Identifying and disentangling the impact of fiscal decentralization on economic growth

• Published in: World development Vol. 127; p. 104742
• Main Authors: Canavire-Bacarreza, Gustavo, Martinez-Vazquez, Jorge, Yedgenov, Bauyrzhan
• Format: Journal Article
• Language: English
• Published: Oxford Elsevier Ltd 01.03.2020; Pergamon Press Inc
• Subjects: Causality; Decentralization; Economic development; Economic growth; Economics; Estimation; Fiscal decentralization; Geographic fragmentation index; Geography; Government spending; Impact analysis; Segmentation; E62; Geography; Fiscal decentralization; O47; Economic growth; H77; Geographic fragmentation index
• ISSN: 0305-750X; 1873-5991
• DOI: 10.1016/j.worlddev.2019.104742

•We revisit the relationship between fiscal decentralization and economic growth by addressing the endogeneity issue.•We use the Geographic Fragmentation Index (GFI) and country size as instrumental variables. Both are valid and strong.•We find that a ten-pp. increase in subnational expenditure shares will increase GDP per capita growth by 0.82 pp.•We also find that a ten-pp. increase in subnational revenue shares will increase GDP per capita growth by 0.57 pp. This paper revisits the relationship between fiscal decentralization and economic growth by addressing the endogeneity issue stemming from reverse causality and unobserved factors that has plagued previous extensive literature on this subject. In our approach, we use the Geographic Fragmentation Index (GFI) and country size as instrumental variables, which we argue are strong and consistent instruments for fiscal decentralization. Empirically, we find that indeed both instruments are strong and valid in the first stage of estimation and that on average, a 10 percent increase in subnational expenditure or revenue shares—the conventional measures of decentralization—will increase GDP per capita growth by approximately 0.82 and 0.57 percentage points, respectively.