with first generation theories, the fiscal decentralization is measured by using basic indexes such as expenditure autonomy (Oates, 1972, 1985; Wallis and Oates, 1988; Heil, 1991; Grossman 1989, 1992; Joulfaian and Marlow, 1991), revenue autonomy (Wallis and Oates, 1988; Heil, 1991; Grossman, 1992) or province number (Forbes and Zampelli, 1989; Joulfaian and Marlow, 1991). However, since the first-generation theories neglect or ignore some important points such as lack of local own source revenue, soft budget constraints, fiscal inequalities and bailout effects, second generation theories have emerged and paid attention to these issues (Dziobek, Mangas and Kufa, 2011). These new theories show that measuring fiscal decentralization with revenue or expenditure autonomy instead of a more comprehensive index would cause a significant information loss in empirical studies (Martinez-Vazquez, Lago-Penas and Sacchi, 2017).

    Therefore, later studies suggest more specific or comprehensive proxies for fiscal decentralization by considering additional dimensions such as own revenues (Rodden, 2003), vertical fiscal inequalities (Stein, 1999; Jia, Guo and Zhang, 2014; MakreshanskaMladenovska and Petrevski, 2019), tax autonomy (Ehdaie, 1994; Kwon, 2013; Qiao, Ding and Liu, 2019) and composite indexes (Ehdaie, 1994; Prohl and Schneider, 2009; Qiao, Ding and Liu, 2019). Based on these more comprehensive or composite indexes, some studies such as Ehdaie (1994), Moesen and van Cauwenberge (2000), Rodden (2003), Prohl and Schneider (2009), Herwartz and Theilen (2017), Makreshanska-Mladenovska and Petrevski (2019), and Qiao, Ding and Liu (2019) support the Leviathan hypothesis, while other studies including Stein (1999), Martinez-Vazquez and Yao (2009), Cassette and Paty (2010), Baskaran (2011), Kwon (2013), Jia, Guo and Zhang (2014) reject this hypothesis. In other words, some studies empirically support the argument that fiscal decentralization would lead to a reduction in the government size while others do not. This implies that using more composite indexes dos not necessarily resolve the disagreement. The rejection of the Leviathan hypothesis might be associated with transfer dependency (Stein, 1999), common pool problem (Baskaran, 2011; Jia, Guo and Zhang, 2014) and corruption (Martinez-Vazquez and Yao, 2009).

    Failure to find a strong or decisive negative relationship between fiscal decentralization and government size in the empirical studies supports the emergence of Local Leviathan in the literature (Josselin, 1995; Craw, 2008). We should note that, despite a rich literature on the relationship between fiscal decentralization and general government size, there are relatively few empirical studies examining the impact of decentralization on local government size (Jin and Zou, 2002; Cassette and Paty, 2010; Liberati and Sacchi, 2013; Jia, Guo and Zhang, 2014; Sacchi and Salotti, 2017). Using tax or revenue autonomy for fiscal decentralization some studies like Liberati and Sacchi (2013), Boetti, Piacenza and Turati (2012) found a negative impact on the local government size, while other studies including Jin and Zou (2002), Jia, Guo and Zhang (2014) did not. On the other hand, using the expenditure autonomy, Jin and Zou (2002), Kwon (2003), Jia, Guo and Zhang (2014) and Zhang (2016) report a positive relationship between fiscal decentralization and the local government size. Apart from these studies, Boetti, Piacenza and Turati (2012) confirm the Local Leviathan hypothesis by using the Akai and Sakata (2002) composite index. Moreover, using fiscal inequalities or...

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