Decentralization and Political Institutions

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Decentralization and Political Institutions
  Centre for Economicand FinancialResearchatNew Economic School Decentralizationand PoliticalInstitutions Ruben EnikolopovEkaterina Zhuravskaya Working Paper No 65 CEFIR / NES Working Paper series  November 2006   1 Decentralization and Political Institutions ∗   Ruben Enikolopov ∗∗  and Ekaterina Zhuravskaya ∗∗∗  First draft: December, 2002 This draft: November, 2006 Abstract: Does fiscal decentralization lead to more efficient governance, better public goods, and higher economic growth? This paper tests Riker’s theory (1964) that the results of fiscal decentralization depend on the level of countries’ political centralization. We analyze cross-section and panel data from up to 75 developing and transition countries for 25 years. Two of Riker’s predictions about the role of political institutions in disciplining fiscally-autonomous local politicians are confirmed by the data. 1) Strength of national political parties significantly improves outcomes of fiscal decentralization such as economic growth, quality of government, and public goods provision. 2) In contrast, administrative subordination (i.e., appointing local  politicians rather than electing them) does not improve the results of fiscal decentralization. Email of corresponding author:  ∗  We thank Alberto Alesina, Scott Gelhbach, Sergei Guriev, James Hines, Rory MacFarquhar, Pierre Pestieau, Gérard Roland, Andrei Shleifer, Konstantin Sonin, Barry Weingast, Luigi Zingales, anonymous referees and seminar participants at the University of Michigan, CEFIR, NES, London Business School, University of California, Berkeley, Institute for Advance Study in Princeton, Harvard University, Princeton University, participants of CEPR-WDI 2003 Transition Conference and Fiscal Federalism workshop in Barcelona in 2005 for useful comments. We also thank Alexander Rumyantsev for excellent research assistance. The work of Ruben Enikolopov was in part supported by a program of the Bureau of Educational and Cultural Affairs, U.S. Department of State, administered  by the American Council for International Education. The views expressed herein are of the authors and not necessarily shared by ECA or AC. A part of the work on this paper took place when Ekaterina Zhuravskaya was on leave in the Institute for Advanced Study in Princeton. Hospitality and congenial environment of the Institute are gratefully acknowledged. ∗∗  Harvard University and Center for Economic and Financial Research (CEFIR), ∗∗∗  Center for Economic and Financial Research (CEFIR) at the New Economic School (NES) and CEPR,   2 1. Introduction Political incentives of public officials determine whether fiscal decentralization is  beneficial for public goods provision. We define fiscal decentralization as devolution of authority over public revenue and expenditure to lower-level government and use this term interchangeably with federalism. The three classic channels which make fiscal decentralization  beneficial – inter-jurisdictional competition (Tiebout, 1956), informational advantages (Hayek, 1948), and higher preference homogeneity (Oates, 1972) – all rely on the premise that local  politicians have political incentives to respond to the needs of local population. A classic cost of federalism – regionalist policies in the presence of inter-jurisdictional spillovers (Musgrave, 1969; Oates, 1972) – relies on the premise that political incentives of local politicians make them cater to their own constituency but ignore preferences of populations in other jurisdictions of the country. This logic gives rise to a trade-off between national and local preferences in political incentives of local officials in a federation. On the one hand, to realize the benefits of federalism, local politicians should have sufficiently high weight placed on the preferences of the population of their own jurisdiction. On the other hand, to minimize inter-jurisdictional externalities, local  politicians should place some weight on voter preferences in other jurisdictions of the country. Henceforth, we refer to the latter side of this tradeoff, i.e., to having local political incentives aligned with national interests, as political centralization. Since political incentives are shaped by  political institutions, a fiscally decentralized country needs political institutions that strike a  balance between the interests of local and national populations. Riker, in his seminal book  Federalism: Origins, Operation, Significance  (1964), named two political institutions that achieve political centralization: strong national political parties and administrative subordination (i.e., having central authorities appoint local governments rather   3than having them being elected). According to Riker, only strong national political parties achieve the necessary balance between national and local interests. On the one hand, even with very strong national political parties, the presence of local elections ensures political accountability of local politicians to their constituencies. On the other hand, strong national  parties align political incentives of local politicians with national objectives by affecting career concerns of local politicians. First, strong parties have higher leverage over promotions of local  politicians to national-level politics compared to weak parties. Second, political support of a strong national party during local elections is more valuable to local politicians than that of a weak party. Local politicians internalize inter-jurisdictional externalities of their policies in the search for promotion and political support by their national governing party because the party cares about national-level performance. In contrast to strong national political parties, administrative subordination weakens local accountability. It solves the problem of inter-jurisdictional externalities by having central-level  politicians reappoint only those local officials who are “well-behaved” from central officials’  point of view. This, however, undermines the benefits of federalism in the first place: in focusing on pleasing their bosses, appointed officials may stop caring for the preferences of local  population even though they know them better than central politicians. Recently, several papers pointed to an additional potential cost of federalism – “local capture,” namely, the situation when the influence of special interests on public policy is higher at the local compared to the central level (Blanchard and Shleifer, 2001; Bardhan, 2002; and Sonin, 2003). Blanchard and Shleifer (2001) indicated that, if local governments are more vulnerable to capture than central governments, then appointing local officials in a federation is  beneficial. This condition is very restrictive, however; and it could be the case that neither   4central nor local authorities serve broad public interests (Bardhan and Mookherjee, 2000). Note that if this condition holds, strong national parties also help alleviate local capture by creating career concerns to resist regional special interests. Modern literature has not reached consensus on the overall effect of decentralization in developing and transition countries. One strand of the theoretical literature argues that benefits of decentralization outweigh the costs (see, for instance, Montinola, Qian, and Weingast, 1995; Qian and Weingast, 1996; Qian and Roland, 1998; and Maskin, Qian, and Xu, 2000); whereas the other strand argues for the opposite (e.g., Prud’homme, 1995; Tanzi, 1996; Cai and Treisman, 2004; and Bardhan, 2002). Previous empirical studies of the effects of decentralization  produced inconclusive results that vary across samples and time periods. 1  This can be partly explained by the fact that these studies overlooked the importance of political institutions. Our paper sheds light on this debate by testing Riker’s two predictions about political centralization and finding solid empirical support to both. Using cross-section and panel data on up to 75 developing and transition countries for 25 years, we evaluate the effect of national  political party strength and appointments of local officials on outcomes of fiscal decentralization. Our findings are as follows. First, strong political parties (measured by the age of main parties and fractionalization of government parties) substantially improve the effect of decentralization on growth, public goods provision, and government quality. Second, administrative subordination of local authorities to higher-level governments (measured by dummies indicating 1  Fisman and Gatti (2002) and de Mello and Barenstein (2001) found negative effect of decentralization on corruption across countries; Treisman (2000) reported no relationship. Zhang and Zou (1998) reported negative effect of decentralization on provincial growth in China; whereas Jin et al. (1999) and Lin and Liu (2000) showed that this relationship is positive once one filters out cyclical effects. Akai and Sakata (2002) reported positive effect of decentralization on growth of US states in early 1990s; while Xie et al. (1999) showed no relationship over 50 years. Woller and Phillips (1998) found no link between decentralization and growth in developing countries; in contrast, Davoodi and Zou (1998) reported negative marginally significant relationship in developing countries and no effect in developed countries. Robalino et al. (2001) found negative cross-country relationship between decentralization and infant mortality.
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