Fiscal Decentralization for Inequality

Decentralization has been a significant topic for all policy makers around the world, particularly in developing countries, as some believe it can be the means to improve redistribution, which ultimately reduces inequality. However, Prud’homme shows that decentralized developing countries may face some capacity constraints which hinder achievement of this objective. As a result, fiscal decentralization may fundamentally be suitable only for developed countries.

The relationship between fiscal decentralization and inequality is complex, and many have tried theoretically and empirically to disentangle it. However, recent evidence is inconclusive. According to the theoretical literature, many sub-national governments should be involved in redistribution policies, since decentralized redistribution increases interjurisdictional competition among local governments. This creates ‘voting by the feet’ incentives à la Tiebout. Nevertheless, one will argue that such fiscal mobility yields a zero-sum situation that breeds new economic costs for all competing regions. Hence, from a dissenting point of view, if both redistributive policies and the preferences of local people regarding public goods and services are to be uniform in all jurisdictions, then central government should play a dominant role in the redistribution

Similarly, we cannot determine whether fiscal decentralization can affect inequality, as the empirical results are still ambiguous. By using developing and developed countries, Sepulveda and Martinez-Vazquez found that the size of government plays a substan- tial role in explaining the relationship between fiscal decentralization and distribution of income. In another study, Goerl and Seiferling showed that decentralization of redis- tributive spending appears to have no significant impact on income inequality. Meanwhile, Lessmann found that fiscal decentralization can significantly decrease income inequality.

In this study, we argue that the mixed results from the fiscal decentralization–inequality nexus is caused by a lack of understanding in identifying such connections based on in- direct mechanisms. The channel can, to some extent, be explained through institutional quality and military spending.