On the Determinants of Fiscal Centralization : Theory and Evidence

Across countries we observe very different institutional arrangements and very different levels of fiscal centralization. The recent years have witnessed strong movements for both decentralization and secession. At the same time, a divided country has reunified (Germany), large free trade zones have been created, and there have been important steps towards the economic and monetary union of some European countries. It is therefore natural that decentralization has been at the center of the political and economic debate in many countries. This paper attempts to identify empirical regularities explaining cross-country differences in the level of fiscal centralization. To set the stage for the empirical work, the paper presents a stylized model describing an economy with two levels of government, one public good, and one private good. The central government obtains utility from the size of its budget and the equilibrium level of centralization is determined by a sequential game were the central government moves first. While most of the existing literature approaches the issues studied in this paper from a normative point of view, the model consists of a positive} analysis of the determinant of fiscal centralization. The key findings of the theoretical model are that the level of fiscal centralization is inversely correlated with: (i) country size; (ii) income per capita; (iii) tastes differentiation; and (iv) level of democracy. The last point is particularly interesting because it explains the wave of decentralization that has followed the end of the Cold War. The model also shows that, while a democratic central government will choose the same level of centralization chosen by a social planner, a less democratic government will be able to appropriate the rents of centralization