Fiscal Decentralization in Specific Areas of Government. A Technical Note

Descentralización fiscal en áreas específicas de la gestión pública: Una nota técnica

Leonardo Letelier S. and José Luis Sáez Lozano*

Senior lecturer, Institute of Public Affairs, University of Chile. Santiago de Chile. lletelie@iap.uchile.cl

Fecha de recepción: 23 de marzo de 2011;
fecha de aceptación: 7 de noviembre de 2011.

Abstract

This study makes a contribution in two basic areas. First, it sets up a model which combines efficiency as well as political economy aspects in explaining the degree of fiscal decentralization. It innovates in making explicit the benefits from better informed politicians and policy makers (Von Hayek effect) and the potential cost push effect on public services and public goods (Scale Effect) resulting from decentralization. It takes advantage of previous literature in recognizing the extent of the ideological distance between the local and the national median voter as a third factor worth considering in the social cost benefit analysis of decentralization. Second, the aforementioned effects are put into the context of specific functional areas of government, each of them having a particular set of characteristics which lead to a different degree of decentralization. The net outcome will be the result of combining the rent seeking orientation of the central government with the particular median voter demand for each different public good.

Keywords: political economy, median voter, fiscal federalism, decentralization.

Resumen

Palabras clave: economía política, votante mediano, federalismo fiscal, descentralización.

JEL classification: D720, H110, H710, H770.

Introduction

Fiscal decentralization (FD) has turned into a topic of major academic and political interest over the last two decades. Its theoretical modelling as well as the empirical research upon its potential effects has moved from the traditional normative public finance framework (Oates, 1972), to the more recent political economy approach (Lockwood, 2006). This latter impulse has been popularized as the second generation of fiscal federalism (Oates, 2008), and is the one that inspires our contribution.

While the existing empirical evidence about the potential effects of FD is rather ample and usually favourable to the hypothesis that it positively contributes to people's welfare (Letelier, 2012; Voigt and Blume, 2012), there is still an active controversy about the case of specific public goods. For example, despite the fact that FD appears to have positive effects on both the level of expenditure in education and the country's educational performance (Lindaman and Thurmaier, 2002; Barankay and Lockhood, 2007; Faguet and Sánchez, 2007; Letelier, 2010), some evidence shows that it also tends to make this performance more heterogeneous across the national territory (Zhao, 2009). Similar evidence may be found in health, in which positive effects of FD on the service quality (Enikolopov and Zhuravskaya, 2007; Uchimura and Jütting, 2009) are potentially compensated by a negative effect on this function's logistics (Bossert et al., 2007). A recent empirical research about the relationship between FD and "government's quality" based on a sample of OECD countries (Kyriacou and Roca-Sagalès, 2011) concludes that decentralization affects this quality in a positive way, albeit such effect diminishes when FD is combined with multiple overlapping politically autonomous sub-national governments. A similar controversy exists regarding the so called "governance" (Neyapti, 2006; Hankla, 2009), the territorial equity (Bonet, 2006; Rodríguez-Pose and Ezcurra, 2009), the danger of elite capture (Bardhan and Mookherjee, 2006), the fiscal balance (Ebel and Yilmaz, 2002; Thornton, 2007) and the economic growth (Martínez-Vázquez and McNab, 2003; Qiao et al., 2008). Along the same lines, the international comparative experience suggests that FD encompasses a broad and generic concept, which admits multiple specific nuances in the cases of particular State's functions (Osterkamp and Eller, 2003; Hooghe and Marks, 2009). At the one end, garbage collection is usually considered a local government's duty. At the other, national defence exhibits almost no exceptions in this function being a national responsibility. In between those extremes we are likely to find a wide variety of functions for which the existing degree of FD originates in a combination of historical, political and public sector's efficiency factors.

Diverse hypotheses have been put forward to explain the behaviour of FD over time as well as its variation across countries. If we were to highlight some usually considered explanatory variables, these include income per head (Wheare, 1964; Pryor, 1967; Pommerehne, 1977; Marlow, 1988; Wallis and Oates, 1988), population density (Litvack and Oates, 1971) and the degree of population heterogeneity (Tiebout, 1956), among others. Evidence in favour of such hypotheses is also ample and robust (Panizza, 1999; Letelier, 2005; Arzaghi and Henderson, 2005). More recently, related theoretical modelling has used political economy models, thereby a trade off is usually presented between the benefits of centralization for the central government and the costs of it for the country as a whole. In this spirit we find the contribution by Panizza (1999), in which an "agenda setter" central government determines the degree of FD and the model proposed by Arzaghi and Henderson (2005), thereby each nation's region decides about staying as members of a unitary country versus the option of becoming autonomous in a federation. Nevertheless, there still exists a vacuum regarding the reason why some specific State's functions exhibit different degrees of FD. The wide variety of publicly provided services requires a case specific approach that takes due account of the benefits, costs and production function at stake in every case.

In such a context, the present paper is intended to explain FD by type of public good. Our contribution builds upon Panizza (1999), albeit it deviates from it when focusing on the specific nature of particular services. It is stated that the socially optimum degree of FD hinges upon a public good specific trade-off between a pro-decentralization target, thereby a deeper specific knowledge of jurisdiction's demands is achieved by delegating powers onto lower tiers of government ("Von Hayek Effect": VHE), versus the centralizing target that takes proper advantage from scale economies in delivering efficiently produced public goods ("Scale Effect": SCE). Since former effects are likely to be different across State's functions, it follows that FD will also differ across types of public goods.

The remaining of this paper is organized as follows. Section I addresses the theoretical context; section II describes the problem faced by the median voter (MV); section III presents the government's problem, and section IV examines the effect of exogenous factors in the model. Conclusions are presented in section V.

I. The Theoretical Context

Our contribution to the existing theoretical debate is twofold. First, it is explicitly acknowledged that decentralization entails a potential positive effect on the quality of public goods, which results from the information advantage being held by sub-national governments in their effort to identify real needs and demands of their local constituency (Hayek, 1945). Second, we also recognize that decentralization may take us away from the optimal scale level in delivering specific public goods. Excess decentralization may result in too small jurisdictions being forced to funding and/or producing scale sensitive services, leading to a high price-quality ratio. As stated above, these two opposing effects will be called VHE and SCE respectively. Along the same lines, the so called Median Voter's ideological distance, which is assumed to be a unique general public good variable in Panizza (1999), may now be assigned a specific dimension for each type of public good.

It will be assumed that the general government (central plus decentralized levels) spends G, which is a combination of n different public goods. The effect of consuming public good x_h by individual "i" will be inversely related to the distance between i's preferences and the median voters', which is defined by Panizza (1999) as α[θl_im + (1 - θ)l_ij]. Parameter α represents the degree of diversity in the spectrum of preferences among voters, θ is the degree of centralization, l_im is the distance of individual i from the national median, and l_ij is the distance between individual i and the local MV. This assumes that the degree of decentralization is the same regardless of the particular public good we are dealing with. Correspondingly, we can define the extent of proximity between voters' i and the median as K_hi = 1 - α_h[θ_hl_im + (1 - θ_h)l_ij]. Coefficient K_hi will only be one in case voter i coincides with the local as well as with the national MV.

As far as relative prices are concerned, the private good will be defined as a numerare (p_n+1 = 1). Voters are assumed to assign a specific price to each public good which relates to the level of taxes they pay. Public good prices will depend on the so called Scale Effect (SCE) parameter. This captures the cost saving effect of centralization. Since this effect differs across public goods, we can state that ∂ p_h/∂ θ_h ≤ 0 ∀ p_h > 0. It follows that the price being paid for the public good x_h will be an inverse function of the degree of centralization and the corresponding scale economies attached to the provision of that particular good. It will be assumed that all jurisdictions have the same number of tax payers, so that no reference is made to the effect of population itself in the unit price of public good h.

Given that the marginal utility from x_h depends on the quantity as much as on the quality of it (Faguet, 2001), a coefficient called π_h will be introduced to capture the probability that x_h posses exactly those characteristics being demanded by individual "i", so that π_h = π_h [θ_h] and π'_h< 0. A maximum quality will be achieved when π_h = 1. In the opposite case, a very low quality leads to n_h = 0. It will be assumed that the specific knowledge on the MV's needs being held by the current government is inversely related to the degree of centralization. Assuming that n different public goods and a single private good exist, every voter will express his demand on n + 1 options, of which n are public goods and the remaining one is a private good (it will be called "x_n+1").

Formally, this amounts to saying that every voter should express his preferences on every available option, such as that, x₁ ≥ 0, ..., x_h ≥ 0,..., x_n ≥0, x_n+₁ ≥ 0, where x₁,... , x_n represent the demands for every public good, and x_n+₁ is the demand for the private good. Prices are represented by p₁ > 0,... , p_h > 0,...,p_n > 0 for the n public goods, and p_n+₁ = 1 for the single private good. As opposed to Panizza (1999), individuals maximize a utility function "u", which entails an n + 1 dimensional solution (equation 1):

The solution for the generic public good xh and the private good x_n+1 for voter "i" is the following:

II. The Median Voter

Providing that all individuals settled down in particular jurisdictions chose their location on the basis of their preferences (Tiebout, 1956), and that space localization may be represented as a continuum of symmetrically distributed jurisdictions around the median voter, Panizza (1999) shows that the MV will choose a national level of x_h≠n+1 = x_m, such that x_m = μy_m / (μ + β) and μ = 1 - α [θ(S/4) + (1 - θ) (S/4J)], where 1 -μ may be interpreted as the ideological distance relative to the center, S is the country's territory and J is the number of jurisdictions.

In the context of a perfectly representative democracy, the national government decides on the level of decentralization by setting up an agenda, thereby it will try to centralize its power over the budget in order to maximize rents being produced from staying in power. As the political system becomes less representative, the ruling national government's power rises and so does its capacity to keep budget control by avoiding fiscal devolution to sub-national governments. Such a behavior confronts the wills of the national MV, whose problem may be presented as follows:

The solution to (3) will be:

where Sub index "m" stands for the MV. Note that results from (3) differ from (1) in the term μ_hm, which corresponds to the expression k_hi for the generic voter "i".

III. The Government's Problem

Sub-index m will be omitted from now on. By substituting 4a and 4b into 5, and assuming that n = 2, it can be shown that government's optimum θ_h for h = 1 hinges upon the following first order condition (equation 6), which assumes that MV's utility function is homogenous of degree one on the whole set of consumption options (see the appendix for details).

While the "non opportunistic'' component of government's behavior in equation 6 is being timed by φ, the opportunistic part is being timed by (1 - φ). Formally, it can be stated that three endogenous effects and a set of exogenous factors (ε) will determine government's optimum degree of centralization on x₁. Formally, this implies that θ*₁ = θ*₁ [μ'₁,π'₁,p'₁, ε], where θ*₁ stands for government's optimum. First, a more centralized delivery of public good h = 1 will rise the average ideological distance between individual voters and the median, turning this public good less representative of local preferences. Term μ'₁ accounts for this effect in equation 6. It will be called the Ideological Effect of centralization (IE). Second, regardless of the extent to which the specific characteristics of public good h = 1 fit voters' preferences, a more centralized delivery of x₁ worsens its quality (VHE), this being captured by π'₁. The effect on government's welfare depends on the strength of democracy (φ) and the degree to which a lower (higher) θ₁ expands (reduces) government's expenditures. Third, a lower (higher) θ₁ raises (reduces) the price of x_h, which further reduces (rises) demand for x₁ (SCE).

The term (γ₀) captures the opportunistic impact on u_gov caused by a θ₁ induced change on x₁ expenditure. Coefficient γ₁ (VHE) depends on the MV's welfare loss from more centralization on x₁ (φU_mp₁) and the effect on government's welfare from the potential for increased decentralized expenditure resulting from α rise in θ₁ (ρ₂). A similar interpretation should be given to g₁, although in this case the effect of a change in θ₁ is being channeled through π₁. Finally, γ₂ stands for the shift in demand for x₁ as a response to a decline on p₁ resulting from more centralization (SCE). Exogenous factors are accounted for in set ε. The following proposition is in order:

Proposition 1. In trying to set up the optimum degree of centralization, the central government will assign different degrees of centralization to different public goods. Government's optimum will differ across public goods, all of them being (potentially) different from each other regarding the median voter distance between the national median and the jurisdiction median for each particular public good, their quality sensitivity to decentralization (VHE), and the cost push effect of decentralization (SCE).

IV. Exogenous Factors

Variations in the model's exogenous variables will affect centralization as long as they change central government's marginal utility with respect to each public good's centralization level. Formally, this implies that first order condition (equation 6) should be differentiated with respect to the set of exogenous variables (ε). It follows that the central government will centralize more in case any derivative from equations 7a to 7c (bellow) is positive.

In a non democratic world (φ = 0) with a single public good "G", with neither VHE nor SCE (p'₁ , π'₁= 0), and identical preferences between the national and the local MV (μ'₁ = 0), a rise in MV's income will also rise the expenditure on this generic public good, which directly improves government's welfare (equation 7a)':

In a democratic context (φ > 0) the MV prevents these rents from being too high by reducing his demand for G, leading to a lower central government's marginal utility from centralization. Strictly speaking, this might be reversed if the opportunistic part in (7a) is larger in absolute terms than the non-opportunistic one, and 1-p₁ η¹_y > 0. The reason being that a low h and/or |p'₁| are likely to induce very little changes in central government's rents as a response to variations in the median income. Nevertheless, if we assume that p'_h< 0, π'_h< 0 and accept that n > 1, the impact of income on decentralization becomes less clear since a high income elasticity of this public good η^h_y> 1 may produce a substantial cost reducing effect, turning more centralization into a welfare winning option for the median as his income rises. We can state the following propositions:

Proposition 2: If π'₁ = 0, p'₁ = 0 and 1 - p₁ η¹_y≤ 0, an increase in the median voter's income unambiguously lowers government's marginal utility from centralization and leads to more decentralization. This result might be reversed if 1 -p₁ η¹_y> 0 and the opportunistic component in equation 7a is larger —in absolute terms— than the non opportunistic one. Since this is likely to be different across public goods, a rise in income will have different implications on every different public good.

Proposition 3: If π'₁≤ 0, p₁' < 0 and 1 - p₁ η¹_y≤ 0, proposition 2 still holds as long as 1 - η¹_y≤ 0. In case 1 - η¹_y> 0, the sign in 7a depends on how strong the SCE of centralization is.

As in Panizza (1999), S (surface) has an "ideological" impact on the median voter's welfare. A larger territory lowers μ_h (see the Appendix) and therefore raises 1 - μ_h, which is formally defined as the ideological distance relative to the center. In our analytical frame nevertheless, this is conditioned upon the specific nature of each different public good. For example, welfare implications resulting from public goods which mostly benefit a particular jurisdiction (as is the case of school and hospital infrastructure) are more likely to differ significantly between the local and the national MV. As expected, such a divergence diminishes as the national benefit becomes larger with respect to the local one. If public good-specificness were ruled out, a larger territory would lead to a rise in 1 -μ_h, which stands for the ideological distance from the center. Since this affects x₁ as well as x₂ it is not clear that MV's marginal utility —and also his demand— for x₁ will be reduced. On the one hand, the non opportunistic part in equation 7b will tend to be positive as long as the demand for x₁ rises along with S. This will be further strengthened if the scale effect (p'₁) is significant. On the other hand, the opportunistic component will also get larger as S raises the demand for x₁. The net effect on government's marginal utility from a change in S depends on the sign as much as on the magnitude of the opportunistic and non opportunistic components all together. Given that αis also common to all public goods, the above argument is equally valid as far as variations on population heterogeneity are concerned.

Proposition 4: Different degrees of population homogeneity (α) as well as different country sizes (S) have an ambiguous effect of θ_h. The net effect depends on whether changes on α and/or S rise or reduce the demand for x_h.

V. Conclusions

In the context of the model, a rise in the MV's income does not necessarily lead to more decentralization, as in the one public good case. On the one hand, more centralization benefits central government as public goods expenditure rises. On the other, given that public goods have different income elasticities, the cost reducing effect of centralization may further strengthen centralization for the median voter in some cases, making the net effect on FD ambiguous. Functional areas of government in which the cost benefit of centralization is very important are likely to be less centralized. Conversely, public goods in which the quality benefit of decentralization and/or the ideological sensitivity of widening the gap between the local and central MV is high, are likely to be more decentralized.

Both the country's territory and the degree of population diversity have ambiguous effects on the degree of FD chosen by the central government. Since these two variables affect all public goods, the net impact on FD depends on how strong the cost reducing effect is in one public good relative to all others. On the one hand, the non opportunistic part of government's behavior will push government to decentralize more as long as the demand for a specific public good rises as a response to a larger S and/ or α. This will be further strengthened if the scale effect (p'₁ ) is significant. On the other hand, the opportunistic component will also get larger as changes in S and/or α rises the demand for x₁.

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*The authors acknowledge the support from the Interministerial Commission on Science and Technology (CICYT: CSO2011-29346).