On the Theory and Practise of Fiscal Decentralization

The traditional theory of public finance has made a strong case for a major role for fiscal decentralization. This case is based on an improved allocation of resources in the public sector. And it has four basic elements. First, regional or local governments are in a position to adapt outputs of public services to the preferences and particular circumstances of their constituencies, as compared to a central solution which presumes that one size fits all. Second, in a setting of mobile households, individuals can seek out jurisdictions that provide outputs well suited to their tastes, thereby increasing the potential gains from the decentralized provision of public services (Tiebout 1956). Third, in contrast to the monopolist position of the central government, decentralized levels of government face competition from their neighbors; such competition constrains budgetary growth and provides pressures for the efficient provision of public services. And fourth, decentralization may encourage experimentation and innovation as individual jurisdictions are free to adopt new approaches to public policy; in this way, decentralization can provide a valuable Alaboratory for fiscal experiments. However, this basic economic rationale for decentralization of the public sector is not quite so simple and compelling as it appears. Some of the more recent literature provides, first, a thoughtful and provocative critique of the traditional view of fiscal decentralization, and, second, some new approaches that reveal its dark side, especially in practice. There is emerging, in short, a broader perspective on fiscal decentralization that raises some serious questions about its capacity to provide an unambiguously positive contribution to an improved performance of the public sector. My purpose in this paper is twofold. First, I want to review the basic theory of fiscal decentralization. There are some loose ends to the traditional argument that open up some intriguing issues. Second, I want to turn to some of new literature on fiscal discipline in multilevel government. This literature has focused attention on some basic and destructive forces that can undermine the economic performance of a relatively decentralized public sector. I find it helpful to begin by revisiting a Decentralization Theorem that I formulated long ago. As a point of departure, I want to explain briefly why I introduced the proposition and the rationale for its particular form and proof.Fiscal Decentralization, Public Finance