Fiscal decentralization : a political economy approach

Abstract

This study presents a theoretical approach to analyze income and welfare implications of fiscal decentralization in a static closed economy model where political factors are taken into account. We provide two alternative Scenarios: in one scenario government acts like a social planner and solves optimally for the level of fiscal decentralization; in the other scenario government is politically oriented and solves for the optimal tax rate. Under both scenarios we obtain non-cooperative solutions resulting from the interactions of the central government with local governments. Comparative statics of the model provide explicit solutions which enable us to derive policy implications. In order to get a better and deeper insight on the model, we also perform calibration and simulation analyses. We observe that benevolent government enhances social welfare whereas Leviathan CG enhances efficiency, measured by effective tax collection.