Fiscal Decentralization and Intergovernmental Finance Reform as an International Development Strategy

The text below is an excerpt from the complete document. Read the full paper in PDF format.

Abstract

Decentralization and intergovernmental finance have been a common element in international development efforts for many years. However, the success of fiscal decentralization as a development strategy is decidedly unclear, and there is growing skepticism about the effectiveness of (fiscal) decentralization as an international development strategy. This short essay explores the current state of knowledge with respect to fiscal decentralization and assesses the relevance of fiscal decentralization to the wider international development agenda, using the fiscal aspects of decentralization as an entry-point into the broader discussion of decentralization. A nuanced assessment of the potential effectiveness of fiscal decentralization reform around the world requires recognition of the following facts: (1) The intergovernmental dimension of public finance is critically important for the public sector to support economic growth and deliver public services in an effective and pro-poor manner. (2) Sound fiscal decentralization reforms require sound decentralized finances as well as sound decentralized governance and administration. (3) Not all countries are at the same stage of fiscal decentralization, and different policy responses are appropriate under different conditions. (4) There is an institutional bias against decentralized approaches in the implementation of international development projects. (5) Realistic expectations and realistic counterfactuals are needed about the benefits of fiscal decentralization in the developing country context. (6) It would be useful to engage in a systematic stock-taking of the state of knowledge surrounding fiscal decentralization and to foster a strong ongoing engagement on the topic to strengthen the practice of fiscal decentralization reforms and the reform of intergovernmental finances.

Introduction

Although fiscal decentralization reforms and intergovernmental finance have been an important element of international development activities over the past 25 years, fiscal decentralization and subnational finance have not always been approached with the same level of enthusiasm by the international development community. Almost invariably, the road to greater fiscal decentralization is described as having "dangers" (Prud?homme 1994), "pitfalls" (Tanzi 2001) and in need of "rethinking" (Litvack, Ahmad, and Bird 1998). A recent global conference of decentralization experts focused exclusively on the obstacles to decentralization around the world (AYSPS 2008), while a recent World Bank workshop highlighted local revenues and local regulation as major obstacles to economic development (Corthay 2009). The hesitant support for fiscal decentralization reforms in international development circles has been compounded by some recent evaluations of support to decentralization reforms in lesser developed and transitional economies, which have been relatively critical of the effectiveness of support to fiscal decentralization reforms (OECD/DAC 2004; World Bank IEG 2008).

Fiscal decentralization is commonly defined as the transfer of fiscal power and resources from the central government to subordinate or quasi-independent (subnational) government units. The fiscal federalism literature (e.g., Oates 1999) posits that numerous economic benefits arise from shifting public finances "closer to the people," including a more efficiently sized (smaller) public sector, improved allocative efficiency (as a result of a better match between the services supplied by the public sector and the needs of local communities), and a more competitive and innovative public sector. Whereas the potential benefits of fiscal decentralization reforms as presented in the fiscal federalism literature have been hard to measure and relatively abstract, anecdotal evidence of the practical concerns and potential costs of decentralized finance—macroeconomic instability, lack of fiscal discipline, inefficient public spending due to weak local administrative capacity, local corruption and local elite capture—often carry significant weight in policy debates surrounding the topic.

It is hard to dispel this critical view of decentralization. While there are some developing and transition countries where fiscal decentralization reforms have been relatively successful, it is indeed quite hard to come up with developing country examples where fiscal decentralization reforms have been an indisputable success story. Furthermore, to the extent that rigorous academic research has been done on the potential benefits of decentralization, little systematic evidence is available to confirm that decentralization is consistently a positive force in promoting economic growth, improved public service delivery, and poverty reduction. In fact, until fairly recently the biggest potential benefit of fiscal decentralization—improved public service delivery—has largely been ignored in the empirical decentralization literature. As a result, disappointingly little is known about the determinants of effective decentralized public service delivery.

Given the current state of knowledge on fiscal decentralization and the seemingly pervasive skepticism about its positive impact, it is appropriate to at least be concerned about the benefits of fiscal decentralization reforms in developing and transition economies and the ability of the development community to effectively support such fiscal decentralization reforms. Indeed, the uncertainty and skepticism begs the very real question whether international development organizations (whether international financial institutions such as the World Bank or bilateral development agencies such as USAID) should reduce or even eliminate altogether their support for fiscal decentralization reforms in favor of newer, experimental development approaches or in support of more traditional, "proven" development strategies (such as support for large-scale infrastructure projects).

The short answer to this question should be a resounding no. In fact, a strong argument can be made that fiscal decentralization (or more accurately, reform of intergovernmental finances) should play a more central role in the global development agenda.

(End of excerpt. The entire paper is available in PDF format.)

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Usage, posting and reprint of materials on the UI web site:

Most publications may be downloaded free of charge from the web site in PDF format. This information may be used and copies made for research, academic, policy or other non-commercial purposes. Proper attribution is required.

Copyright of the written materials contained within the Urban Institute website is owned or controlled by the Urban Institute. Posting UI research papers on other websites is permitted subject to prior approval from the Urban Institute—contact paffairs@urban.org.

If you are unable to access or print the PDF document please contact us or call the Publications Office at (202) 261-5687.