How Does Fiscal Decentralization Affect Fiscal and Governance-Related Performance?: Evidence From OECD Countries by Dynamic Panel Data Analysis

Introduction

The public sector efficiency is a crucial problem for both developed and developing countries in terms of recent public finance reforms. To solve that problem, governments are in search of various reforms, specifically with the globalization process. Decentralization, which is one of the most preferred solution tools, aims to gain efficiencies by devolving central governments’ authority on fiscal, policy and political topics to lower-level governments. Although decentralization has been a trend public reform since the 1980’s, its basis goes to 17^th and 18^th centuries in the philosophers’ thoughts, advocating small and democratic governments are better than autocratic central government for human liberties (Faguet, 2000). Therefore, as a constant agenda for public sector, fiscal decentralization is studied intensively both theoretical and empirical manner. As a pioneer advocator of the decentralization, the World Bank acknowledges decentralization as a vital instrument of development process specially for developing and transition economies. According to Bahl (1999) the rationale of decentralization can be defined by four elements. First is related to political expectations which defines the increasing demand on self-governance by both local administrators and voters, specially depend on democratic developments since 1980’s. Second is related to the economic side which emphasizes that local governments provide cheaper and more efficient public services rather than central government. Third is related to the urbanization and economic development relationship, which gives the cities more roles and responsibilities. By the urbanization, local units gained importance for both using public resources and deciding public services. Hence, this circumstance contributed to develop of decentralization process, by specially ensuring more adequate resources to the local units. Finally, some political and social disparities also made the decentralization as an important subject for policy makers.

Decentralization is a process and it requires transferring authority on three areas from central to local governments. In other words, decentralization occurs in terms of fiscal, policy and political. Fiscal decentralization is more popular than the others, because of its easy measurement and pervasive usage in the empirical literature. However, all of three parts of decentralization are interdependent and a shortage in one of them can damage the others’ efficiency. Conceptually, decentralization is related to an authority and its level. In this sense, policy decentralization is related to an authority for decision making on policies while political decentralization is related to availability an election in different government levels by ensuring an authority on governing themselves. Finally, fiscal decentralization is related to an authority on usage and acquisition financial resources. Surely, it is not possible to mention of availability of 100% decentralization in the world, however, the ratio of decentralization gives an information on a country’s decentralization picture. It is important, especially when doing an empirical analysis.

Fiscal decentralization requires sharing of both public functions and public revenues and its purpose to get efficiency by matching resources and needs accurately. The pervasive view in the literature is that local governments defines local needs better than central government, which refers an essential reason of the fiscal decentralization. However, it is only possible under the condition of sufficient resources by the local governments. Therefore, fiscal decentralization organizes fiscal issues, such as public expenditure, public revenue, and their imbalances in a systematic manner. The purpose of this chapter is to explore how fiscal decentralization effects fiscal and governance performance in OECD countries. To do this, firstly fiscal decentralization discussed in the theoretical framework, including the opposite views on its results. Secondly, the empirical literature of fiscal decentralization on fiscal and governance performance is illustrated. Finally, empirical results of the dynamic panel data estimation are given and results are compared with previous studies.