W HAT D RIVES F ISCAL D ECENTRALISATION

from all the issues linked to income redistribution) but that they differ in their tastes for the type of public good.2 Education is an example of * Economist in the Research Department of the Inter-American Development Bank. Email UGOP@iadb.org. 1 Vaubel (1966) studies the relationship between decentralisation and the presence of a federal constitution. 2 Since it is not possible to capture in a single model the richness of the vast literature on fiscal centralisation, the focus of the model described here is simplification and unification. The model extends the framework developed by Alesina and Spolaore (1997) and Alesina, Baqir and Easterly (1999) to an economy with two levels of government. publicly provided good on which preferences are often polarised: some citizens may prefer religious as opposed to secular schools or may favor the use of a specific language. It is assumed that the individuals are stratified and sorted according to their preferences for the public good. The degree of fiscal centralisation is defined as the share of public good that is produced by the central government (therefore, centralisation is 100 percent if all public goods are produced by the central government and centralisation is zero if all goods are produced by the local governments). The equilibrium level of centralisation is derived under the assumption that the central government is the first mover and decides the level of centralisation. While this assumption may seem at odds with democratic voting over the type and amount of public good, its theoretical background relates to the large political science literature that shows how the agenda setter can manipulate the final outcome of an election. After observing the level of centralisation, the citizens vote on the amount of the public good, and then on the type of the public good.3 On principle, anybody who promises to supply the type of public goods preferred by the median voter could play the role of central government, but only one individual can credibly commit to provide such type of public good: the “national” median voter herself. Besides sharing the preferences of the national median voter, the central government derives additional utility from staying in power. Following Brennan and Buchanan’s interpretation (1980), it is assumed that the utility that the government obtains from staying in power is a function of the budget it controls. Given the discretional power of the agenda setter, the central government will always be able to extract some rent. The level of democracy measures how much of this rent the central government is willing to extract as well as the level of utility that the government derives from the budget. The government maximises its utility function by solving the model backward. The last decision (and therefore the first to analyse) is on the type of public good. The next step is to determine the amount of the public good to be provided in equilibrium. By applying the median voter theorem, it is possible to show that the optimal quantity of public good is a weighted average of the median distance from the national median and the jurisdiction median and that the equilibrium level of fiscal centralisation is decreasing in: (i) the level of taste differentiation; (ii) the level of democracy; (iii) the level of income per capita and (iv) country size.4 What do the data say? The model discussed above generates four predictions. First, it suggests that, other things equal, countries with polarised preferences for the type of public good should be more decentralised than countries with homogeneous preferences. Hence, we should find a negative correlation between the level of centralisation and heterogeneity in the demand of public goods. Economic theory indicates that the key factors in determining demand are tastes and income. Since the model assumes constant income, the empirical analysis concentrates on the role of taste heterogeneity. The second result focuses on the role of democracy and suggests that we should find a negative correlation between the level of democracy and the degree of centralisation. The theoretical model suggests that perfect democracies should set centralisation equal to zero, and very repressive dictatorships should be fully centralized. The majority of countries included in the empirical analysis fall between these two extremes. Most of the real world governments are neither perfect democracies (because they are run by self-interested politicians with some agenda-setting power) nor perfect dictatorships (even dictators need to rely on the support of the group of people who put them in power). Furthermore, some public goods cannot be efficiently produced by the local governments (these are goods with large spillover; defense is an example of such a good). Hence, even perfect democracies will have levels of centralisation greater than zero. CESifo DICE Report 1/2004 22 Forum 3 The assumption of sequential decision-making reflects the budget process adopted in many countries (Alesina and Perotti 1999). The model considers two types of median voters: the “national” median voter and the median voter of a given jurisdiction. Given the assumption on the spatial distribution of individuals, the median voters are located at the center of the country and at the center of their jurisdictions, respectively. 4 The relationship between decentralisation and democracy is in line with Alesina and Spolaore’s finding (1997) that democratisation should be positively correlated with the equilibrium number of countries and it confirms the claim that their analysis can be applied to the division of a country into jurisdictions. This result is also consistent with Ades and Glaeser’s (1995) finding that dictatorships tend to have larger capital cities.