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Unformatted text preview: n democracy (Rojas, 1999). In other countries, the poor performance of the central governments in
achieving macroeconomic stability, sustainable growth, and adequate level of public services has fueled the interest in 151 Commission on Fiscal Imbalance fiscal decentralization. Countries, such as India,7 Philippines,8 Columbia,9 and Brazil,10 have started assigning certain
functions of public sector to subnational governments in order to offloadthe burden from central government's shoulder
and rely more on lower level governments, which are often underutilized and have untapped revenue potential (Smoke,
In some developing countries, decentralization reforms are carried out without institutional and legal support
mechanisms and appropriate intergovernmental fiscal arrangements to support decentralized system. In these countries,
subnational governments fell short of meeting the expectations and decentralization has been blamed for
macroeconomic instability, regional inequalities and inefficiencies in the public sector.
Some macroeconomists argue that in a decentralized system, since policymaking becomes a responsibility shared by
different levels of government, circumvention of central control over monetary and fiscal policies may have aggravated
macroeconomic problems in these countries (Prud'homme, 1995; Tanzi, 1996). According to them, central governments
are better equipped in dealing with spillover effects of local spending, inflationary pressures of monetization of local debt
and cyclical shocks. To the extent that this line of argument highlights the potential problems arising from
decentralization when checks and balances of intergovernmental relations system are not in place, decentralization can
make matters worse. A good decentralization policy is not easy to design; clearly, it can be done well or badly (Bird and
Vaillancourt, 1999). 2.2. Stability
Empirical research on decentralization and macroeconomic governance gives little a priori support to the concerns that
decentralization is inherently destabilizing. Recent studies on the relationship between fiscal federalism and
macroeconomic governance find that “decentralized fiscal system offers a greater potential for improved
macroeconomic governance than centralized fiscal systems.”13 In fact, highly decentralized federal countries, such as
Switzerland, Germany, Austria, and USA, have very stable macroeconomic performance and low rates of inflation
The concern over macroeconomic instability in a decentralized system stems from different factors:
(i) local pursuit of independent demand management policies will be largely ineffective in small, open, local
(ii) uncoordinated local monetary policies will pose a severe inflation risk;
(iii) local debt will have national repercussions with an integrated capital market; and
(iv) economic shocks tend to be correlated across localities (Hemming and Spahn, 1997, p. 112).
In traditional Keynesian theory, fiscal policy is...
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