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Unformatted text preview: f fiscal flows between central and subnational fiscal and financial institutions. Consequently, in order
for the decentralization to be effective and successful, the transfer of fiscal power from the center to the localities must
be supplemented by institutional arrangements that monitor the system. Such proper arrangements should enforce hardbudget constraints, motivate responsible behavior by the subnational governments, and reduce the possibility of
It is therefore important to recognize that fiscal decentralization does not necessarily lead to macroeconomic instability.
In fact, most countries choose to decentralize because of macroeconomic distress—that is in response to large central
budget deficits central governments are increasingly relying on local governments for service provision. In some
countries, decentralization is part of the fiscal adjustment strategy of the central government—pushing expenditure
responsibilities downward without designing an intergovernmental financial system that allocates revenue sources to
subnational governments. In the absence of appropriate rules that regulate intergovernmental relations, forcing local
governments to provide adequate level of services and maintaining a sustainable decentralized system is a difficult task:
when appropriate rules are not in place, the institutions of political control and accountability are not mature, and
administrative professionalism and control mechanisms are not developed, fiscal decentralization aggravates
macroeconomic problems. 14 Op. cit. Wildasin (1998). 153 Commission on Fiscal Imbalance Box -1: Empirical Studies on the Impact of Fiscal Decentralization on Public Sector Size
If greater decentralization increases number of alternative fiscal jurisdictions, any attempt to increase tax rates in one
jurisdiction would result in migration of its residents to another jurisdiction (Tiebout, 1956). In Tiebout's analysis,
taxpayers migrate to alternative jurisdictions in order to avoid higher taxes and interjurisdictional competition limit
excessive taxing power of the governments. Along with the lines of Tiebout, Brennan and Buchanan (1980) developed
the “Leviathan” hypothesis, which argues that fiscal decentralization serves as a constraint on the behavior of the
revenue-maximizing government. The "Leviathan" hypothesis predicts that the overall size of the public sector should
vary inversely with fiscal decentralization; fiscal decentralization increases competition among local governments,
which ultimately limits the size of the public sector. Empirical studies have tested the relationship between fiscal
decentralization and public sector size and reported conflicting results.
Studies Testing “Leviathan” Hypothesis
Oates (1985) Unit of Analysis
Cross-country comparison Findings
No significant relationship Nelson (1986)
Marlow (1988) United States
United States No significant relationship
Strong negative correlation Grossman (1989) Unit...
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