What is the impact of fiscal decentralization on economic growth?

An Empirical Study of Decentralization and Growth in Federal Developing Countries

Fiscal decentralization is a complex challenge for developed countries with mature fiscal federalism processes. The fiscal decentralization challenge is even greater for developing countries, which often face considerable capacity constraints hurdles in implementing more decentralized fiscal arrangements between their different government levels.

Nonetheless, in recent decades, many developing countries with federal (or quasi-federal) political systems as varied as India, Pakistan, South Africa, Mexico, Ethiopia, Brazil, or Malaysia, among others, have shown increasing movements toward fiscal decentralization. Federations are those that have one federal government and at least one subnational tier of government, although many federal countries have multiple government levels (for instance, a regional government level and a municipality government level).

One of the reasons why developing countries have been attracted to decentralization is the argument that at a more decentralized public sector may encourage efficiency in the provision of public goods and may promote economic growth: decentralized systems can enhance public welfare by better matching public services to local needs and that in turn can accelerate mobilization of revenues and the country’s economic performance. While the conceptual link between fiscal decentralization and economic performance may be convincing, empirical findings are largely inconclusive; empirical evidence is especially limited regarding the relationship between fiscal decentralization and economic growth in the developing world.

A recent study by Imran Hanif, Sally Wallace and Pilar Gago-de-Santos estimates the relationship between fiscal decentralization and economic growth for 15 developing countries at different points along the “young” decentralization spectrum, using data that spans the period 2000–2015 (including the recent Great Recession). The 15 countries considered by the study include Argentina, Bosnia and Herzegovina, Brazil, Comoros, Ethiopia, India, Malaysia, Mexico, Micronesia, Nepal, Pakistan, the Republic of South Africa, St Kitts and Nevis, Swaziland, and Venezuela.

The target countries for the empirical study are 15 developing countries listed as federations. By and large, even though these countries have shown a political and an institutional will to pursue further fiscal devolution of powers to subnational governments, in general, their actual decentralization process is still weak compared with more mature federations. Nonetheless, the speed and intensity of the decentralization processes among these developing federations varies considerably.

The results of the empirical investigation by Hanif, Wallace and Gago-de-Santos suggests a positive and direct impact of fiscal decentralization on economic growth in the countries studied. The results show that for these federations, tax revenue and expenditure decentralization impact economic growth positively. In the most expansive regression with multiple controls, the estimated impact is substantial, given that one percentage change in tax revenue decentralization is estimated to yield between 0.528 and 0.832 increase in economic growth and one percentage change in expenditure decentralization yields between 0.046 and 0.282 increase in economic growth.

While the results show that in federal developing countries, both tax revenue and expenditure decentralization have a significant, positive impact on economic growth, the analysis further shows that the impact of fiscal decentralization on economic growth depends upon the level of perceived corruption and on the quality of the country’s institutions. Thus, the empirical evidence suggests that the positive effect of fiscal decentralization on economic growth is tempered if the country is plagued with corruption, if it has weak institutions, and/or if it suffers from political instability. By contrast, a relatively corruption-free country featuring healthy institutions and a stable political environment could take fuller advantage of the effects of fiscal decentralization to improve economic growth.

This post is a summation of Economic Growth by Means of Fiscal Decentralization: An Empirical Study for Federal Developing Countries by Hanif I, Wallace S, Gago-de-Santos P. The article was first by SAGE Open on October 23, 2020. Read the full article in SAGE OPEN.