Chapter 55. Fiscal Decentralization

Fiscal decentralization is on the rise worldwide while barriers to factor and population mobility are declining. Greater decentralized government activity is therefore taking place in an economic environment characterized by increased competition for mobile resources, and government policy within this environment is increasingly cognizant of profound implications this combination of decentralization and mobility may have on political and economic outcomes. As these trends have become important, the academic literature across several disciplines in economics has paid increasing attention to the issues that arise from these trends. This chapter summarizes the progress that has been made in this literature in both theoretical and empirical dimensions while simultaneously pointing out some open questions for future research. Several important themes emerge: First, while simple versions of more general models have clarified many analytic issues, policy trade-offs are ultimately made in complicated settings rich with institutional detail. Thus, the search for a greater connection between theoretical models and data has taken on particular importance. Complex general equilibrium models of fiscal decentralization ultimately become most useful when underlying parameters within such models are determined by the data. Both calibration and structural estimation techniques are advancing this portion of the literature. Second, the last decade has seen an increasing emphasis on political forces in debates over fiscal decentralization. Not only does such decentralization carry with it potential economic benefits and costs, but political decisions are likely to be fundamentally different in a decentralized environment. Important further work on political institutions under fiscal decentralization is needed. Finally, as decentralization has been studied in multiple contexts, it has become increasingly clear that the micro-foundations of local goods and services need further theoretical and empirical investigations. Many such goods (such as crime prevention and schooling) depend on peer and neighborhood effects, and predictions can change fundamentally as such effects are introduced.