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Fiscal decentralization and fiscal performance

Author

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  • Shah, Anwar
Abstract
A resurgence of recent interest in fiscal federalism has been a source of concern among macroeconomic stabilization experts. They argue that a decentralized fiscal system poses a threat to macroeconomic stability as it is incompatible with prudent monetary and fiscal management. The author addresses these concerns by taking a simple neo-institutional economics with an econometric analysis perspective. His analysis concludes that, contrary to a common misconception, fiscal decentralization is associated with improved fiscal performance and better functioning of internal common markets. Fiscal policy coordination represents an important challenge for federal systems. In this context, fiscal rules and institutions provide a useful framework but not necessarily a solution to this challenge. Fiscal rules binding on all levels can help sustain political commitment in countries having coalitions or fragmented regimes in power. Coordinating institutions help in the use of moral suasion to encourage a coordinated response. Industrial countries'experiences also show that unilaterally imposed federal controls and constraints on subnational governments typically do not work. Instead, societal norms based on fiscal conservatism such as the Swiss referenda and political activism of the electorate play important roles. Ultimately capital markets and bond-rating agencies provide more effective discipline on fiscal policy. In this context, it is important not to backstop state and local debt and not to allow ownership of the banks by any level of government. Transparency of the budgetary process and institutions, accountability to the electorate, and general availability of comparative data encourages fiscal discipline. Fiscal decentralization poses significant challenges for macroeconomic management. These challenges require careful design of monetary and fiscal institutions to overcome adverse incentives associated with the"common property"resource management problems or with rent seeking behavior. Experiences of federal countries indicate significant learning and adaptation of fiscal systems to create incentives compatible with fair play and to overcome incomplete contracts. This explains why that decentralized fiscal systems appear to do better than centralized fiscal systems on most aspects of monetary and fiscal policy management and transparent and accountable governance.

Suggested Citation

  • Shah, Anwar, 2005. "Fiscal decentralization and fiscal performance," Policy Research Working Paper Series 3786, The World Bank.
    • Handle: RePEc:wbk:wbrwps:3786
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    2. Olga Marut & Jacek Lewkowicz, 2022. "The effect of decentralization of government power on the character of public goods provision," Working Papers 2022-11, Faculty of Economic Sciences, University of Warsaw.
    3. Violeta Vulovic, 2010. "The effect of sub-national borrowing control on fiscal sustainability: How to regulate?," Working Papers 2010/36, Institut d'Economia de Barcelona (IEB).
    4. Llanto, Gilberto M., 2009. "Fiscal Decentralization and Local Finance Reforms in the Philippines," Discussion Papers DP 2009-10, Philippine Institute for Development Studies.
    5. International Monetary Fund, 2006. "Bosnia and Herzegovina: Selected Issues," IMF Staff Country Reports 2006/368, International Monetary Fund.
    6. Abdul Jalil, Ahmad Zafarullah, 2009. "Decentralization, Subnational Governments' Behaviour and Macroeconomic Instability: The Case of Malaysia," MPRA Paper 19071, University Library of Munich, Germany.

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    Banks&Banking Reform; Economic Stabilization; Public Sector Economics&Finance; Economic Theory&Research; Financial Intermediation;
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